Topic 4&5: Price indicies and inflation + costs of inflation

Inflation

the rising general level of prices that reduces the purchasing power of money.

When there is inflation

each dollar of income will buy fewer goods than before

Is high inflation good or bad?

in general, it is bad becasuse banks do not lend and people do not save. It lowers investment and GDP

Deflation

decrease in general prices (negative inflation rate). Bad because people will hoard money and assests which will decrease consumer spending and GDP.

Disinflation

prices increasing at slower rates

how do we measure inflation

government tracks prices of “market baskets” which include the same goods and services

Two ways to measure inflation over time

the inflation rate and price indicies

the inflation rate

the percent change in prices from year to year

price indicies

index numbers assigned to each year that show how prices have changed relative to a specific base year

What is the market basket

a basket of goods and services that is set (but does change over time). includes items that consumers would normally purchase

how to calculate the price of the market basket

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

Consumer price index (CPI)

the most common measurement of inflation for consumers in the US

CPI= ((price of current year market basket)/(price of market basket in base year)) *100

3 problems with CPI

• substitution bias

• new products

• product quality

Substitution bias

as prices increase for the fixed market baskets, consumers buy less of these products and more substitues that may not be apart of the market basket.

Results in a CPI that could be higher than what consumers are paying.

New products

the CPI market basket may not include the newest consumer products. CPI measures price but not the increase in choices.

Product quality

the CPI ignores both improvements and decline in product quality. CPI may suggest that prices stay the same even though the economic well being has improved significantly

The government role is

to prevent unemployment and prevent inflation at the same time

If they focus on inhibiting one factor, they other one with rise

Good rates uig

U: 4-6%

I: 1-4%

GDP growth: 2.5-5%

worry rates of uig

U: 6.5-8%

I: 5-8%

GDP growth: 1-2%

bad rates of uig

U: 8.5% or more

I: 9% or more

GDP growth: .5% or less

Hurt by inflation

• Lenders- people who lend money at fixed intrest rates

• people with fixed incomes

• savers

helped by inflation

• borrorwers- people who borrow money

• a business where the price of the product increases faster than the price of resources

Nominal wage

wage measured by dollars rather than purchasing power

ex: $5/hr $15/day

real wage

wage adjusted for inflation

(if there is inflaition, you must ask your boss for a raise)

how does high inflation rate diver people from productive activities

• menu costs

• shoe leather costs

• unit of account costs

menu costs

it costs money to change listed prices.

Ex: businesses update menu, signs, etc.

Shoe leather costs

costs that people incur to minimize their cash holdings during times of high inflation.

the costs of transactions increase. People reduce their real money holdings so they must spend time and effort making additional trips to the bank. (More applicable to older times like when there were no credit cards and you had to take out money from the bank every time you went food shopping)

Unit of account costs

money doesn’t reliably measure the value of goods and services.

Leads to efficient use of resources because of uncertainty caused by changes in currecncy value.