Inflation Flashcards

Inflation

Overview

• This chapter covers:
  • Definition of inflation.
  • Government methods for measuring price level changes and calculating inflation rates.
  • Consequences and root causes of inflation.

What is Inflation?

• Inflation is an increase in the general (average) price level of goods and services in the economy.

What is Deflation?

• Deflation is a decrease in the general (average) price level of goods and services in the economy.

Key Conclusion about Inflation

• Inflation reflects an increase in the overall average level of prices, not just an increase in the price of a specific product.

Consumer Price Index (CPI)

• The Consumer Price Index (CPI) is the most widely reported measure of inflation.

Definition of CPI

• It's an index that measures changes in the average prices of consumer goods and services.

CPI vs. GDP Chain Price Index

• The CPI includes only consumer goods and services to assess how rising prices impact consumers' purchasing power. It excludes items purchased by businesses and the government.

CPI Preparation

• The Bureau of Labor Statistics (BLS) collects data monthly from retail stores, homeowners, and tenants in selected U.S. cities.
• The BLS records average prices for a "market basket" of items commonly purchased by a typical urban family.

Composition of the Consumer Price Index

• Housing: 33%
• Transportation: 17%
• Food: 13%
• Personal Insurance: 11%
• Other Goods and Services: 8%
• Health Care: 8%
• Entertainment: 5%
• Apparel: 3%
• Education: 2%

CPI Calculation

• The formula for calculating the CPI is:
  $CPI = \frac{\text{Cost of market basket at current-year prices}}{\text{Cost of same market basket at base-year prices}} \times 100$

Base Year

• A base year is a reference point for comparison with earlier or later years.

CPI Value in Base Year

• The CPI value in the base year is always 100 because the numerator and denominator in the CPI formula are the same.

Inflation Rate

• The inflation rate is the percentage change in the official consumer price index (CPI) from one year to the next.

Annual Inflation Rate Calculation

• The formula is:
  $\text{Annual rate of inflation} = \frac{\text{CPI in given year} - \text{CPI in previous year}}{\text{CPI in previous year}} \times 100$

Disinflation

• Disinflation is a reduction in the rate of inflation.

Criticisms of the CPI

• The market basket might not be representative, leading to over or underestimation of inflation for certain groups.
• It has difficulty adjusting for quality changes in products.
• It ignores the relationship between price changes and the importance of items in the market basket.

Impact of Inflation on Standard of Living

• Inflation tends to reduce the standard of living by decreasing the purchasing power of money.
• Higher inflation rates result in a greater decline in the quantity of goods that can be purchased with a given nominal income.

Nominal Income

• Nominal income is the actual number of dollars received over a period of time.

Purchasing Power

• Purchasing power is measured by converting nominal income to real income.

Real Income

• Real income is the nominal income adjusted for changes in the CPI.

Formula for Real Income

• The formula is:
  $\text{Real income} = \frac{\text{Nominal income}}{\text{CPI (as decimal, or CPI/100)}}$

Percentage Change in Real Income

• Calculated as: Percentage change in nominal income - Percentage change in CPI.

Purchasing Power and Inflation

• If nominal incomes rise faster than the rate of inflation, purchasing power increases.
• If nominal incomes do not keep pace with inflation, purchasing power decreases.

Wealth

• Wealth is the value of the stock of assets owned at a point in time.

How Inflation Affects Wealth

• Inflation can benefit wealth holders as asset values tend to increase with rising prices.
• Inflation penalizes those without wealth, making it harder to acquire assets.

Nominal Interest Rate

• The nominal interest rate is the actual rate of interest without adjustment for the inflation rate.

Real Interest Rate

• The real interest rate is the nominal interest rate minus the inflation rate.

Real Interest Rate and Inflation

• When the real interest rate is negative, lenders and savers lose because interest earned does not keep up with the inflation rate.

Example

• If an anticipated inflation rate is 2%, and a loan is given with a 2% interest rate to offset inflation, but the actual inflation rate turns out to be 5%, the lender's purchasing power decreases by 3%.

Adjustable-Rate Mortgage (ARM)

• A home loan that adjusts the nominal interest rate based on changes in an index rate, such as rates on Treasury securities.

Hyperinflation

• An extremely rapid rise in the general price level.

Economic Outcomes of Hyperinflation

• Inflation psychosis
• Credit market collapses
• Wage-price spiral
• Speculation

Inflation Psychosis

• A situation where people spend earnings immediately to avoid paying even more tomorrow.

Wage-Price Spiral

• Occurs when increases in nominal wage rates are passed on in higher prices, leading to even higher nominal wage rates and prices.

Types of Inflation

• Demand-pull inflation
• Cost-push inflation

Demand-Pull Inflation

• A rise in the general price level resulting from an excess of total spending (demand).

When it Occurs

• Occurs at or close to full employment, when the economy is operating near full capacity.

Cost-Push Inflation

• An increase in the general price level resulting from an increase in the cost of production.

Influence of Expectations on Inflation

• Demand-Pull: If buyers expect prices to rise, they may purchase items sooner, leading to demand-pull inflation near full employment.
• Cost-Push: If firms expect production costs to rise, they may raise prices in anticipation, leading to cost-push inflation.