Chapter_22_Slides

Chapter 22: Inflation

1. Defining Inflation

• Inflation Rate: Percentage change in aggregate price index.

• GDP Deflator: Aggregate price index which tracks prices of major components of GDP (Consumption, Investment, Government spending).

• Consumer Price Index (CPI): Focuses on changes in cost of living for households by measuring inflation in consumer prices.

2. The Costs of Inflation

• Higher Inflation Rate: Causes a rise in consumer prices, leading to increased costs for maintaining consumption levels.

• Cost #1: Loss of Purchasing Power

  • If incomes do not rise with inflation, purchasing power declines, affecting welfare.

  • Example: Fixed pensions remain constant while prices double, halving purchasing power.

  • Wage contracts may not accurately reflect true inflation, leading to reduced purchasing power for individuals.

• Cost #2: Diminished Purchasing Power of Savings

  • Storing cash or low-interest savings leads to losses if inflation exceeds those rates.

  • High inflation discourages savings, impacting overall economic lending, reducing loans for students, businesses, etc.

• Cost #3: Difficulty in Long-term Planning

  • High and volatile inflation complicates financial forecasting for households and businesses regarding retirement and major investments.

• Cost #4: Hyperinflation

  • Extreme case where inflation exceeds 50% per month, rendering currency nearly worthless.

  • Historical examples of hyperinflation include:

    1. Hungary (1945-46): Inflation rate = 4.19 x 10^16% (prices doubled every 15 hours).

    2. Zimbabwe (2007-08): Inflation rate = 7.96 x 10^10% (prices doubled every 24.7 hours).

    3. Yugoslavia (1992-94): Inflation rate = 313,000,000% (prices doubled every 34 hours).

3. Inflation Rates in Canada

• Canada has maintained a low inflation rate, averaging 2% since mid-1990s, which would see prices double every 35 years.

• Peak inflation rates witnessed in the late 1970s and early 1980s (e.g., 13% in 1981).

• Vigilance required to avoid recurrence of past inflationary periods.

4. Weighted Averages and Computing the Inflation Rate

• Understanding Averages:

  • Simple average: Sum of observations divided by the number of items.

  • Weighted Average: Assigns different weights to different observations. All weights must sum to 1.00.

• Inflation Rate Calculation:

• Measures percentage change in price level over time, reflecting consumer costs.

5. The Consumer Price Index (CPI) and Core CPI

• CPI Calculation: Uses a basket of over 80,000 goods across categories like food, shelter, transportation.

  • Index value is set to 100 for the base year.

• Inflation Rate from CPI: Computed as percentage change in CPI from one period to the next.

• Calculation requires CPI data from preceding year.

6. Core CPI

• Core CPI excludes volatile components (food, energy) to provide a clearer measure of price changes.

• Different measures of Core CPI exist, aimed at smoothing out volatility caused by transitory price movements.

7. Inflation in Canada vs the Rest of the World

• Canadian inflation trends often reflect global conditions due to substantial trade volume.

• Economic actions in other countries can influence Canada’s inflation rate.

• Historical trends reveal Canada's inflation rate aligns closely with international peers while influenced by domestic factors.