Inflation and Nominal vs. Real Values - Week 8

Inflation

A sustained increase in the price level of an economy (prices are on average 3% higher than they were a year ago’).

Price level

The average level of prices in an economy

Deflation

A sustained decrease in the price level of the economy

Demand - pull inflation

Caused by an increase in the demand- side activities of the economy

Cost - push inflation

Caused by an increase in the cost production (higher input prices)

Consequences of high inflation

• an increase in the cost of living, as things become more expensive

• a decrease in purchasing power of the people in the economy (a decrease in real income)

• a decrease in purchasing power (a decrease in real interest rate)

  Savers lose (a decrease in real value of savings)

• Lenders lose & borrowers gain

• a regressive effect if prices of food, water and electricity rise rapidly

• menu costs: costs of having to change the price tags and menu lists (reduced by better technologies)

Uncertainty of inflation

Volatile and high inflation rates makes decisions difficult for businesses (not sure about the costs of businesses and prices of the products) as well as for households (how much to spend/save), therefore affecting business and consumer confidence. UK government aims for 2% inflation rate to indicate stability

Price index

Expresses the cost of a ‘basket’ (set) of goods and services relative to its cost in some ‘base’ period

Consumer Price Index (CPI)

is calculated using a ‘basket’ of goods & services consumed by a typical urban household

GDP deflator

is calculated using a market basket of every item in the GDP

Producer Price Index (PPI)

Is calculated using prices of goods & services received by domestic producers for their outputs

Issues with CPI

• the value depends on what’s in the baskt; it does not capture the changes in the consumption behaviour when the relative prices change (substiution bias), and new products may not go into the basket promptly (new product bias)

• a price increase could mean an increase in the quality of a product, rather than just a price increase (quality bias)

• We may change where to buy things (eg. online) but the basket may include items sold at stores

Issues with GDP delfator

Focus only on goods and services produced domestically

Nominal values

Are represented in current monetary values

Real values

Are represented in “constant” monetary values, using the prices of a chosen base year to adjust for inflation

Real value formula

nominal value/price index x 100