BUSA 2210: Prices, Inflation and the Cost of Living: Part III - Notes

Inflation: What’s the Problem?

  • Inflation's impact on the economy and citizens is generally not great.

  • Milton Friedman: "Inflation is caused by too much money chasing after too few goods" and is a monetary phenomenon.

  • Bad government policy (excess spending, increasing money supply) can cause inflation.

  • Consumer behavior and economic events also contribute.

    • Demand-pull inflation.

    • Cost-push inflation.

Inflation: Prices Over Time

  • Inflation examples:

    • U.S. (May 2020 to June 2022): 15.4%.

    • Hyperinflation examples: Israel (1985): 400%; Nicaragua (1988): 33,000%; Zimbabwe (2007): up to 150,000%; Germany (1923): 102,000,000%; Hungary (1945): 3.8X10273.8 X 10^{27}.

Inflation: Uncertainty

  • Unpredictable future price levels cause problems.

    • Uncertainty alters decisions and plans.

    • Price confusion.

    • Money illusion.

    • Menu costs.

    • Wealth redistribution and tax distortion.

    • Cost of holding money (“shoe leather” costs).

  • Impacts of uncertainty about future inflation:

    • Difficulty in making optimal decisions.

Inflation: Price Confusion

  • Price changes may be specific to a market or due to general inflation.

  • Incorrect assumptions lead to flawed decisions.

  • Market output distortion.

The CPI is Not Perfect

  • Substitution Effect: Consumers change behavior in response to price changes.

    • CPI assumes a fixed "basket of goods".

    • CPI may overestimate true effect if consumers substitute goods.

  • Quality Changes: CPI doesn’t fully account for changes in product quality.

  • New Products: CPI updates slowly, so the "basket" differs from previous years.

    • New goods tend to decrease in price over time due to production costs.

    • Chained CPI as a solution.

Fun Example: Grandma and the CPI

  • CPI has a slight upward bias.

  • Social Security is adjusted based on the basic CPI (C.O.L.A.).

  • Economist vs. Politician views on using Chained-CPI for more accurate correction.

CPI and Inflation

  • Unpredictable inflation causes economic problems.

    • Consumers: real earnings decrease.

    • Firms: reluctance to make long-run decisions.

  • Hyperinflation can lead to economic collapse.