Inflation & its costs

inflation

rising general level of prices, reduces the “purchasing power” of $$

in general high inflation bad - banks don’t lend & ppl don’t save

• decreases investment & GDP

Deflation

decrease in general prices or a negative inflation rate

• prblm because ppl will hoard assets → decreases consumer spending & GDP

Disinflation

prices increasing @ slower rates

inflation rate

the % in change in prices from year to year

price indices

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

CPI

consumer Price Index

• base year gets index of 100

• every year is giving a # index as well

CPI= (Price of market basket/” “ in base year) x100

Problems w/ the CPI

1. substitution bias - diff goods available, as price increases ppl buy substitutes that may not be part of the market basket

2. new products - the CPI market basket may not include the newest consumer products

3. Product Quality - the CPI ignores both improvements & declines in product quality

ppl hurt by inflation

• lenders (w/ fixed interest rates)

• ppl w/ fixed incomes

• savers

ppl helped by inflation

• borrowers

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

real wage

wage adjusted for inflation

costs of inflation

1. menu costs - costs $ to change listed prices

2. shoe leather costs - the costs of transactions increase, ppl reduce their real money holdings so they must spend more time & effort making additional trips to the bank

3. unit of account costs - money doesn’t reliably measure the value of goods/services → less efficient use of resources because of uncertainty caused by changes in currency value