Economics 2.2.2

Inflation

Deflation

A decrease in the general price level of goods and services over time.

Opposite of inflation

Disinflation

A decrease in the rate of inflation.

Prices are rising, but at a slower pace than before

Base Year

A year chosen as a reference point for comparison with some earlier or later years.

Stagflation

An economics condition characterized by stagnant economic growth, high unemployment, and high inflation at the same time.

Inflation

An increase in the general price level of goods and services in an economy.

Consumer Price Index (CPI)

An index that measures the changes in the prices of a sample of consumer goods and services over time.

Market Basket

A selected list of food and household items chosen as a representative sample of common purchases and used to measure the cost of living.

Steps to Calculate Inflation

• Fix the basket

• Find the prices

• Compute the basket’s costs

• Choose the Base Year and compute the CPI

• Calculate the inflation rate

Calculating CPI

current year cost of market basket / base year cost of market basket x100

Calculating Inflation Rate

(CPI for current period - CPI for previous period) / CPI for previous period x100%

Demand-pull Inflation

A rise in the general price level due to excess demand or spending from consumers, businesses, the government, or foreigners.

Cost-push Inflation

A rise in the general price level due to an increase in the cost of production for businesses.

Consequences of High Inflation

• A decrease in purchasing power

  • ↑P → Nominal Income can buy less g&s

• Uncertainty

  • Discourage investment spending & ↓ production capacities

Effects of Inflation

Higher than expected inflation: lenders lose, borrowers win

• ↑inflation → lender lose, borrower gain

• ↓inflation → lender gain, borrower lose

Limitations of CPI as a measurement of Inflation

CPI will always overstate inflation

• Coverage

  • Market Basket ≠ actual basket purchased

• Change in product quality

  • ↑P may be due to improvements in quality

• Substitution effect

  • Consumers are likely to switch to cheaper close substitutes

• New products

  • Takes time for new products to be included in the CPI basket