GDP and Economic Challenges Unit 6 Macroeconomics: GDP and Economic Challenges Chapters 13.2 Economics Mr. Biggs

Inflation The Effects of Rising Prices Inflation - A general increase in prices. In the American economy, prices have mostly risen since World War II. Purchasing power - The ability to purchase goods and services. Inflation can shrink the purchasing power of money. For example, in 1954 a Mercedes Benz 300SL cost $11,000. In 2011 a Mercedes Benz SLS AMG cost $183,000.

Price Indexes Using Price Indexes Economists do not compare individual prices, they compare price levels. Price Index - A measurement that shows how the average price of a standard group of goods changes over time. For example, a home price index. Using Price Indexes Price indexes help consumers and businesses make economic decisions. For example, increased savings in time of inflation. Governments also use indexes to make policy decisions. For example, increasing minimum wage if purchasing power has been decreased.

The Consumer Price Index There are several price indexes, the best-known index focuses on consumers. The Consumer Price Index (CPI) - A measurement that shows how the average price of a standard group of goods changes over time. They measure the price of a standard group of goods that represent the “market basket” of an urban consumer. Market basket - A representative collection of goods and services. Price Indexes and the Inflation Rate Economists also calculate the inflation rate but the CPI is the index you will most often hear about. Inflation rate - The percentage rate of change in price level over time.

Calculating the Inflation Rate Determining the CPI To determine CPI, the BLS establishes a base period to which it can compare current prices. Currently, the base period is 1982 – 1984. The cost of the market basket for that period is assigned the index number 100. The BLS determines the CPI for a given year using the following formula: Calculating the Inflation Rate The BLS determines the inflation rate using the following formula:

Types of Inflation Inflation rates between 1% - 3% do not typically cause problems for an economy. When the rate exceeds 5%, the inflation rate itself becomes unstable and unpredictable. In order to study long-term trends in inflation rate, economists calculate the core inflation rate. Core inflation rate - The rate of inflation excluding the effects of food and energy prices. Hyperinflation - Inflation that is out of control. For example, inflation of 100% causes your money to lose much of its value and can lead to an economic collapse.

Causes of Inflation The Quantity Theory Demand-Pull Theory Economists incorporate the quantity theory, demand-pull theory, and cost-push theory when they try to understand the inflation process. The Quantity Theory Quantity theory - Theory that too much money in the economy causes inflation. Demand-Pull Theory Demand-pull theory - Theory that inflation occurs when demand for goods and services exceeds existing supplies.

The Cost-Push Theory Effects of Inflation Cost-push theory - Theory that inflation occurs when producers raise prices in order to meet increased costs. Wage increases are usually the reason for the increased costs. Wage-price spiral - The process by which rising wages cause higher prices, and higher prices cause higher wages. Effects of Inflation The effects of inflation can be seen mainly in purchasing power, income, and interest rates.

Purchasing Power Income Interest Rates Inflation can erode purchasing power. In an inflationary economy, a dollar will not buy the same number of goods that it did in years past. Income Inflation will erode income if wage increases do not keep up with inflation. People on a fixed income will see the real value of their paycheck steadily decrease. Fixed income - Income that does not increase even when prices go up. Interest Rates Savers may lose money if the inflation rate is higher than their interest rate.

Recent Trends In the late 1990s and early 2000s, unemployment levels were low and inflation began to increase (wage-price spiral). In 2009, prices seemed to be falling and some experts predicted a period of deflation. Deflation - A sustained drop in price level. In the late 2000s, the unemployment rate rose to 10% with less than 2% inflation.

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