Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 8 Inflation

8-2 Chapter Objectives Basics of inflation Average price level Inflation rate Globalization and inflation Quality improvements Adjusting for inflation Money illusion and expectations

8-3 Basics of Inflation Inflation is the rise and fall in the overall level of prices in the economy as a whole. –The overall price level is an average of millions of prices of different goods and services. Inflation is one of the key measures of the health of the economy. –The economy is in trouble if prices are rising or falling too fast.

8-4 Basics of Inflation The goal of economic policymakers is to keep inflation under control. Inflation is a problem since it reduces consumers’ purchasing power. –If inflation increases, your money buys less and less. The situation where prices are falling is known as deflation.

8-5 Average Price Level At any time in the economy, the price of some goods and services will be rising, while others will be falling. So when we measure inflation, we are concerned with the extent that overall prices (prices across the economy) are rising or falling, not with the rise or fall of any particular good or service.

8-6 Average Price Level The average price level in the economy measures how much it costs to buy a market basket of common goods and services. The US Bureau of Labor Statistics (BLS) selects the contents of the market basket which represents the goods and services the typical US household will buy. The BLS gives each item in the market basket a certain weight to represent its relative importance in the typical budget.

8-7 Market Basket The two largest items in the market basket: –The cost of housing measured by the owners’ equivalent rent of primary residence. This is the single biggest part of the market basket. –Food consumed at home. This is the second largest part of the market basket, and is followed by medical care. The market basket, while not perfect, is a reasonable representation of the spending pattern of an average US household.

8-8 Consumer Price Index (CPI) The consumer price index (CPI) is a measure that tracks the average price level in the US. CPI is based on a market basket of goods. BLS selected the average price level as the base year. –The base year is assigned a value of 100. The CPI measures all other years relative to this base period.

8-9 Consumer Price Index (CPI) Consumer Price Index, =

8-10 Inflation Rate Inflation is defined as a sustained upward movement in the average level of prices. The inflation rate is the annual percentage change in the average price level. –Since the CPI tracks the average price level, the inflation rate is also the annual percentage change in the CPI. CPI is published each month by the BLS.

8-11 Inflation Rate 0% 2% 4% 6% 8% 10% 12% 14% 16% Annual increase in consumer price index (percent)

8-12 Calculating Percentage Change Economists are concerned with the speed of change over time. The inflation rate measures how fast prices are rising. Measure the rate of change as an annual percentage change, which is calculated as follows: –Percentage change = [(original number – new number)/original number] x 100

8-13 Relative Price Shifts BLS reports not only overall inflation rate, but also the inflation for subcategories of goods and services. A relative price shift happens when the inflation rate of a good or service is significantly higher or lower than the overall inflation rate. –If it’s higher, then that good or service is getting more expensive over time, relative to other possible purchases. –If it’s lower than the overall inflation rate, then it’s getting relatively cheaper.

8-14 Globalization and Inflation The inflation rate has been higher for services compared to goods. The main reason goods have become cheaper is globalization. Production of goods has shifted from the US to lower-cost countries such as China. It is much harder to shift the production of services overseas.

8-15 Quality Improvements and Inflation A difficulty involved in measuring inflation is that the quality and features of a product change over time. When the price of a good or service goes up because of an improvement in quality, the BLS does not count that price increase as part of the inflation rate. –Rapid technological change makes the job of measuring inflation especially difficult, since the product changes are rapid and it’s hard to compare them to the original.

8-16 Adjusting for Inflation To compare household income over time, we must adjust the income for the impact of inflation. Otherwise, we run the risk of suffering from money illusion. Money illusion happens when we compare dollar amounts in different time periods without adjusting for inflation.

8-17 Real versus Nominal Dollars To avoid money illusion, we should use the real or inflation-adjusted increase. –This is calculated as the percentage increase in dollars minus the inflation rate. The increase without the adjustment for inflation is called the nominal increase. The real or inflation-adjusted increase is the nominal percentage change minus the inflation rate.

8-18 Expectations and Inflation Expected inflation is the inflation rate that consumers and businesses expect will hold for some future period. Expected inflation forms the basis for pricing and wage decisions that businesses make. If people expect that the higher rate of inflation will continue, a wage-price spiral may occur. –Business now boosts prices and wages faster and faster to stay ahead of expected inflation. –The worst possible case of a wage–price spiral is hyperinflation.

8-19 Harm from Inflation The harm from inflation depends on two cases. –First is the case of unanticipated inflation, which occurs when the actual inflation rate is above the expected inflation rate. In this case, lenders are harmed since they’re being paid back with less valuable dollars. Borrowers benefit from unanticipated inflation.

8-20 Harm from Inflation –Second is the case of anticipated inflation, where the actual rate of inflation is equal to the expected rate of inflation. The problem with anticipated inflation is that it leads to cost-of-living adjustments (COLA) in union contracts and certain government programs. High levels of inflation increase the cost of transactions - the time and effort that goes into managing your spending.

8-21 Deflation Deflation is an actual fall in the average price level. In contrast, disinflation is a reduction in the inflation rate. Deflation is a problem for two reasons : –First, deflation usually means demand is so weak that businesses cannot raise their prices. –Second, deflation hurts borrowers, because they are paying back their loans with more expensive dollars.