Price Indices and Inflation
Intro to Inflation
inflation is the rate at which the general level of prices for goods and services rises over time
as inflation increases, each unit of currency buys fewer goods and services
the purchasing power of money decreases
consumer price index (CPI): measures inflation
CPI = (Current cost of basket in current year) / (Cost of basket in base year) x 100
Inflation Rate (%) = ((cpi this year - cpi last year)/cpi last year) x 100
CPI overstates the burden of inflation on households bc households can substitute cheaper goods instead of more expensive goods when prices increase
inflation affects how much people need to spend to maintain their cost of living
if incomes don't keep up with inflation, individuals may afford less over time
inflation can erode the value of money saved, impacting long-term financial planning
Deflation
lowering of prices for goods and services
negative inflation
money gains value, allowing consumers to purchase more with the same amount.
concerns of deflation
reduced consumer spending: when prices fall, people may delay purchases, expecting even lower prices in the future. This behavior can decrease overall economic activity
lower business revenues: with decreased spending, businesses earn less, which can lead to cost-cutting measures like layoffs or reduced wages
increased debt burden: as prices and incomes fall, the real value of debt rises, making it harder for borrowers to repay loans
deflationary spiral: these factors can create a cycle where falling prices lead to reduced spending, further price drops, and economic contraction
causes of deflation
decrease in money supply: less money circulating in the economy can lead to lower prices.
increased productivity: technological advancements can reduce production costs, leading to lower prices.
reduced demand: economic downturns can decrease consumer and business spending, causing prices to fall
Terms
inflation | a sustained increase in the overall price level in the economy, which reduces the purchasing power of a dollar |
inflation rate | the pace at which the overall price level is increasing; this is the percentage increase in the price level from one period to the next. |
deflation | a sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative. |
disinflation | a slowing of the rate of inflation; for example if the rate of inflation is \[5\%\] in 2016 and \[3\%\] in 2017, there is still inflation in 2017.Prices are just not rising as fast as they were before. |
aggregate price level | a single number that summarizes all prices in an economy; price indices are frequently used to represent the aggregate price level. |
price index | a measure that calculates the changing cost of purchasing a particular (and unchanging) combination of goods (called a “market basket”) each year; the consumer price index and the producer price index are examples. |
consumer price index (CPI) | an index that calculates the cost of a market basket of goods purchased by a typical family that lives in an urban area; the purpose of the CPI is to track changes in the cost of living over time. |
market basket | the combination of goods that are used to calculate a price index; the goods stay the same from year to year. |
base year | a reference year to which variables are compared; for example, the current CPI in the United States uses 1983 as its base year, so all values of the CPI compare the current to 1983. |
real variables | variables that are adjusted for the rate of inflation that represent the true value of something (such as real interest, real income, or real GDP); for example if your boss gives you a \[10\%\] raise, but the purchasing power of your money has decreased by \[8\%\] because of inflation, your raise is really only worth \[2\%\]. |
nominal variables | variables such as wages, income, or interest that have not been adjusted for the rate of inflation; you can think of nominal variables as the “sticker price.” The bank tells you they will pay you \[3\%\] interest, but the real interest rate that tells you what you are actually earning. |
purchasing power | what can actually be bought with money; if you walk into a store with \[\$10\] and want to buy apples that cost \[\$1\] each, the purchasing power of your \[\$10\] is \[10\] apples; If the next day the price of apples increases to \[\$2\], you can only buy \[5\] apples, so the purchasing power of your \[\$10\] has decreased. |
real interest rate | the interest rate earned that reflects the actual purchasing power of that interest; for example if a bank pays \[3\%\] interest, but there is \[2\%\] inflation, you really have only gained \[1\%\] interest because the purchasing power of your interest has decreased. |