INFLATION
Part 1: An Overview
Part 2: Measures and Calculations
Part 1: Inflation—An Overview
The level of prices doesn’t matter…
…but the rate of change of price does

If wages and price level increase at the same time, then
the real value of your money has stayed the same!
Nominal wage: dollar amount of any given wage paid
 Real wage: the wage rate divided by the price level


INFLATION RATE (overall percentage increase of prices)
makes people poorer (because it outpaces wage
increases).
Inflation rate= Price level in Year 2 – Price level in base year X 100
Price level in base year
Three Main Economic Costs

1.
High rates of inflation impose significant economic cost
Shoe-Leather Costs: increased costs of transactions
caused by inflation

Menu Costs: the real cost of changing list prices
2.

3.

Ex. German Hyperinflation of 1921-1923
Ex. Brazil Supermarket workers
Unit-of-Account Costs: costs arising from the way
inflation makes money a less reliable unit of
measurement
All of these costs are felt more severely when the
inflation rate is severe
Winners and Losers from Inflation

Economic transactions, such as loans, often involve
contracts that extend over a period of time and
these contracts are normally specified in nominal
term.
 Nominal interest rate – the interest rate as
stated in the contract (i.e., a car loan with 7%
interest)
 Real interest rate – interest rate after
adjustment for inflation
Nominal interest rate – Inflation rate = Real interest rate
Winners and Losers from Inflation

If the inflation rate is higher than expected, borrowers win!
The money they pay back has lower real value (less
purchasing power) than the money they borrowed.
For this reason, long-term contracts are rare in regions with high
inflation.
 If lenders attempt to battle this by setting higher nominal
interest rates, borrowers lose!



If the inflation rate is lower, lenders win! The money they
receive back from the borrower is worth more than the
money they lent.
Inflation reduces the real interest rate of savings. Money in
the bank/invested is earning interest, but inflation cuts into
the value of the money saved and earned in interest (“real
interest rate”), so savers lose!
Inflationary Spirals
This increases
inflation
Inflation reduces
incentive to save,
so consumers
spend
Higher prices
cause workers to
demand higher
wages, which
increases cost of
production
This cause
demand-pull
inflation
Disinflation



Recessions/depressions bring down inflation.
Government actions to deflate (bring down the
inflation rate) can create a decrease in GDP, so the
government responds early (2% or so) in order to
minimize the impact of these policies.
Disinflation is NOT deflation. Deflation is a
decrease in price levels. Disinflation is a decrease in
the inflation rate.
To read more on the distinction between them:
http://www.nbcnews.com/id/7149156/ns/businessanswer_desk/#.UR58QR2ceSo
Cost-Push Inflation

Cost-push inflation occurs when certain inputs that are
universally important to business operations rise in
price (i.e., oil). For all businesses, this creates a
situation in which the cost of producing has gone up –
so many will choose to produce less.
Demand-Pull Inflation

Demand-pull inflation occurs when aggregate
demand is greater than aggregate supply. People
have money to spend and there simply isn’t enough
for consumers to buy.
Part 2: The Measurement and
Calculations of Inflation
Price Indexes and the Aggregate Price Level

Aggregate Price Level: measures the overall level
of prices in the economy.
To measure the average price changes for consumer
goods and services, economists track changes in the
cost of a typical consumer’s consumption bundle
 Market Basket: a hypothetical set of consumer
purchases of goods and services
What goes into the US Market Basket?
Market Baskets and Price Indexes


Economists track changes in the cost of buying a
given market basket. Working with a market basket
and a base year, we obtain a price index, a
measure of the overall price level.
Price Index: measures the cost of purchasing a
given market basket in a given year. The index
value is normalized so that it is equal to 100 in the
selected base year.
Trend of CPI since 1913
Formulas
Price index = Cost of basket for that year
X 100
Cost of market basket in base year
 Price index for the base year is always 100
 This is the method for calculating both Consumer
Price Index and Producer Price Index
Inflation rate
= PI in Year 2 – PI in Year 1 X 100
PI in Year 1
Consumer Price Index


Consumer Price Index (CPI): measures the cost of
the market basket of a typical urban American
family
CPI is used to accomplish two things:
 Simplify
the way we notice the changes in prices
 Measure inflation rates
Other Price Indices


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
GDP Deflator: for to measure change in nominal vs
real GDP; measures aggregate price level
Key Concepts (Part 1)




Rapid inflation imposes costs on society in the form
of: shoe-leather, menu, and unit-of-account costs
Nominal interest rate = real interest rate +
expected inflation
Unexpectedly high rates on inflation benefit
borrowers and hurt lenders. Unexpectedly low rates
of inflation hurt borrowers and benefit lenders.
If the inflation rate gets too high, the process of
reducing (disinflation) can be painful for the
economy
Key Concepts (Part 2)



Inflation is a broad measure of how fast overall
prices in the economy are rising. It’s important to
understand that some goods may actually be falling
in price, yet overall the economy is experiencing
inflation.
Creation of a price index allows economists to track
changes to overall price of a market basket of
items.
Consumer inflation is the rate of increase in the CPI