ECON 3212 – Exam 2 Study Guide: Inflation and Interest Rates

Price Level and Inflation

• Price Level (Index): Measures the average prices of goods and services in an economy.
• Inflation: A rise in the overall price level, resulting in a reduction of purchasing power.

Inflation Rate Formula

• Formula: To calculate the inflation rate, use the formula:
  • (New - Old) / Old \times 100
  • Represents the annual percentage change in price level.

Consumer Price Index (CPI)

• CPI: Represents the average price of a market "basket" of goods purchased by a typical urban family of four.

Biases in CPI

• Substitution Bias: CPI assumes consumers buy the same quantity of goods, ignoring substitutions made for cheaper goods.
• Quality Change Bias: CPI does not account for improvements in the quality of goods over time.
• New Product Bias: CPI does not immediately capture the impact of new products on the market.
• Outlet Bias: Data collection for CPI often overlooks sales from discount and outlet stores.

Other Inflation Measures

• PCE (Personal Consumption Expenditures): Measures domestic purchases by households and is used by the Fed for price measurement.
• Core PCE: Excludes volatile food and energy prices for more stable measurement.
• PPI (Producer Price Index): Indicates the price producers pay at different production stages and can signal future price changes.

Interest Rates

• Nominal Interest Rate (i): The stated interest rate without adjustment for inflation; reflects the opportunity cost of holding money.

Real Interest Rate

• Real Interest Rate (r): The true cost of borrowing after adjusting for inflation, given by the formula:
  • r = i - \pi
• Fisher Equation: Relates nominal interest rate, real interest rate, and inflation.
  • i = r + \pi
• Fisher Effect: Indicates that a 1% increase in money supply results in a 1% increase in inflation, which also raises nominal interest rates.

Real Interest Rates Explained

• Ex Ante Real Interest Rate: The anticipated real interest rate at the start of a loan, given by:
  • r = i - E\pi
• Ex Post Real Interest Rate: The actual real interest rate realized after the loan repayment, calculated as:
  • r = i - \pi

Example Calculation

• If you want to buy a car with a 5.25% interest rate, expecting 3% inflation:
  • Ex Ante: 5.25\% - 3\% = 2.25\%
  • After 5 years, if actual inflation averages 4%:
  • Ex Post: 5.25\% - 4\% = 1.25\%

Costs of Expected Inflation

1. Inflation Tax: Erosion of cash and bond values, leading to more withdrawals.
2. Menu Costs: Costs associated with changing prices.
3. Price Changes: Regular price changes become complex amid higher inflation.
4. Tax Liability: Inflation may alter tax obligations without accounting adjustments.
5. Need for Adjustment: Inflation complicates long-term financial planning, particularly retirement.

Costs of Unexpected Inflation

1. Redistribution of Wealth: Affects borrowers and lenders differently based on actual vs. expected inflation:
   • If \pi > E\pi , borrowers benefit.
   • If \pi < E\pi , lenders benefit.
2. Fixed Income Recipients: Individuals on fixed incomes face difficulties when inflation rises unexpectedly.

Example Scenario

• Consider a 30-year mortgage at a nominal 3% interest rate:
  • Expected inflation: 2%
  • Realized inflation: 3%
  • Ex Ante: r = 3\% - 2\% = 1\%
  • Ex Post: r = 3\% - 3\% = 0\%
  • Outcome might leave you disappointed.

Comparing Inflation, Deflation, and Disinflation

• Inflation: Continuous rising prices; preferable to deflation.
• Deflation: Decreasing prices, which can be harmful economically.
• Disinflation: Slowdown in inflation; prices rise at a decreasing rate (e.g., from 6% to 4%).

Impact on Workers and Real Wages

• Workers resist nominal wage cuts. As prices rise, real wages decline unless nominal wages increase accordingly.