AP Economics
Mr. Bernstein
Module 14:
Inflation: An Overview
January 2016
AP Economics
Mr. Bernstein
Inflation: An Overview
• Objectives - Understand each of the following:
• The economic costs of inflation
• How inflation creates winners and losers
• Why policy makers try to maintain a stable rate of
inflation
• The difference between real and nominal values of
income, wages and interest rates
• The problems of deflation and disinflation
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AP Economics
Mr. Bernstein
Price Levels don’t matter, Relative Prices do
• If the price of gas doubles, one can only drive half
as much…unless income also doubles!...in this
case real income was flat
• The rate of change is therefore important, not the
absolute value of price changes
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AP Economics
Mr. Bernstein
Price Levels don’t matter, Relative Prices do
• Inflation rate = (Price level, year 2 – Price level,
year 1) / (Price level, year 1) x 100
• Costs of inflation
• Shoe leather costs
– Effort spent by consumers seeking lower prices or substitutes
• Menu costs
– Effort spent by businesses realigning pricing strategies
• Unit of Account costs
– Tax increases based on inflating asset values may not be
matched by income increases
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AP Economics
Mr. Bernstein
Winners and Losers from Inflation
• Borrowers pay back loans in dollars with reduced
purchasing power
• Nominal Interest Rates = Real Interest Rates +
Expected Inflation
• So when inflation exceeds expectations, the
borrower benefits; when inflation is below
expectations, the lender benefits
• Inflation can redistribute income from those that
are hurt by rising prices to those who gain from
rising prices
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AP Economics
Mr. Bernstein
Inflation is Easy; Disinflation is hard
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Inflation is a rise in overall price levels
Deflation is a decline in overall price levels
Disinflation is the reduction in inflation rates
Most obvious policy to bring about disinflation is
Monetary Policy (reduce money supply)
• Can be painful because it causes a reduction in the
demand for goods and services, which in turn causes a
reduction in demand for labor
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