(4) Measurement - Inflation

Inflation

The sustained increase in the general level of prices in the economy

Price level

A measure of the average prices of goods and services in the economy

Inflation rate

The percentage increase in the general price level from one year to the next

Consumer Price Index (CPI)

A measure of (rate of) changes in retail prices of a basket of goods and services representative of household consumption (measures quarterly)

Market basket

The goods typically purchased by households

Producer Price Index (PPI)

An average of prices received by producers of goods and services at all stages of production

Substitution bias

Occurs when consumers switch to cheaper alternatives not captured in CPI, overstating inflation

Increase in quality bias

Part of a price increase may be due to improved product quality rather than inflation

New product bias

New goods are not included in CPI until they become common, overstating inflation in early years

Outlet bias

CPI may not fully account for consumers switching to cheaper stores or online shopping

Purchasing power

The quantity of goods and services that can be bought with a unit of currency; it falls when prices rise

Nominal value

The face value measured in current dollars, not adjusted for inflation

Real value

The nominal value adjusted for inflation using a price index

Formula to adjust for inflation

Value in current dollars = Value in base year × (CPI in current year / CPI in base year)

Nominal interest rate

The stated interest rate on a loan

Real interest rate

The nominal interest rate minus the inflation rate; measures the true cost of borrowing

Anticipated inflation

Inflation that is expected and built into decisions about wages and interest rates

Unanticipated inflation

Inflation that is not expected, causing redistributions between borrowers and lenders

Menu costs

The costs to firms of changing prices (e.g. reprinting menus or price lists)

Bracket creep

When inflation pushes income into higher tax brackets, increasing taxes even if real income hasn’t risen

Hyperinflation

Extremely rapid increases in prices, often associated with political instability or recession

Deflation

A fall in the general price level; increases real debt burden and can slow economic growth

Demand-pull inflation

Inflation caused by an increase in aggregate demand when production cannot immediately meet demand

Cost-push inflation

Inflation caused by a decrease in aggregate supply due to higher input costs or negative supply shocks

Aggregate demand

The total quantity of goods and services demanded by households, firms, government, and net exports

Aggregate supply

The total quantity of goods and services that firms produce and sell at each price level

Wage-price spiral

Cycle where higher wages increase costs and prices, leading to demands for even higher wages

Q - If inflation rate is higher than expected, then:

B) Borrowers pay lenders a lower real interest rate than expected

Q - Which of the following is an example of anticipated inflation?

B) Inflation that has been built into wage contracts and interest rates

Q - Which of the following describes substitution bias?

A) Consumers switch to cheaper alternatives not captured in CPI

Q - If CPI in 1990 was 59 and CPI in 2016 was 109, what is the formula to convert $30,000 in 1990 to 2016 dollars?

A) $30,000 × (109 / 59)

Q - Nominal interest rate is:

B) The stated interest rate on a loan

Q - Which of the following is an example of cost-push inflation?

B) Rising wages or input prices that reduce aggregate supply

Q - Which of the following best describes demand-pull inflation?

B) Inflation caused by increased demand when economy is near full employment

Q - Which of the following is a problem caused by deflation?

C) Increased debt burdens and slower economic growth

Q - What is hyperinflation?

B) A rapid increase in the general price level often with political instability

Q - Which of the following is an example of menu costs?

B) Firms updating catalogues or menus due to price changes