Inflation L & V

Inflation

• A general rise in the overall level of prices

• A rise in the cost of living

• A decline in the purchasing power of money

GDP Deflator

Measures the prices of all final goods and services produced in Canada by comparing nominal GDP to real GDP. Includes exports excludes imports

Consumer Price Index

CPI = (Value of basket measure in current prices / Value of basket in base year) *100

• Cost of purchasing a fixed basket of goods/services relative to its cost in a specified base year. Includes imports but excludes exports. Tracks the average price consumers pay for a representative basket of goods and services. Weighted

Inflation Rate

Inflation = [(CPI_current - CPI_previous ) / CPI_previous] *100

Percentage change in CPI from the preceding year to current year

Nominal Adjustment Formula

Real Amount = Nominal Amount/Price Level

Real Amount = Nominal Amount / (Price Index/100)

Amount of Year A dollars in Year B

Amount of Year B Dollars = Amount of Year A dollars x (CPI Year B/CPI Year A)

Nominal Interest Rate

Rate of return on financial asset in nominal terms

1 + r (real interest rate) =

(1+i)/(1+pi)

Real interest Rate

Approx, r= i - pi

• Change in real purchasing power of a finacial asset. Nominal return adjusted for inflation

Money Illusion

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

Costs of expected inflation

• Distortions in the tax and benefits systems when not indexed

• Menu costs: Price adjustments by firm

• Shoe-leather costs (for very high inflation levels): tax on holders of money

• Confusion and inconvenience

Costs of unexpected inflation

• Loss in real wages, because wages were set to increase with expected inflation

• Redistributed between borrowers and lenders, higher than expected inflation is good for borrowers and bad for lenders (loans typically in nominal terms)

Deflation

A generalized decrease in the overall level of prices

Deflation Cons

• Households stop buying goods waiting for them to become cheaper, causes negative feedback loop

• Wage rigidity: people usually resist nominal wage cuts even during deflation

• Investment: Businesses become hesitant to invest when they expect prices to fall

• Redistribution towards lenders away from borrowers

Disinflation

Decrease in the rate of inflation - meaning prices are still rising just more slowly then before

Hyperinflation

Monthly inflation over 50%

Challenges in measuring inflation

• Substitution Bias: People adjusting their buying habits by opting for cheaper options can lead to exaggerated inflation

• Quality Adjustment Bias: Price rises many not be due to inflation, but instead price increased because of quality increase leads to overstatement

CPI 8 Main Categories

1. Food

2. Shelter

3. Household Operations

4. Clothing & Footwear

5. Transportation

6. Health and Personal Care

7. Recreation, education and reading

8. Alchohol, Tobacco, Recreational Cannabis