ECON 2105: Inflation and Money

inflation

a general rise in the overall level of prices (rise in cost of living and a decline in purchasing power)

Consumer Price Index (CPI)

tracks average price consumers pay over time for a representative basket of goods

basket of goods

list of goods and services people typically buy

(PL now - PL last year) divided by (PL last year) all multiplied by 100

Formula for the inflation rate

deflation

general decrease in price level; can be a problem because people stop buying some goods in favor of cheaper alternatives

Inflation tells us that:

prices are __ % higher than last year

cost of living is __ % higher than last year

a dollar buys roughly __ % less than last year

Drawback of CPI

overstates changes in cost of living because It tracks the changing price of a fixed basket of goods

Quality Improvements

Introduction of New Products

Substitution

CPI Misses

substitution bias

the overestimation of the cost of living that occurs because people substitute toward goods whose prices rise by less

CPI is used for:

cost of living adjustments

Personal Consumption Expenditure (PCE) Deflator

includes items you consume but don’t directly pay for (medical care through employer)

Core Inflation

excludes food and energy because their prices are often volatile

Chained CPI

modified measure of CPI that corrects for changes in what people buy by updating the basket of goods monthly

Producer Price Index (PPI)

tracks the prices of inputs into the production process; helps businesses see how prices are changing

GDP Deflator

tracks prices of al goods and services produced domestically; includes prices of consumption goods, capital goods, government goods, and export goods

Uses of GDP Deflator

used when adjusting dollar amounts describing what an economy produces

(nominal GDP divided by real GDP) x 100

Formula for GDP Deflator (used to convert nominal GDP to real GDP)

Inflation Adjustment

used to adjust for changing prices and convert past dollars into today’s dollars

Todays dollars = (Past $) x (PL today/ Past PL)

Inflation Adjustment Formula

Nominal Variable

a variable measured in dollars whose value may fluctuate over time

Real Variable

a variable that has been adjusted to account for inflation

Real value in base year = (Nominal value in year t) x (PL in base year/PL in year t)

formula to convert nominal variables into real variables by adjusting them into dollars from a base year

Real Interest Rate

the interest rate in terms of changes in your purchasing power

Nominal interest rate

the stated interest rate without a correction for the effects of inflation

real interest rate = nominal interest rate - inflation rate

Real Interest Rate Formula

Money illusion

the mistaken tendency to focus on nominal dollar amounts instead of inflation adjusted amounts

Money illusion can:

distort decisions

lead to mis-pricing

creat nominal wage rigidity

medium of exchange

unit of account

store of value

Functions of money

Money as a medium of exchange

used to buy things and in exchange for work

Double coincidence of wants

the agreement from both parties to engage in trade; money eliminates this by creating opportunities for specialization

Money as a store of value

occurs when you save money and shift your wealth to the future

Money as a unit of account

common unit used to measure economic value; simplifies comparisons and tradeoffs; should be stable

Costs of inflation

undermines the productive benefit of money

Expected Inflation

can stabilize at the same rate as people come to anticipate a certain level of inflation

Costs of expected inflation

menu costs for sellers

shoe leather costs

menu costs

the cost of adjusting prices (reprinting menus and adjusting price tags); occurs because inflation made money an unstable unit of account

Shoe leather costs

costs incurred trying to avoid holding cash; Inflation undermines money’s function as a store of value; as price increases, money loses value

Costs of unexpected inflation

confuses the signals that prices send

inflation redistributes from savers and lenders toward borrowers

Costs of hyperinflation

erodes ALL functions of money

Inflation Fallacy

mistaken belief that inflation destroys purchasing power