Inflation Unit 6 Flashcards

This flashcard set covers the definitions of inflation and deflation, measurement indices like CPI, GDP Deflator, and PCE Deflator, and the social costs of both expected and unexpected inflation.

Inflation

An overall increase in prices, typically measured using the price level.

Deflation

Deflation is the opposite of inflation. Characterized by an overall decrease in the level of prices.

Price Level

The average level of prices in the economy.

Inflation is typically measured using the price level.

Classical Response to Inflation (Unit of Measurement Analogy)

The view that inflation is seen as only changing the units of measurement (moving from one price level to another is like moving from feet to inches) but the total distance (real value) does not change, only the numbers used to represent it change.

Consumer Price Index (CPI)

a measure of how the prices of everyday goods and services change over time, which is computed monthly by the Bureau Labor Statistics (BLS).

Market Basket

a collection of various goods and services that are commonly purchased by an average urban consumer within a month. This basket is used to track changes in the price levels over time, allowing economists to measure inflation by comparing the current cost of this basket to its cost in a base year.

Comparative measurement

When you measure something by comparing it to a base value (a reference point) instead of just looking at its original number. It tells you how much something is bigger, smaller, or changed relative to something else.

Base Year

The year whose prices are used as a reference point for a price index, in which the index value is always $100$.

CPI Formula

$$\text{CPI} = \frac{\text{Cost of the basket in current period}}{\text{Cost of the basket in the base period}} \times 100$$

Inflation Rate Formula

$$\text{Inflation Percentage} = \frac{\text{New CPI} - \text{Old CPI}}{\text{Old CPI}} \times 100$$

Substitution Bias

A potential problem with the CPI because it uses fixed baskets which cannot reflect the fact consumers' often substitute towards goods whose relative prices have fallen.

BASICALLY: when inflation is measured too high because the price index does not fully account for consumers switching from expensive goods to cheaper substitutes.

Introduction of New Goods

A problem with the CPI where new goods often make consumers better off, increasing the value of their dollar, but are not reflected because the CPI uses fixed baskets and cannot compare old products with new ones that just released into the market.

Unmeasured changes in Quality

A problem with the CPI where improvements in the quality of goods, increase the value of the dollar but are often not fully measured.

For example, if a smartphone now has a better camera, it's worth more than an older model.

GDP Deflator Formula

$$\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$$

Capital Goods

Included in the GDP deflator (if produced domestically) but excluded from the CPI.

Imported Consumer Goods

Included in the CPI but excluded from the GDP deflator.

PCE Deflator

a measure of inflation that tracks changes in the prices of goods and services consumed by households over time.

How PCE is similar to CPI

It only includes consumer spending and imported consumer goods.

Core Inflation

Excludes the prices of food and energy to provide a clearer view of long-run underlying inflation trends. It helps address the issue of volatility (prices changing a lot and very quickly)

Nominal Interest Rate ($i$)

The stated interest rate on a loan or investment, not adjusted for inflation. (think of the interest rate being fixed no matter how much inflation changes that year or the next)

Real Interest Rate ($r$)

The interest rate after accounting for inflation. In other words, it tells you how much your purchasing power actually increases (or decreases), not just how many dollars you gain.

Real interest rate example

Example

Suppose:

Nominal interest rate = 6%

Inflation rate = 2%

Then: Even though you earned 6% more dollars, prices also rose by 2%, so your actual gain in purchasing power is only 4%.

Real Interest Rate Equation

Shoe Leather Cost

The inconvenience and cost of reducing money holdings during inflation because an individual has to walk to the bank more often.

Menu Costs

The literal costs of changing prices, such as reprinting menus or updating systems.

Tax Law Distortion

A cost of expected inflation where laws do not account for price changes, such as in the taxation of stocks.

Unexpectedly High Inflation (Borrowers)

A condition that helps borrowers because they pay back their debt in less valuable dollars.

Unexpectedly High Inflation (Lenders)

A condition that hurts lenders because the money repaid to them has less purchasing power than expected.

Fixed Pensions

Retirement payments that cause holders to be harmed by unexpectedly high inflation because they receive a fixed payment while the cost of living increases.

Unexpected Deflation (Firms)

A condition that harms firms because they receive less than expected for their output, which can cause labor distortions if margins are small.

Bureau of Labor Statistics

The government agency responsible for computing the Consumer Price Index each month.

Capital goods definition

goods that businesses buy to produce other goods and services.