inflation

inflation is

continuing increase in the general (average) price level of goods and services in a nation over time

deflation definition

a continuing decrease in the general price level of goods and services in a nation over time

disinflation

a decrease in the rate of inflation

hyperinflation is

price level rises that are more than 50% a month

how is inflation measured?

using the consumer price index CPI

consumer price index (CPI) is

defined as a measure of price changes in consumer goods and services over time

price index is

an average of prices for a selection of goods and services in a particular nation over time

CPI formula

CPI = (price of a particular basket of goods/price of the basket of goods of the base period)*100

weighting of categories in the CPI

1. to account for the different proportions of a typical household's disposable income, government assign weights to categories of goods measured in the CPI

weights in the CPI

% total income spent

what is the purpose of weighting of categories in the CPI

to ensure that when a particular category of goods experiences large fluctuations in price over time, the overall CPI does not fluctuate wildly

Inflation Rate formula

(CPI final - CPI initial)/CPI initial *100%

deflation vs disinflation

deflation = negative percent

disinflation = lower rate compared with previous year

4 limitations of the CPI as a measure of inflation

1. CPI does not reflect the purchases of all households in a nation

2. CPI does not reflect changes in the quality of the products produced and consumed in a nation

3. Inflation calculated using the CPI may not measure changes in prices of important products like food and oil

4. CPI does not reflect price changes that affect producers

3 winners who are helped by inflation

1. borrowers

2. flexible-income earners

3. importers

why are borrowers helped by inflation

inflation lowers the real interest rate paid by borrowers, so money paid back from a loan is worth less than the money borrowed

why are flexible-income earners helped by inflation

wages are indexed to inflation, so any increase in the price level is matched by an income increase

why are importers helped by inflation

imports appear relatively cheaper when the price of domestic output rise

4 losers who are hurt by inflation

1. lenders

2. fixed income earners

3. savers

4. exporters

why are lenders hurt by inflation

inflation lowers the real interest rate earned on loans, so the money paid back by borrowers is worth less than the money lent

why are fixed income earners hurt by inflation

inflation reduces real income, making fixed-income earners poorer in real terms as inflation rises

why are savers hurt by inflation

inflation lowers the real interest rate earned on savings, so money saved is eroded by inflation

why are exporters hurt by inflation

domestic inflation makes products to be exported less attractive to foreign buyers

2 types of inflation

1. demand-pull

2. cost-push

demand-pull inflation

- this is when too many consumers are chasing too few goods, so the average price of goods and services in a nation rises

- it is illustrated by an outward shift of AD when a nation is at or near its full-employment level of output

demand-pull inflation diagram

draw

cost-push inflation

this is when the costs of production faced by a nation's producers rise (due to higher energy costs, wages for workers, business taxes, etc.), so the nation's SRAS curve shifts to the left and the average price level of the nation's output rises

it is usually accompanied by stagflation

cost-push inflation diagram

draw

5 causes of cost-push inflation

1. increase in oil prices

2. increase in the nominal wage rae

3. depreciation of the nation's currency

4. natural disaster or war

5. higher taxes on firms

4 consequences of inflation

1. loss of purchasing power

2. lower real interest rates for savers

3. higher nominal interest rates for borrowers

4. reduction of international competitiveness

the inflationary spiral

1. AD increases, PL and output increase

2. workers, expecting continued inflation, demand higher wages

3. firms lay off workers and raise prices in response to higher wages

4. SRAS shifts to the left, further increasing inflation

5. due to inflation, consumption and investment increase and savings decrease

6. expenditures increase without an increase in AS

and then it loops back

2 types of deflation

1. demand-deficient deflation

2. supply-side deflation

demand deficient deflation

this occurs as a result of a fall in aggregate demand

this is bad

supply-side deflation

this is causes by increase in productivity of the nation's resources or lower costs of production to firms

this is good, but can turn into demand-deficient deflation

the deflationary spiral

1. AD falls

2. employment and output decreases

3. disposable income falls

4. consumption falls

5. AD falls more

6. expecting deflation, firms reduce investment

7. prices fall, discouraging consumption and investment

8. consumption, investment, or net exports fall

back to the start, it loops

8 costs of deflation (demand-deficient)

1. business uncertainty

2. redistributive effects

GPL falls, winners are individuals with fixed income, now they are able to afford more. banks will benefit too - borrowers pay more

3. deferred consumption (decrease in wages or wait for even larger decrease in prices). firms may try to decrease labor costs to compensate for decreased revenue

4. high levels of cyclical unemployment - the spiral

5. bankruptcies - firms lower prices to compensate for consumption

6. increase in the real value of debt

7. inefficient resource allocations

8. policy ineffectiveness- uncertainty for gov.

6 costs of high inflation rate

1. greater uncertainty

2. redistributive effects - lower income HHs are affected more

3. effects on savings

4. damage to export competitiveness

5. impact on economic growth

6. inefficient resource allocation