Inflation
sustained increase in overall price level of goods and services in an economy over time
CPI
measures the average price level faced by consumers
index # assigned to each year that show how prices have changed relative to a specific base year
price level
- average level of prices in the economy at a given time
- measured using price indexes like the CPI
- does not affect real purchasing power because wages and incomes adjust proportionally
inflation rate
percentage change in the price level from one period to the next
( (CPI (new) - CPI (old) ) / CPI (old) ) * 100
Key Causes of Inflation
Demand-Pull Inflation
when aggregate demand increases faster than aggregate supply
cost-push inflation
production costs increase and aggregate supply shifts left
inflation vs deflation
- inflation = rising price level
- deflation = sustained decrease in teh price level
deflation increases the real value of debt - harms borrowers
shoe-leather costs
- costs from people reducing money holdings to avoid losing purchasing power
- includes extra trips to bansk and financial institutions
menu costs
real costs of changing listed prices
increases when inflation is high because prices must be changed more often
unit of account costs
- inflation makes money a less reliable unit of measurement
- causes confusion in contracts, budgeting, and tax calculations
Winners from Unanticipated Inflation
- borrowers benefit if inflation is higher than expected
- repay loans with money that is worth less in real terms
losers from unanticipated inflation
- lenders lose because repayments have lower purchasing power
- people on fixed incomes are hurt if pyments are not indexed
disinflation
- process of reducing the inflation rate
- achived through tight monetary policy
- costly and usually causes higher unemployment in the short run
constructing CPI
- determine market basket of goods/services
choose base year
calculate cost of each basket
use formula: (Cost of basket (cy) / cost of basket (by) ) x 100
Calculating Inflation rate
( (CPI2 - CPI1 ) / CPI1 ) * 100
calculating dollar values / prices across time periods
value in year y dollars = value in year z dollars x CPI Y/CPIZ
real value
nominal value / CPI x 100
real wage
nominal wage / price level
real interest rate
nominal interest rate - inflatiion rate
the BLS
bureau of labor statistics
federal agency responsible for calculating CPI, inflation rate, employment data
limitations of CPI
substitution bias - consumers switch to cheaper alternatives
production innovation - new products increase consumer value but aren’t fully captured
quality improvements - cpi struggles to measure improevd quality accurately
CPI may overstate the true cost of living increase
PPI - producer price index
measures prices paid by producer – acts as an EARLY warning for inflation
GDP deflator
(nominal GDP / real GDP ) * 100
