Chapter 9 Macroeconomics

Inflation

A general and ongoing rise in the level of prices in an entire economy

Inflation does not refer to change in relative (individual) prices

There is pressure for prices to rise in most markets in the economy

Basket of Goods and Services

A hypothetical group of different items, with specified quantities of each one meant to represent a “typical” set of consumer purchases

Used to calculate the price level, by looking at how the prices of those items change over time

Computed using a weighted average

Index Number

A unit-free derived from the price level over a number of years, which makes computing inflation rates easier, since the index number has values around 100

No dollar signs or other units attached

Base Year

Arbitrary year whose value as an index number economists define as 100

Inflation Calculation

(Level in new year-Level in prior year)/Level in prior year=x100=percentage change

Indexing

Allows easier eyeballing of the inflation numbers between different years

Consumer Price Index (CPI)

A measure of inflation that U.S. government statisticians calculate based on the price level from a fixed basket of goods and services that represents the average consumer’s purchases

Change in fixed basket of goods and services vs. change in cost of living

Subsitution Bias

An inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise considerably

Quality/New Goods Bias

Inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not account for improvements in the quality of existing goods or the invention of new goods

Core Inflation Index

Takes the CPI and excludes volatile economic variables, like energy and food prices

Economists can have a better sense of the underlying trends in prices that affect the cost of living

A preferred gauge from which to make important government policy changes

Producer Price Index (PPI)

A measure of inflation based on prices paid for supplies and inputs by producers of goods and services

Different industries, commodities, and stages of processing

International Price Index

A measure of inflation based on the prices of merchandise that are exported or imported

Employment Cost Index

A measure of inflation based on waged paid in the labor market

GDP Deflator

A measure of inflation based on the prices of all the GDP components (consumption, investment, government, exports minus imports)

Notable Waves of U.S. Inflation

After World War I

After World War II

The 1970s

Deflation

Sever negative inflation

When most prices in the economy are falling

Notable Periods of U.S. Deflation

Following the 1920-1921 recession

The Great Depression of the 1930s

Hyperinflation

An outburst of high inflation that often occurs (although not exclusively) when economies shift from a controlled economy to a market-oriented economy

The closest the U.S. has ever reached hyperinflation was during the 1860-1865 Civil War in the Confederate States

People are Hurt from Inflation When

They are holding cash

They have financial asset investments where the nominal return does not keep up with inflation (also can be exacerbated by taxes)

Wages lag behind inflation

-Wage adjustments are often somewhat sticky and occur only once or twice a year

They are a retiree receiving a private company defined pension

Ordinary People Can Sometimes Benefit from Inflation Like

A borrower paying a fixed interest rate can end up better off, because they can repay their loans in dollars that are worth less that originally expected

Blurred Price Signals

Prices are messengers in a market economy, conveying information about conditions of demand and supply

Inflation blurs those price messages

Inflation means that we perceive price signals more vaguely, like static on the radio

When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals

Inflation Can Make Long Term Planning Difficult Like

Planning for retirement in unknown future dollar levels

More time spent by businesses finding ways of profiting from inflation vs. less time spent on productivity, innovation, or quality of service

Indexed

A price, wage, or interest rate is adjusted automatically for inflation

Examples of Indexing Arrangements in Private Markets

Cost of Living Adjustments (COLAs)

Adjustable-Rate Mortgage (ARM)

Cost-of-Living Adjustments (COLAs)

A contractual provision that wage increases will keep up with inflation

Adjustable-Rate-Mortgage (ARM)

A type of loan a borrower uses to purchase a home in which the interest rate varies with market interest rates

Examples of Indexing Arrangements in Government Programs

The U.S. income tax code is designed so income levels where higher tax rates kick in are indexed to rise automatically with inflation

The level of Social Security benefits increases each year along with the Consumer Price Index

-An indexed increase in the Social Security tax base accompanies the indexed rise in the benefit level

U.S. government offers indexed bonds promising to pay a certain real rate of interest above whatever inflation rate occurs