Chapter 22: Inflation

Inflation

A general and ongoing rise in the level of prices in an entire economy. Does not refer to a change in relative (individual) prices. There is pressure for prices to rise in most markets in the economy.

Basket of Goods and Services

A hypothetical group of different items, with specified quantities of each one meant to represent a “typical” set of consumer purchases. Used to calculate the price level, by looking at how the prices of those items change over time. Computed using a weighted average.

Index Number

A unit-free number derived from the price level over a number of years, which makes computing inflation rates easier, since the index number has values around 100. No dollar signs or other units attached

Base Year

Arbitrary year whose value as an index number economists define as 100

Inflation Calculation

(Level in new year - Level in prior year)/Level in prior year x 100 = Percent Change

Consumer Price Index (CPI)

A measure of inflation that U.S. government statisticians calculate based on the price level from a fixed basket of goods and services that represents the average consumer's purchases

Substitution Bias

An inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise considerably

Quality/New Goods Bias

Inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not account for improvements in the quality of existing goods or the invention of new goods

Other Goods and Services

3%

Education and Communication

7%

Recreation

6%

Medical Care

9%

Transportation

15%

Apparel

3%

Food and Beverages

15%

Housing

42%

Core Inflation Index

Takes the CPI and excludes volatile economic variables, like energy and food price. Economists can have a better sense of the underlying trends in prices that affect the cost of living. A preferred gauge from which to make important government policy changes

Producer Price Index (PPI)

A measure of inflation based on prices paid for supplies and inputs by producers of goods and services. Different industries, commodities, and stages of processing.

International Price Index

A measure of inflation based on the prices of merchandise that are exported or imported

Employment Cost Index

A measure of inflation based on wages paid in the labor market

GDP Deflator

A measure of inflation based on the prices of all the GDP components (consumption, investment, government, exports minus imports)

Notable Waves of U.S. Inflation

After WWI, after WW2, the 1970s

Deflation

Severe negative inflation. When most prices in the economy are falling.

Notable Periods of U.S. Inflation

Following the 1920-21 recession, the Great Depression of the 1930s.

Hyperinflation

An outburst of high inflation that often occurs (although not exclusively) when economies shift from a controlled economy to a market-oriented economy

People Hurt Inflation When

They are holding cash, they have financial asset investments where the nominal return does not keep up with inflation (also can be exacerbated by taxes), wages lag behind inflation (wage adjustments are often somewhat sticky and occur only once or twice a year), they are a retiree receiving a private company defined pension

Indexed

A price, wage, or interest rate is adjusted automatically for inflation

Cost-of-living adjustments (COLAs)

A contractual provision that wage increases will keep up with inflation

Adjustable-Rate Mortgage (ARM)

A type of loan a borrower uses to purchase a home in which the interest rate varies with market interest rates

Examples of indexing arrangements in government programs

The U.S. income tax code is designed so income levels where higher tax rates kick in are indexed to rise automatically with inflation. The level of Social Security benefits increases each year along with the Consumer Price Index. U.S. government offers indexed bonds promising to pay a certain real rate of interest above whatever inflation rate occurs.