Learning Objectives

Chapter 07:Inflation

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Learning Objectives

• 07-01. Know how inflation is measured.• 07-02. Know why inflation is a

socioeconomic problem.• 07-03. Know the meaning of “price stability.”• 07-04. Know the broad causes of inflation.

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What Is Inflation?

• Inflation: an increase in the average level of prices, not a change in any specific price of a good.

• The prices of specific basket of goods are collected and computed into an average price level for that basket in a year.– A rise in that average price level is inflation.– A decrease in that average price level is

deflation.

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Relative Prices• The market mechanism causes the prices of

individual goods and services to rise or fall – an essential market function.– Relative price: the price of one good compared

to the price of other goods.– Buyers switch from one good to another when

their relative prices diverge.• Inflation is a rise in the average price of all

goods.– It is not a market function.

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Effects of Inflation

• Some prices rise and some fall.• Rising prices require you to reallocate your

purchasing power to ensure that you get the most satisfaction per dollar spent.– You might reduce buying goods with higher prices

and increase buying goods with lower prices.

• This can be seen by the difference between nominal income and real income.

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Effects of Inflation• Nominal income: the amount of money

income received in a given time period, measured in current dollars.

• Real income: income in constant dollars; nominal income adjusted for inflation.

• You may get a raise (nominal income increases) – but if it does not rise as fast as inflation, your purchasing power decreases (real income falls).

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Redistribution of Income and Wealth by Inflation

• Price effects.– Those who buy products that are increasing in

price the fastest end up worse off.– Those who sell products that are increasing in

price the fastest end up better off. – Those who buy products that are increasing in

price the slowest end up better off.– Those who sell products that are increasing in

price the slowest end up worse off.

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Redistribution of Income and Wealth by Inflation

• Income effects. – People with nominal incomes rising more

slowly than inflation end up worse off.– People with nominal incomes rising faster than

inflation end up better off.

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Redistribution of Income and Wealth by Inflation

• Wealth effects. – Those who own assets that are declining in real

value end up worse off.– Those who own assets that are increasing in

real value end up better off.

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Money Illusion• Money illusion: using nominal dollars rather

than real dollars to gauge changes in one’s income or wealth.

• Exercise:– In the “good old days” a movie ticket was 50 cents

and the minimum wage was $1.00.– Compare the purchasing power of the minimum

wage today to the “good old days.”– You could buy two movie tickets with one hour’s

work before, but not now.

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Macro Consequences of Inflation• Uncertainty: not knowing the prices of

goods in the future makes purchasing and production decision making much more difficult.

• Speculation: decisions will shift from standard economic activity to betting on the future prices of goods.

• Bracket creep: in a progressive tax system, when nominal incomes rise, the taxpayer gets pushed into a higher tax bracket.

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Deflation• Deflation: a general decrease in average

prices.• This has redistribution effects that are just the

opposite of those for inflation.• This has macro consequences also.– Sellers are reluctant to stock inventory.– Buyers are reluctant to buy now.– Businesses are reluctant to borrow funds or invest.– Incomes fall, and asset values decrease.

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Consumer Price Index (CPI)

• Consumer price index (CPI): a measure (index) of the average price of consumer goods and services. – Used to calculate the inflation rate.

• Inflation rate: the annual percentage rate of increase in the average price level.

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Creating a Price Index

• Select a “market basket” of goods: a standardized list of goods and services customers usually buy.

• Select a base year: the reference year whose dollar value will be used.

• Set the price index in the base year always equal to 100.

• Measure the prices for the basket of goods in both the current year and in the base year.

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Computing a Price Index

• Basket price in the base year = $6,000.• Basket price in the current year = $6,600.• Compute the price index (CPI) for the current year:

– X/100 = $6,600/$6,000– X = (6,600 x 100)/6,000– X = 110

• CPI in the current year is 110.• A CPI of 110 indicates that prices in the current year are

10% higher than prices in the base year.

Price index in current year Basket price in current yearPrice index base year = Basket price in base year

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Other Measures of Inflation

• Core inflation: changes in CPI, excluding food and energy prices.

• Producer price index (PPI): changes in the average prices at intermediate steps of production.

• GDP deflator: changes in prices of all goods and services included in GDP.– Used to correct nominal GDP to real GDP.

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Computing Inflation Rate from CPI

• CPI in 2006 was 201.6.• CPI in 2005 was 195.3.• Compute the inflation rate for 2006:• Inflation rate = (201.6-195.3)x100/195.3

= 3.23%

CPI year 2 – CPI year 1

Inflation rate = X 100 CPI year 1

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The Goal: Price Stability

• Price stability: the absence of significant changes in the average price level.– Officially defined as a rate of inflation of less

than 3 percent.– Established by Full Employment and Balanced

Growth Act of 1978.

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The Goal: Price Stability

• Measurement concerns.– We are seeking price stability at the lowest rate

of unemployment.– From year to year, there are quality

improvements in the basket of goods.– New products change the content of the basket

of goods we buy.

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Causes of Inflation

• Demand-pull inflation: results from excessive pressure to buy on the demand side of the economy.– A booming economy creates shortages.– Too much money pumped into the economy by

the Federal Reserve.

• Cost-push inflation: due to higher production costs putting pressure on suppliers to push up prices.

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Protective Mechanisms

• Cost of living allowances (COLA): nominal incomes are indexed to automatically rise at the same rate as inflation.

• Adjustable-rate mortgage (ARM): interest rate on a mortgage rises along with inflation so that lenders do not lose money.

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The Real Interest Rate• Real interest rate: the nominal interest rate

minus the anticipated inflation rate.– The borrower pays the nominal rate.– The inflation-adjusted (real) rate of interest:

– Protects the lenders. Hurts the borrowers.– Borrowers will pay back loan using more lower-

valued dollars, but lenders receive the same purchasing power.

Real interest rate = Nominal interest rate – Anticipated rate of inflation