1. Inflation

2. Inflation
Inflation at its simplest just means a “general increase in prices”.
A more complicated way to look at it is that inflation is a decrease in the Purchasing Power of your money.
Purchasing power means your money’s ability to purchase goods and services

3. Measuring Inflation
We measure inflation by looking at ‘price levels’ and ‘price indexes’.
Price level is an average of the prices of all the goods and services made in one year.
Price Index is an average of the prices of a certain set of goods

4. CPI The most famous price index is the “Consumer Price Index” or CPI
It is an index of the prices of a set of items intended to represent the “market basket” of a typical consumer.
In other words, it’s an index of the goods and services the government thinks most people buy in a year.

5. Official CPI Composition

6. Determining the Inflation Rate
Inflation Rate: the percentage change in price level over time.
It is essentially the same formula as measuring Economic Growth
Start with the CPI of the later year (CPI2)
Subtract from it the CPI of the earlier year (CPI1)
Divide by CPI1
Multiply by 100
((CPI2 – CPI1) ÷ CPI1) x 100 = Inflation Rate

7. Calculating the Inflation Rate
So if the CPI for 2003 is 184
And the CPI for 2004 is 188.9
What was the inflation rate?
((188.9 – 184) ÷ 184) x 100
(4.9 ÷ 184) x 100
.027 x 100 = 2.7%
In other words the average price of EVERYTHING rose by 2.7% in one year.

8. A Few More Terms
Core Inflation Rate: the rate of inflation excluding food and energy prices.
Used because food and energy prices can sometimes shift rapidly
Hyperinflation: inflation that is out of control

9. What Causes Inflation?
There are several theories, that the government uses to fight inflation.
However, the simplest way to understand it is The Wage-Price Spiral

10. The Wage-Price Spiral Let’s use Home Depot as an example:
HD employees want more money
HD gives pay raises.
To pay for higher wages, HD must raise prices of its goods.
All the companies that buy HD goods must raise their prices so they can afford HD’s new prices
HD workers find their money doesn’t buy as much at all other businesses.
HD employees want more money.

11. Causes of inflation Rapid increases in AD Rising costs
If increases in AD are too great and too rapid for AS to keep pace, we see inflation caused by Demand , also called Demand-Pull Inflation
Rising costs
As AS shifts left due to increased cost of productive resources, the price level rises
Called Cost-Push Inflation (of which Wage-Price Spiral is an example)
Stagflation

12. Effects of Inflation Reduced purchasing power
Sometimes reduces income.
You get a 4% raise.
Inflation raises prices 5% this year
You actually make less money this year than last year.
Sometimes negates interest rates.
You put your money in an account that pays you 3.5% interest.
The inflation rate for the year is 4.0%
The money in your account effectively shrunk.

13. Unexpected v. Expected inflation
Unexpected worse
When expected, business and consumers prepare for it
Cost of living raises
Nominal or real interest rate
Nominal (the actual rate) includes the real interest rate + the inflation rate
Example:The bank expects inflation to be 3%. They charge a Nominal interest rate of 5% which includes the 3% inflation rate so they are actually receiving 2% real interest
If the Bank expected a 2% inflation rate and the actual inflation rate is 6% and the Nominal rate they charged was 5%, what would the bank position be?
A 1% loss
This applies to paying interest as well.