Unit 2.4 : Price Indices & Inflation ; Unit 2.5 : Costs of Inflation

Business Cycle

national economy goes up and down over time

recession

6 month period of decline in Real GDP (if really bad = depression)

inflation

rising general level of prices and decrease in "purchasing power" of money; doesn't effect everyone equally

because banks don't lend and people don't save, this decreases investments and GDP

Why is high inflation generally bad?

deflation

decrease in general prices or a negative inflation rate

because people hoard money and assets, decrease in consumer spending and GDP

Why is deflation bad?

disinflation

prices increase at slower rates

lenders (ppl who lend money at fixed interest rate), ppl with fixed incomes, and savers

Who's hurt by inflation?

borrowers and a business where price of product increases faster than price of resources

Who's helped by inflation?

nominal wage

wage measured by dollars rather than purchasing power

real wage

wage adjusted for inflation

the govt tracks prices of specific "market baskets" that include some goods and services; inflation rate and price indices

How is inflation measured?

inflation rate

the percent of change in price from year to year (ex. 2014 - US i.r. = 0.8%)

[(New CPI - Old CPI)/Old CPI] x 100

inflation rate formula

price indices

index numbers assigned to each year that show how prices have changed relative to a specific base year (ex. consumer price indices for 2014 = 235, base yr 1982, means price increased 135% since 1982)

add up prices of all items in basket in a given year . Quantity in basket must be same as base year

to get cost of basket ...

Consumer Price Index (CPI)

most commonly used measurement of inflation; only includes items consumers would normally buy; base yr is given an index of 100; to compare, each yr is given an index number as well

(price of market basket/price of market basket in base yr) x 100

CPI formula

substitution bias, new products, and product quality

Problems with CPI

substitution bias

as prices increase for fixed market basket, consumers buy less of these products and more substitutions that may not be part of the market basket

CPI may be higher than what consumers are really paying

result of substitution bias

new products

CPI market basket may not include newest consumer products

CPI measures prices but not the increase in choices

result of new products

product quality

CPI ignores both improvements and decrease in product quality

CPI may suggest prices stay same though the economic well being has improved significantly

result of product quality

Unemployment (6% or less), Inflation (1% - 4%), and GDP Growth (2.5% - 5%)

The 3 Goals

prevent unemployment and prevent inflation at the same time

the government's role is to ...

economy slows down and we'll have unemployment

if govt focuses too much on preventing inflation ...

economy overheats and we'll have inflation

if govt focuses too much on limiting unemployment ...

money costs, shoe leather costs, and unit of account costs

costs of inflation

menu costs

costs money to change listed prices; ex. businesses must update menus, signs, etc

shoe leather costs

costs of transactions increase; ex. people decrease their real money holdings so they must spend time and effort making additional trips to the bank

unit of account costs

money doesn't reliably measure value of goods and services, leads to less efficient use of resources because of uncertainty caused by changes in currency value

Real value

When the price of a product has been adjusted for price changes (base year price)

Nominal Value

When the price of a product has not been adjusted for price changes (current year price)

the value of money decreases and unemployment increases

Effects of Hyperinflation

Nominal GDP

GDP measured in current prices. It does not account for inflation from year to year.

Real GDP

GDP expressed in constant, or unchanging, dollars; adjusts for inflation

Real GDP

What GDP is better for measuring actual growth?

The GDP deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers.

What's the difference between the GDP deflator and CPI?

GDP deflator; CPI

An increase in the price of goods bought by firms or the government will show up in the ____ but not in the ____.

domestically

The GDP deflator includes only those goods and services produced ____

Imported

_____ goods are not a part of GDP and therefore don’t show up in the GDP deflator.

(Nominal GDP/Real GDP) x 100

GDP Deflator

(Deflator x Real GDP)/100

Nominal GDP

hyperinflation

inflation gets totally out of control; 500% a year or more

galloping inflation

more intense form of inflation that can be 100% - 300%

creeping inflation

occurs when the price level persistently rises over a period of time at a mild rate; ex. if the inflation is at the rate of 3% it will take 33 years for the prices to double

demand pull inflation

too much money chasing too few goods