Objectives:
 What is the economic cost of inflation?
 Why do policy makers try to maintain a
stable rate of inflation?
The Level of Prices Doesn’t
Matter…..
 Most common complaint about inflation…... is that
it makes everyone poorer
 But it doesn’t make everyone poorer
 Example: 2002 in France with the currency
conversion
 Rate of 6.55957 francs per euro
 All contracts were reinstated in euros at the same
exchange rate
 500,000 Francs because 76,224.51 Euros
The Level of Prices Doesn’t
Matter…..
 Not everything became cheaper because prices
were lower, wages and incomes also lower
 The real wage is the wage rate divided by the
price level.
 Real income is income divided by the price
level.
 The outcome: the level of prices doesn’t matter
…But the Rate of Change
of Prices Does
 Distinguish between the level of prices and the
inflation rate
 Inflation rate is the percent change per year in a price
index – typically the consumer price index
Price level in year 2 – price level in year 1
Inflation Rate =
X 100
Price level in year 1
The Price Level versus the Inflation Rate, 1968-2008
Inflation
rate
Price
Level
250
16%
14
200
12
10
150
8
100
6
4
50
2
1968
2008
1970
1980
1990
2000
Year
…But the Rate of Change
of Prices Does
 Economists believe that high rates of
inflation impose significant economic costs
 Most important costs:
 Shoe-Leather Cost
 Menu Costs
 Unit-of-Account Costs
Shoe-Leather Costs
 People hold money for convenience in making
transactions
 High inflation rate discourages people from holding
money because the purchasing power of the cash in
your wallet and the funds in your bank account
steadily erodes as the overall level of prices rises
 People search for ways to reduce the amount of
money they hold – sometimes at a considerable
economic cost
 Shoe-leather costs are the increased costs of
transactions caused by inflation
 They are an allusion
 Shoe-leather costs are substantial in economies with
very high inflation rates
Menu Costs
 Everything we buy has a listed price
 Menu costs are the real costs of changing
listed prices
 With inflation, have to change prices more
often than would if the price level was more
or less stable
 Higher costs for the economy as a whole
Unit-of-Account Costs
 Role of the dollar as a basis for contracts and
calculations is the unit-of-account role of money
 Can be easily degraded by inflation which causes the
purchasing power of a dollar to change over time
 Dollar next year is worth less than a dollar this year
 Unit-of-account costs of inflation are the costs
arising from the way inflation makes money a less
reliable unit of measurement
Winners & Losers from
Inflation
 High inflation rate imposes overall costs on
the economy
 The interest rate on a loan is the % of the
loan amount that the borrower must pay to
the lender, in addition to the repayment of
the loan amount itself
 Nominal interest rate vs. real interest rates
Winners & Losers from
Inflation
 Nominal interest rate is the interest rate that is
actually paid for a loan, unadjusted for the effects of
inflation
 Interest rates on student loans, and loans at banks
 Real interest rate is the nominal interest rate adjusted
for inflation
 Subtract the inflation rate from the nominal
interest rate
 Nominal Interest rate of 8% - inflation rate of 5%
= real interest rate of 3%
Winners & Losers from
Inflation
 Borrower and Lender enter a contract, the
contract specifies a nominal interest rate
 If the actual inflation rate is higher than
expected, borrowers gain at the expense of
lenders
 Borrowers will repay their loans with funds that
have a lower real value than had been expected
 Can purchase fewer goods and services than
expected due to high inflation rate
Winners & Losers from
Inflation
 If inflation rate is lower than expected,
lenders will gain at the expense of borrowers
 Borrowers must repay their loans with funds that
have a higher real value than had been expected
Inflation is Easy;
Disinflation is Hard
 Disinflation is the process of bringing the
inflation rate down
 Policy makers always try to bring inflation
back down when it goes above 2% or 3%
 The best way to avoid putting an economy
through a wringer is to reduce inflation
The Cost of Disinflation
Inflation
rate
Inflation
rate
12%
16%
14
12
10
10
8
8
6
6
4
2
1978
1980
1982
1984
1986
Year
1988
Objectives:
 How is the inflation rate measured?
 What is price index and how is it calculated?
Aggregate Price Level
 The aggregate price level is a measure of the
overall level of prices in the economy
 How can someone summarize all the prices
of all goods and services in an economy with
a single number?
 Through price index
Market Baskets & Price
Indexes
Pre-Frost
Post-Frost
Price of Orange
$0.20
$0.40
Price of Grapefruit
0.60
1.00
Price of Lemon
0.25
0.45
1. How much has the price of fruit increases?
2. Consumption bundle – the typical basket of goods and
services purchased before the price changes
3. Market Baskets is a hypothetical set of consumer
purchases of goods and services
Pre-Frost
Post-Frost
Price of Orange
$0.20
$0.40
Price of Grapefruit
0.60
1.00
Price of Lemon
0.25
0.45
Cost of Market Basket
(200 oranges, 50
grapefruit, 100 lemons)
(200 x $0.20) + (50 x
0.60) + (100 x 0.25) =
$95.00
(200 x $0.40) + (50 x
1.00) + (100 x 0.45) =
$175.00
 Economists use this method to calculate changes
in the overall price level, track changes in the
cost of buying a given market basket
 Price index is the overall price level
 It is always cited along with the year for which the
aggregate price level is being measured and the base
year
Price index in a
given year =
Cost of market basket in a given year
X 100
Cost of market basket in a base year
 Price index is used to calculate consumer price index
and producer price index
 Price indexes are a basis for measuring inflation
Consumer Price Index
 Consumer price index (CPI) measures the
cost of the market basket of a typical urban
American family
 Intended to show the costs of all purchases by
a typical urban family has changed over time
 Calculated by surveying market prices for a
market basket that is constructed to represent the
consumption of a typical family of four living in a
typical American city
 Does not use a single base year but two
Consumer Price Index
 Economists believe that the consumer price
index systematically overstates the actual rate
of inflation
1. CPI measures the cost of buying a given
market basket
 Consumer alter the mix of goods and services
they buy, reducing the purchases of products that
have become relatively more expensive and
increasing purchases of products that have
become relatively cheaper
Consumer Price Index
2. Innovation
 Many goods now didn’t exist
 Widening of the range of consumer choice –
innovation makes a given amount of money
worth more
 CPI somewhat overstates inflation when we
think of inflation as measuring the actual
change in the cost of living of a typical urban
American family
Other Price Measures
 Producer Price Index (PPI) measures the cost
of a typical basket of goods and services,
containing raw commodities such as steel,
electricity, coal, and so on – purchased by
producers
 Responds more quicker to inflationary or
deflationary pressures
 “early warning signal” of changes in
inflation rate
Other Price Measures
 GDP deflator is not a price index but it serves
the same purpose
 The GDP deflator for a given year is equal to
100 times the ratio of nominal GDP for that
year to real GDP for that year expressed in
prices of a selected base year