Inflation and Money

lecture 10

inflation

a generalized rise in overall level of prices

consumer price index(CPI)

an index that tracks the average price consumers pay over time for a representative “basket” of goods and services

• basket is a metaphor for the list of goods and services people typically buy

inflation rate

the annual percentage increase in the average price level

how to measure inflation

1. find out what people buy

2. collect prices

3. tally up cost of basket

4. calculate inflation as the percentage change in the prices of the basket

deflation

a generalized decrease in overall level of prices

Challenges to CPI

overstates cost of living because it tracks the changing price of a fixed basket of goods

• misses:

  • quality improvements (which hide price decreases)

  • new products (iPhone example)

  • substitutions(when prices rise, you substitute what is in the basket to find CHEAPER ways to achieve the same quality of life

substitution bias

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

personal consumption expenditure deflator (PCE deflator)

basket includes items you consume but dont directly pay for

core inflation

used by forecasters to examine underlying trend in inflation

• excludes food and energy because those prices are often volatile

producer price index (PPI)

a price index that tracks the prices of inputs into the production process

GDP deflator

a price index that tracks the prices of all goods and servoces produced domestically

• (nominal gdp/real gdp) times 100

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

nominal interest rate

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

real interest rate

the interest rate in terms of changes in your purchasing power

money illusion

the (mistaken) tendency to focus on nominal dollar amounts instead of infaltion-adjusted amounts

• can distort decisions

• lead to mis pricing

• create nominal wage rigidity

what is money?

an asset regularly used in transactions

what does money do?

provide 3 key functions:

• medium of exchange

• unit of account

• story of value

different forms of inflation

• hyperinflation

• expected inflation

• unexpected inflation

hyperinflation

extremely high rates of inflation

menu costs

the marginal cost of adjusting prices

shoe- leather costs

the costs incurred trying to avoid holding cash

inflation fallacy

the mistaken belief that inflation destroys purchasing power