Inflation -A rise in the general level of prices. -Price index numbers(as described in previous lessons) measure inflation. -The price index measures the general level of prices in a given year relative to prices in a base year.

EXAMPLE In the year 2000 the CPI was 172, which means that the price level was 72% higher in 2000 than in the base period of , when the CPI was 100.

Inflation The rate of inflation for any given year is found by subtracting the preceding year’s price index from that year’s index, dividing by the preceding year’s index, and multiplying by 100 to express the result as a percentage.

Example The CPI was in 2003 and in Rate of inflation for 2004 is calculated as follows: / x 100 = 3.4% inflation rate

Inflation Types: – 1. demand-pull: changes in the price level are caused by an excess of total spending beyond the economy’s capacity to produce. “too much spending chasing too few goods”

Inflation Types: Demand-pull -There are three ranges of changes in price level and real output.

Inflation Types: Demand-pull Range 1: Output is very low relative to the economy’s full- employment output. This implies a low level of total spending and a GDP gap. Unemployment rates are high.

Inflation Types: Demand-pull Range 1: Assume now that total spending increases. As it does, real GDP will increase, and the unemployment rate fall. There will little or no increase in price level. Large amounts of idle human and property resources will be put back to work at their existing prices.

Inflation Types: Demand-pull Range 2 = As output continues to expand in response to further increases in total spending, the economy enters range 2. It approaches and surpasses its full- employment output.

Inflation Types: Demand-pull Range 2= Price levels begin to rise. More workers are employed, and each added worker contributes less to output. Labor costs therefore begin to rise, forcing up product prices.

Inflation Types: Demand-pull Range 2= As production expands, supplies of idle resources disappear at different rates in various industries. Some input supplying industries are able to reach their full-production capacity before others and thus cannot respond to further increases in total spending for their products.

Inflation Types: Demand-pull Range 2 = Shortages of inputs cause resource prices to rise, boosting the production costs and product prices of industries that still have excess capacity.

Inflation Types: Demand-pull Range 2 = As total spending in range 2 increases beyond full-employment level of output.

Inflation Types: Demand-pull Range 2 = Firms may employ additional work shifts and use overtime to achieve greater output. Households may supply additional workers such as teenagers and spouses. The rate of unemployment falls below the natural rate and the actual GDP exceeds potential GDP, the pace of inflation quickens.

Inflation Types: Demand-pull Range 3 = As total spending increases into range 3, the economy simply cannot supply more resources.

Inflation Demand-pull Inflation: Range 3 -Firms cannot respond to increases in demand by increasing output. So, in effect, further increases in demand raise the price level. The rate of inflation may be high and still rising because total demand greatly exceeds society’s capacity to produce. There is no increase in real output to asorb some of the increased spending.

Inflation Cost-Push Inflation: Inflation may also arise on the supply, or cost, side of the economy. These are times when output and employment both decline while the general price level rises.

Inflation Cost-Push Inflation: explains rising prices in terms of factors that raise per-unit production costs at each level of spending.

Inflation Cost-Push Inflation: -A per-unit production cost is the average cost of a particular level of output. This is found by dividing the total cost of all resource inputs by the amount of output produced.

Inflation Cost-Push Inflation: Per-unit production cost = total input cost/ units of output Rising per-unit production costs squeeze profits and reduce the amount of output firms are willing to supply at the existing price level. As a result,____________________

Inflation Cost-Push Inflation: As a result, the economy’s supply of goods and services declines and the price level rises. In this scenario, costs are pushing the price level upward, whereas in demand-pull inflation demand is pulling prices upward.

Inflation Cost-Push Inflation: The major source of cost-push inflation has been supply shocks.

Inflation Cost-Push Inflation: Abrupt increases in the costs of raw materials or energy inputs have driven up per-unit production costs and thus product prices. Ex= imported oil in and again in

Inflation Cost-Push Inflation: As energy prices surged upward during these periods, the costs of producing and transporting virtually every product in the economy rose. Rapid cost- push inflation ensued.

Inflation Effects of Inflation: Inflation redistributes real income from some people to others. There is a difference between money (nominal) income and real income.

Inflation Nominal income is the number of dollars received as wages, rent, interest, or profits. Real income is a measure of the amount of goods and services nominal can buy; it is the purchasing power of nominal income, or income adjusted for inflation.

Inflation Real Income = nominal income/ price index (in hundredths) Inflation need not alter an economy’s overall real income – it’s purchasing power. (Explain)

Inflation -Real income will remain the same when nominal income rises at the same percentage rate as does the price index. -But when inflation occurs, not everyone’s nominal income rises at the same pace as the price level.

Inflation If the change in the price level differs from the change in a person’s nominal income, his or her real income will be affected.

Inflation Effects of inflation: Example -The price level rises by 6% -If Bob’s nominal income rises by 6%, his ________________________. -If his nominal income rises by 10%, his _________________________. -If his nominal income rises by 2%, his__________________________.

Inflation Who is hurt by Inflation? – Fixed-Income Receivers – Savers – Creditors

Inflation Who is Unaffected or Helped by Inflation? – Flexible Income Receivers – Debtors

Inflation Real Interest Rate = is the percentage increase in purchasing power that the borrower pays the lender. The nominal interest rate = is the percentage increase in money that the borrower pays the lender, including that resulting from the built-in expectation of inflation.

Inflation Effects of Inflation on Output Cost Push Inflation and Output: Explain Demand Pull Inflation and Output: Explain

Inflation Hyperinflation: an extremely rapid inflation whose impact on real output and employment usually is devastating. Explain how it happens.