Inflation


Purchasing Power: the real goods and services that money can buy, which determines the value of money


Inflation: a rise in general level of prices in an economy (INC. quantity → DEC. value)

  • Measured by the inflation rate - the % of increase in prices in the economy

  • Considering all things equal , causes a decline in purchasing power

  • Good range PER YEAR is 2-3%

Cause of inflation

  • prices rise when the government prints too much money

  • Large quantities of money available … so value of money falls

Why print money? 

  • Pay off debt (not enough tax revenue)

  • To get out of a recession/depression


Deflation: a prolonged decline in the general level of prices in an economy

  • May be more damaging than inflation 

    • If things cost less, people are getting paid less

    • Producers are earning less →  get less stock 

Shrinkflation: companies reducing the size or quantity of their products while charging the same price or even more

  • Ex. ziploc boxes reducing the # of bags, but keeping the same price


Measures of Inflation: 

  1. GDP Deflator

  2. Consumer Price Index (CPI)

  3. Producer Price Index (PPI)


GDP Deflator: removes the effects of inflation from GDP 

  • This enables the overall economy in one year to be compared to a different year


GDP Deflator = Nominal Value / Real (AFI)  Value X 100

% Change = new bigger value – new smaller value / smaller value X 100


2023 GDP = 27 T / 23 T X 100 = 117.3 T


2022 GDP = 24 T / 21 T X 100 = 114.2


% change = 117.3 - 114.2 / 114.2 X 100 = 2.7% INCREASE


Consumer Price Index (CPI): measure of the overall cost of the goods and services bought by a typical consumer

  • Measures changes in the cost of living over time

  • When CPI rises, the typical family has to spend more dollars to maintain the same standard of living

  • Calculated by market basket


Market Basket: a collection of goods and services that the typical consumer buys

  • This ‘basket’ is created by the Bureau of Labor Statistics (BLS)

  • The BLS conducts monthly surveys of 80,000 prices to determine how the %’s in the market basket are affected


Components of CPI : 


  1. Housing -  40%

  2. Transportation - 15%

  3. Food & beauty - 15%

  4. Apparel 

  5. Medical / healthcare

  6. Education

  7. Recreation (fun) 

  8. Other G & S


Problems in measuring the CPI: 


The BLS is slow to change the market basket:


  • Substitution Bias: consumers substitute expensive goods for cheaper goods


  • Introduction of New Goods: BLS does not initially add new products to the basket, ignoring increased variety of goods


  • Unmeasured Quality Changes: > quality = > dollar value (and vise versa)

    • Hard to adjust prices for quality changes


These 3 problems cause the CPI to overstate the true cost of living (0.5-1% per year)

  • C.O.L changes may not be as bad as the CPI implies

  • Many gov’t programs use the CPI to adjust budgets, so inaccuracies can cost money


Producer Price Index: measures the cost of a basket of goods and services bought by firms rather than consumers



Adjusting for Inflation


  • CPI indexes are used to correct for the effects of inflation when comparing dollar figures from different times


  • To adjust for inflation, “inflate” the past value to determine the current value:


Value of current year = Value of past year X ( CPI in current year / CPI in past year )