macroeconomics inflation

inflation

A sustained increase in the overall price level of goods and services in an economy. As prices rise, each dollar buys fewer goods and services.

Deflation

A decrease in the overall price level of goods and services.

Disinflation

A decrease in the inflation rate. Prices are still increasing, but they are rising more slowly.

Purchasing Power

The amount of goods and services that money can buy.

Why does inflation matter?

It reduces purchasing power, changes the cost of living, creates uncertainty, affects spending and saving decisions, and influences the standard of living.

How can income rise while purchasing power falls?

If income rises by 3% but prices rise by 5%, purchasing power falls because prices increase faster than income.

Price Index

A measure that tracks changes in the prices of goods and services over time.

Four common measures of inflation

CPI (Consumer Price Index), GDP Deflator, PPI (Producer Price Index), and PCE (Personal Consumption Expenditures) Index.

Consumer Price Index (CPI)

Measures the prices consumers pay for a fixed basket of goods and services.

Step 1 of constructing the CPI

Determine the basket of goods and services typically purchased by consumers.

Step 2 of constructing the CPI

Collect the prices of the goods and services in the basket.

Step 3 of constructing the CPI

Calculate the total cost of purchasing the basket.

Step 4 of constructing the CPI

Choose a base year for comparison.

Step 5 of constructing the CPI

Calculate CPI using: (Cost of Basket in Current Year ÷ Cost of Basket in Base Year) × 100.

Step 6 of constructing the CPI

Calculate the inflation rate using the percentage change in CPI from the previous year.

CPI Formula

CPI = (Cost of Basket in Current Year ÷ Cost of Basket in Base Year) × 100.

Inflation Rate Formula

Inflation Rate = [(CPI This Year − CPI Last Year) ÷ CPI Last Year] × 100.

What does a CPI of 100 mean?

The basket costs the same as it did in the base year.

What does a CPI above 100 mean?

The basket costs more than it did in the base year.

What does a CPI below 100 mean?

The basket costs less than it did in the base year.

Substitution Bias

A limitation of CPI that occurs because consumers switch to relatively cheaper goods when prices change, while the fixed basket does not fully reflect this behavior.

New Goods Bias

A limitation of CPI caused by new products that expand consumer choices and may improve living standards.

Quality Changes

A CPI measurement problem that occurs when products improve over time, making it difficult to separate price increases from quality improvements.

Why may CPI overstate increases in the cost of living?

Because it may not fully account for substitution toward cheaper goods, new products, and quality improvements.

GDP Deflator

Measures the prices of all domestically produced final goods and services.

CPI vs. GDP Deflator: imports

CPI includes imported consumer goods; the GDP Deflator excludes imports.

CPI vs. GDP Deflator: basket

CPI uses a fixed basket; the GDP Deflator reflects current domestic production.

CPI vs. GDP Deflator: coverage

CPI focuses on consumer purchases; the GDP Deflator covers all domestically produced final goods and services.

Which index includes domestically produced capital goods?

The GDP Deflator.

Which index includes imported consumer goods?

The Consumer Price Index (CPI).

Producer Price Index (PPI)

Measures changes in prices received by domestic producers for their goods and services.

Personal Consumption Expenditures (PCE) Index

A measure of prices associated with personal consumption expenditures.

Nominal Value

A value measured using current prices without adjusting for inflation.

Real Value

A value adjusted for inflation to account for changes in purchasing power.

Why do economists use real values?

To compare purchasing power and economic values across different time periods more accurately.

Real Value Formula

Real Value = (Nominal Value ÷ Price Index) × 100, when the price index is expressed with a base of 100.

Deflating a nominal value

The process of adjusting a nominal value for inflation to calculate its real value.

Demand-Pull Inflation

Inflation that occurs when spending increases faster than the economy's ability to produce goods and services.

What phrase describes demand-pull inflation?

Too much spending chasing too few goods.

Cost-Push Inflation

Inflation that occurs when production costs increase, causing firms to raise prices.

Three causes of cost-push inflation

Rising energy prices, supply disruptions, and higher raw-material costs.

How can rising production costs cause inflation?

Firms may increase prices to maintain profitability when their production costs rise.

Real Income

Income adjusted for inflation to reflect purchasing power.

Approximate Change in Real Income

Change in Real Income ≈ Change in Nominal Income − Inflation Rate.

Real Interest Rate

The interest rate adjusted for inflation, representing the approximate increase in purchasing power from saving or lending.

Real Interest Rate Formula

Real Interest Rate = Nominal Interest Rate − Inflation Rate.

Example of calculating the real interest rate

If the nominal interest rate is 7% and inflation is 3%, the real interest rate is approximately 4%.

Who is often hurt by unexpected inflation?

Fixed-income recipients, savers, creditors, and lenders.

Why can inflation hurt savers?

The purchasing power of savings may fall if interest earned does not keep up with inflation.

Why can inflation hurt creditors and lenders?

They may be repaid with money that has less purchasing power than when they lent it.

Who may be protected from inflation?

Workers receiving cost-of-living adjustments (COLAs) and individuals whose income automatically adjusts for inflation.

Cost-of-Living Adjustment (COLA)

An adjustment to income or benefits intended to help keep up with increases in the cost of living.

Why can borrowers benefit from unexpected inflation?

They may repay loans with dollars that have less purchasing power than the dollars they originally borrowed.

Hyperinflation

Extremely rapid and uncontrollable increases in the overall price level.

Four consequences of hyperinflation

Money loses value quickly, businesses struggle to set prices, savings lose value, and investment and production decline.

What happens to money during hyperinflation?

It rapidly loses purchasing power.

Unemployment Rate

The percentage of the labor force that is unemployed and actively seeking work.

Employed

People who work for pay, are self-employed, or work without pay in a family business.

Unemployed

People who do not have a job, have actively searched for work during the previous four weeks, and are available for work under the standard labor-force definition.

Not in the Labor Force

People who are neither employed nor actively looking for work.

Labor Force

The total number of employed people plus unemployed people actively seeking work.

Labor Force Formula

Labor Force = Employed + Unemployed.

Unemployment Rate Formula

Unemployment Rate = (Unemployed ÷ Labor Force) × 100.

Labor Force Participation Rate

The percentage of the adult population that is in the labor force.

Labor Force Participation Rate Formula

(Labor Force ÷ Adult Population) × 100.

Example: unemployment rate

If 90 people are employed and 10 are unemployed, the labor force is 100 and the unemployment rate is 10%.

Example: labor force participation rate

If the labor force is 100 and the adult population is 200, the labor force participation rate is 50%.

Who counts as unemployed?

Someone without a job who is actively looking for work and meets the official criteria.

Who does not count as unemployed?

Someone without a job who is not actively looking for work; they are classified as not in the labor force.

Discouraged Workers

People who want a job but have stopped looking because they believe suitable jobs are unavailable.

Why are discouraged workers not counted as unemployed?

They have stopped actively searching for work, so they are classified as not in the labor force.

Underemployment

A situation in which people work fewer hours than they want or work in jobs that do not fully use their skills; people working part-time because they cannot find full-time work are still counted as employed.

Why can the unemployment rate understate labor market problems?

It does not count discouraged workers as unemployed and counts underemployed part-time workers as employed.

Full Employment

A situation in which cyclical unemployment is zero, not a situation in which all unemployment disappears.

Natural Rate of Unemployment (NRU)

The unemployment rate that exists when cyclical unemployment is zero and frictional and structural unemployment remain.

Which types of unemployment exist at the natural rate?

Frictional and structural unemployment.

Frictional Unemployment

Short-term unemployment that occurs while people search for jobs or transition between jobs.

Characteristics of frictional unemployment

It is usually short-term, often voluntary, and exists even in a healthy economy.

Structural Unemployment

Unemployment that occurs when workers' skills do not match the jobs available.

Three causes of structural unemployment

Technological change, changes in consumer demand, and shifts in industry composition.

Why is structural unemployment often long-lasting?

Workers may need new skills, education, or training to qualify for available jobs.

Cyclical Unemployment

Unemployment caused by economic downturns and recessions.

What happens to cyclical unemployment during a recession?

It rises as demand falls, production decreases, and workers lose jobs.

When does cyclical unemployment occur?

When actual unemployment exceeds the natural rate because of an economic downturn.

Minimum Wage Laws and Structural Unemployment

If a minimum wage is set above the market equilibrium wage, some low-skilled workers may find it harder to obtain jobs.

Labor Unions

Organizations that negotiate wages, benefits, and working conditions for workers.

How might labor unions contribute to unemployment?

Some economists argue that negotiated wages above equilibrium may reduce the number of workers employers hire.

What is another perspective on labor unions?

Unions can provide benefits to workers, including improved wages, benefits, and working conditions.

Efficiency Wages

Wages that firms voluntarily set above the market equilibrium wage.

Why do firms pay efficiency wages?

To improve worker health, reduce turnover, attract higher-quality employees, and encourage effort and productivity.

Job Placement Services

Services that help unemployed workers find available jobs and connect with employers.

Worker Training Programs

Programs that help workers develop skills needed for available jobs.

Retraining Programs

Programs that help displaced workers learn new skills for different jobs or industries.

Unemployment Insurance

Temporary income support for eligible workers who become unemployed.

Benefit of unemployment insurance

It reduces financial hardship while eligible workers search for new jobs.

How might unemployment insurance increase frictional unemployment?

It may allow some people to spend longer searching for a suitable job.

Government policies to reduce unemployment

Job placement services, employment agencies, worker training, retraining programs, and unemployment insurance.

Economic costs of unemployment

Lost income and production, loss of job skills, and higher poverty levels.

Social costs of unemployment

Lower self-esteem, family stress, health problems, and social or political instability.

Frictional vs. Structural Unemployment

Frictional: workers are between jobs or searching. Structural: workers' skills do not match available jobs.