ECON CH24: Inflation and Money

inflation

a generalized rise in the overall level of prices

• a rise in the cost of living

• a decline in the purchasing power of money

consumer price index

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

basket

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

inflation rate

annual percentage increase in the average price level

price level this year - price level last year/price level last year x 100

inflation rate equation

find out what people buy, collect prices, tally up the cost, calculate

to measure inflation:

creating the price index

pick an arbitrary year, called the base year, scale the cost of that basket to $100, and then track changes in the cost of that basket over time

deflation

a generalized decrease in the overall level of prices

some people stop buying goods and services in order to wait for them to become cheaper

Why can deflation be a problem?

overstates, fixed

CPI likely _____ changes in the cost of living because it tracks the changing price of a ____ basket of goods.

quality improvements

_____ ______ can hide price decreases.

new products

Doesn’t account for the reduction in the cost of living due to the introduction of ___ ______.

substitute

When prices rise, you _____ what’s in your 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 goods whose prices rise by less

cost-of-living adjustments

CPI is used for…

personal consumption expenditure deflator

basket includes items you consume but do not directly pay for

ex: medical care paid by employer

core inflation

used by forecasters to examine the underlying trend in inflation → excludes food and energy

producer price index

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 services produced domestically

another time’s dollars x price level today/price level in another time

today’s dollars =

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

saving, borrowing

The benefits and costs of _____ or ____ money are impacted by inflation.

nominal interest rate

the stated interest rate without a correct for the effects of inflation

real interest rate

the interest rate in terms of changes in your purchasing power

nominal interest rate - inflation rate

real interest rate =

money illusion

the mistaken tendency to focus on nominal dollars amounts instead of inflation-adjusted amounts

distort decisions, lead to mis-pricing and create nominal wage rigidity

money illusion can…

medium of exchange, unit of account and store of value

Money serves three key functions:

money as a medium of exchange

hand it over to buy stuff, accept it from your employer in exchange for your work; must be widely accepted

• do not have to make everything or barter

money as a unit of account

a common unit that people use to measure economic value → should be stable

money as a store of value

easy to store and reliably holds its value over time → saving for the future

undermines

Inflation _____ the productive benefit of money.

low and stable, high or unpredictable

When inflation is _______, then money serves its function well. _____ inflation erodes the function of money.

hyperinflation

extremely high rates of inflation → at least doubling

• can make life harder and erode all functions of money

expected inflation

inflation goal of 2%

menu and shoe-leather costs

costs of expected inflation:

menu costs

the marginal cost of adjusting prices

shoe-leather costs

the costs incurred trying to avoid holding cash

confuses signals and redistributes

costs of unexpected inflation

inflation confuses the signals that prices send

prices help coordinate economic activity

redistributes

Unexpected inflation ______ from savers and lenders toward borrowers.

inflation fallacy

the mistaken belief that inflation destroys purchasing power

labor

Inflation means all prices are rising, including the price of _____.

unchanged

If prices and wages rise together, then purchasing power is roughly _____.