Inflation

Inflation

  • Inflation Rate- The percentage increase in the price level from one year to the next.

  • Price Level- A measure of the average prices of goods and services in the economy.

Inflation vs deflation and other measures

  • Inflation- An increase in the price level.

  • Deflation- A decline in the price level.

  • Disinflation- A decline in the inflation rate.

  • Hyperinflation- An out-of-control inflationary spiral.

Main Objectives

  1. Demand driven inflation

  2. Inflation due to increases in money supply

The GDP Deflator

The GDP deflator includes the price of every final good and service it is the broadest measure of the price level we have. However, it may not clearly indicate how changes in the price level affects you.

The CPI Market Basket (Expenditure shares)

  • The consumer price index is a measure of the average change over time in the prices a typical urban family of four pays for the goods and services they purchase.

The Producer Price Index

  • Producer Price Index (PPI)- An average of the prices received by producers of goods and services at all stages of the production process.

Calculating Inflation

To calculate the CPI (price level) in a given year, we need:

  • A basket of goods (which is kept constant)

  • The cost to purchase the basket of goods in a base year

  • The prices in the current year

    The CPI in the current year is the cost to purchase the basket of goods this year, divided by the cost in the base year. By convention, we multiply this by 100, so that the CPI in the base year is 100.

    -The inflation rate is the percentage change in the CPI form one year to the next.

Is CPI reflective of true inflation?

Four biases that make changes in the CPI overstate true inflation rate:

  • Substitution bias

  • Increase in quality bias New product bias

  • Outlet bias

    Economists believe the CPI overstates true inflation by 0.5 to 1 percentage point.

Using inflation to correct for price changes over time

Inflation is useful to correct for the changes in prices. We may want to know:

  • Did our (nominal) wage increase 2% per year over the last 10 years really make us better off?

  • What is the value today of a dollar in 1960?

  • I will lend money to a friend over the next year. How much must I ask for back in a year to get the same value for money?

When we correct a variable for price changes, we get a real variable

  • Sometimes we want to define a variable in real terms, rather than nominal terms (real income)

  • A nominal variable=a variable defined in the current year’s prices. A real variable= a nominal variable that is corrected for price changes (inflation). A real Variable is therefore measured in the dollars of the base year for a price index.

Changes in a variable over time

  • Say that we want to know how much a salary has changed over time, measured in real terms. (For instance: does our increase in nominal wage mean we have increased our purchasing power?)

  • To correct for the effects of inflation, we divide the nominal variable by CPI and multiply by 100 to obtain a real variable.

Real vs Nominal Interest Rates

  • Interest rate- cost of borrowing, expressed as a percentage of the amount borrowed

  • Inflation impacts the costs and gains of borrowing.

  • Nominal Interest Rate- Nominal Interest Rate - Inflation Rate

  • The real interest rate is a better measure of the cost of borrowing than is the nominal interest rate.

Anticipated vs Unanticipated inflation

  • if inflation is anticipated, people can prepare for it and consider the level of inflation when negotiating wages and interest rates.

    BUT anticipated still imposes costs:

  • Some workers still won’t get a pay raise at least as high as inflation

  • People have to hold some paper money (and they lose in value)

  • Firms experience costs to changing prices (menu costs)

  • Inflation is often unanticipated

  • When we sign up for a nominal interest rate for a loan, or negotiate wages, over the next year, we therefore do not know what our change in purchasing power will be. We may gain, or we may loose, depending on the outcome of the inflation that particular year.

  • When inflation is very volatile and high this is particularly troublesome.

  • Borrowers and lenders agree on the nominal interest rate.