1. Inflation

2. What Is Inflation?
Inflation is an increase in the average level of prices, not a change in any specific price.

3. The Average Price
The average price is determined by finding the average price of all output.
A rise in the average price is called inflation.
A fall in the average price is called deflation.

4. Relative Prices vs. the Price Level
Changes in relative prices may occur in a period of stable average price, or in periods of inflation or deflation.
A relative price is the price of one good in comparison with the price of other goods.

5. Relative Prices vs. the Price Level
By reallocating resources in the economy, relative price changes are an essential ingredient of the market mechanism.
A general inflation doesn’t perform this market function.

6. Redistributive Effects of Inflation
Although inflation makes some people worse off, it makes some people better off.
The three major methods inflation redistributes money by are:
The Price Effect
The Income Effect
The Wealth Effect

7. Price Effects
Nominal income is the amount of money income received in a given time period, measured in current dollars.
Real income is income in constant dollars: nominal income adjusted for inflation.

8. Price Effects Not all prices rise at the same rate during inflation.
Two basic lessons about inflation:
Not all prices rise at the same rate during inflation.
Not everyone suffers equally from inflation.
Not all prices rise at the same rate during inflation.
Not everyone suffers equally from inflation.

9. Price Effects
People who prefer goods and services that are increasing in price least quickly end up with a larger share of income.

10. Price Changes in 2000

11. Income Effects
Even if all prices rose at the same rate, inflation would still redistribute income.
Redistributive effects originate both in expenditure and income patterns.

12. Income Effects If prices are rising, incomes must be rising too.
What looks like a price to a buyer looks like an income to a seller.
If prices are rising, incomes must be rising too.
People whose nominal income rise faster than inflation end up with a larger share of total income.

13. Nominal Wages and Prices
100
120
140
160
180
200
1980
1982
1984
1986
1988
1990
1992
1994
1996
Wages
YEAR
1998
2000
Prices

14. Wealth Effects
People hold wealth in different forms (accounts, stocks, commodities).
When the value of these changes due to inflation, some people will get wealthier and some will lose wealth.

15. The Real Story of Wealth

16. Uncertainty
One of the most immediate consequences of inflation is uncertainty.
Uncertainties created by changing price levels affect consumption and production decisions.

17. Shortened Time Horizons
People tend to shorten their time horizons in the face of inflation uncertainties.
Time horizons are shortened as people attempt to spend money before it loses further value.

18. Shortened Time Horizons
During the German hyperinflation, workers were paid two or three times a day so that they could buy goods in the morning before prices increased in the afternoon.
Hyperinflation is an inflation rate in excess of 200 percent, lasting at least one year.

19. Speculation
If you expect prices to rise, it makes sense to buy things now for resale later.
Few people will engage in production if it is easy to make speculative profits.
People may be encouraged to withhold resources from the production process, hoping to sell them later at higher prices.

20. Speculation
As such behavior becomes widespread, production declines and unemployment rises.

21. Bracket Creep
Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow.
As prices rise, incomes rise, and then taxes rise.

22. Deflation Dangers
Deflation — a falling price level — might not make people happy either.
Deflation reverses the redistributions caused by inflation.
Lenders win and creditors lose.

23. Deflation Dangers
When prices are falling, people on fixed incomes and long-term contracts gain more real income.

24. Deflation Dangers Time horizons get shorter.
Falling price levels have similar macro consequences.
Time horizons get shorter.
Businesses are more reluctant to borrow money or to invest.

25. Deflation Dangers
People lose confidence in themselves and public institutions when declining price levels deflate their incomes and assets.

26. Measuring Inflation Measuring inflation serves two purposes:
Gauges the average rate of inflation.
Identifies its principal victims.

27. Consumer Price Index (CPI)
The CPI is the most common measure of inflation.
The consumer price index (CPI) is a measure (index) of changes in the average price of consumer goods and services.

28. Consumer Price Index (CPI)
By observing the extent of price increases, we can calculate the inflation rate.
The inflation rate is the annual percentage rate of increase in the average price level.

29. Constructing the CPI
The Bureau of Labor Statistics constructs a market basket of goods and services that consumers usually buy.
Specific goods and services are itemized within the broad categories of expenditures.

30. Constructing the CPI
The relative importance of a product in the CPI is reflected in its item weight.
Item weight is the percentage of total expenditure spent on a specific product; used to compute inflation indexes.

31. Constructing the CPI percentage change in CPI =
The impact on the CPI of a price change for a specific good is calculated as follows:
percentage change in CPI =
item weight X percentage change in price of item

32. The Market Basket Transportation 19.0% Housing 32.6% Food 13.6%
Clothing 4.7%
Miscellaneous 10.5%
Health care 5.3%
Entertainment 5.1%
Insurance and pensions 9.3%

33. Producer Price Indexes
There are three producer price indexes (PPI) which keep track of average prices received by producers.
One includes crude materials, another intermediate goods, and the last covers finished goods.

34. Producer Price Indexes
PPIs are watched as a clue to potential changes in consumer prices.
In the short run, the PPIs usually increase before the CPI.
The PPIs and the CPI generally reflect the same inflation rate over long periods.

35. The GDP Deflator:
The GDP deflator is a price index that refers to all goods and services included in GDP.
It is the broadest price index is the GDP deflator.
It covers all output including consumer goods, investment goods, and government services.

36. The GDP Deflator:
The GDP deflator usually registers a lower inflation rate than the CPI.
Unlike the CPI and PPI, the GDP deflator is not limited to a fixed basket.
Its value reflects both price changes and market responses to those changes.

37. Real vs. Nominal GDP
The GDP deflator is used to adjust nominal output values for changing price levels.
Nominal GDP is the value of final output produced in a given period, measured in the prices of that period (current prices).
Real GDP is the value of final output produced in a given period, adjusted for changing prices.

38. Real vs. Nominal GDP
Nominal and Real GDP are connected by the GDP deflator:

39. The Goal: Price Stability
Price stability is the absence of significant changes in the average price level; officially defined as an inflation rate of less than 3 percent.

40. Unemployment Concerns
A little bit of inflation might be the “price” the economy has to pay to keep unemployment rates from rising.
Some unemployment may be the “price” society has to pay for price stability.

41. The Historical Record
In the long view of history, the U.S. has done a good job in maintaining price stability.
Upon closer inspection, however, our inflation performance is very uneven.

42. The Historical Record Inflation Deflation 20 16 12 8 4 1920 1930 1940
1920
1930
1940
1950
1960
1970
1980
1990
2000
Inflation B A
Deflation

43. Causes of Inflation Inflation is rooted in supply and demand.
The most common types of inflation come from demand-pull and cost-push.

44. Demand-Pull Inflation
Demand-pull inflation results from excessive pressure on the demand side of the economy.
“Too much money chases too few goods” enabling producers to raise prices.

45. Cost-Push Inflation
The pressure on price could also originate on the supply side.
Higher production costs put upward pressure on product prices.

46. Protective Mechanisms
Low rates of inflation don’t have the drama of hyperinflation, but they still redistribute real wealth and income.
For example, if prices rise by an average of just 4 percent a year, the real value of $1,000 drops to $822 in five years and to only $676 in ten years.

47. COLAs
Cost-of-living adjustments (COLAs) are automatic adjustments of nominal income to the rate of inflation.
COLAs are commonly used by landlords as well as in labor agreements and government transfer programs.

48. ARMs
An adjustable-rate mortgage (ARM) is a mortgage (home loan) that adjusts the nominal interest rate to changing rates of inflation.
ARMs were developed to protect lenders against losses during long term rises in inflation.

49. Real interest rate = nominal interest rate – anticipated interest rate
ARMs
The real interest rate is the nominal interest rate minus the anticipated inflation rate.
Real interest rate = nominal interest rate – anticipated interest rate

50. ARMs
If prices rise faster than interest accumulates, the real interest rate will be negative.

51. Inflation
End of Chapter 7