Inflation Introduction and Measurement

Introduction to Inflation

Inflation and Price Stability

• Economists and central banks are greatly concerned with inflation.
• Price stability is a goal of many policymakers, typically defined as an inflation rate close to or just above 2%.
• Central banks like the ECB, BOE, and FED target a 2% inflation rate because a small amount of inflation is considered healthy for the economy.

Defining Key Terms

• Inflation: A steady and persistent increase in the general level of prices. It represents the rate at which your money is losing value.
• Disinflation: A fall in the inflation rate, meaning prices are still increasing, but at a slower rate.
• Deflation: A general decrease in the average level of prices, which can be very damaging to the economy.

Impact of Deflation

• Consumers may postpone purchases of goods and services in anticipation of lower prices in the future.
• Rising unemployment occurs due to a drop in aggregate demand.
• The government faces budget difficulties as social welfare spending increases and tax revenues decrease.
• Investment falls during periods of uncertainty.
• According to the law of supply, a fall in prices results in a fall in quantity supplied.

Measuring Inflation: Simple Price Index

• To measure the change in the price of one good over time, compare the prices at different time periods.

Example

• The price of a garlic bulb increased by 9 cents between year 1 and year 4. This shows price changes for a single good using the simple price index.

Composite Price Index

• To examine changes in the general price level (i.e., in many goods), a composite price index is used.

Steps to Construct a Composite Index

1. Choose a base year: Let all prices equal 100 in the base year.
2. Select the goods: Identify the goods included in the index and find their prices for each year.
3. Construct a simple price index: Calculate the price index for each good.
4. Multiply by the weight: Multiply the simple price index by the weight given (proportion of income spent on each good).
5. Add figures: Sum the weighted figures to get the composite index for the current year.

Example

• Year 1 (Base Year):
  • Food: \frac{19}{19} \times 100 = 100 \times 40\% = 40