1. Inflation

2. Defined as: –A SUSTAINED RISE IN THE AVERAGE PRICE LEVEL OVER A PERIOD OF YEARS.

3. Inflation Measured by: –CONSUMER PRICE INDEX = CPI

4. Inflation Measured by: CPI = price of the most recent market basket in a particular year price estimate of same market basket in 1982-1984

5. Inflation Percent increase in CPI = [(CPI in current year – CPI in previous year)] [CPI in previous year] all*100

6. Inflation From 1972 to 1982, the consumer price index rose from 125.3 to 289.1 By what percentage did the cost of living rise?

7. Inflation Percent increase in CPI = [(289.1 – 125.3] [125.3] *100 =130.7%

8. Inflation The CPI rose from 114.3 in 2013 to 126.1 in 2020. By what percent did the CPI rise?

9. Inflation Percent increase in CPI = [(126.1 – 114.3] [114.3] *100 =10.3%

10. Inflation The CPI rose from 200 in 1991 to 240 in 1997. By what percent did the CPI rise?

11. Inflation The CPI rose from 129.6 in 2029 to 158.3 in 2045. By what percent did the CPI rise?

12. Inflation Percent increase in CPI = [(240 – 200] [200] *100 =20%

13. Inflation Percent increase in CPI = [(158.3 – 129.6] [129.6] *100 =22.1%

14. Deflation Defined as: –A SUSTAINED FALL IN THE AVERAGE PRICE LEVEL OVER A PERIOD OF YEARS.

15. Deflation Around the world from 1929-1933 In Japan from 1998-2005 Fear that it would happen again 2008-?

16. Deflation Fall in stock prices Fall in real estate and housing prices Fall in consumer prices Business profits down since their prices are down, but their debts and costs don’t fall Wage cuts to lower costs Rising unemployment

17. Types of Inflation A.DEMAND PULL B. COST PUSH - WAGE-PRICE SPIRAL - PROFIT PUSH - EXTERNAL SHOCK

18. Types of Inflation A. DEMAND PULL Defined as: - Excess demand pulls up prices Often caused by increases in government spending, such as wars

19. Types of Inflation B. COST-PUSH Defined as: - Rising costs drive up prices

20. Types of Inflation B. COST-PUSH Three types: - Wage-price spiral - Profit-push inflation - Supply-side shocks

21. Types of Inflation B. Wage-price spiral Rising wages force companies to increase prices. Blamed on labor unions or shortage of workers. Not a problem since early 1980’s.

22. Types of Inflation B. Profit-push inflation In many industries, there are only a small number of companies. Easy for them to raise prices to protect their profit margins.

23. Types of Inflation B. Supply-side shocks Dramatic and unexpected increases in the prices of key materials, such as oil or energy in general.

24. Inflation Who is hurt by inflation?

25. Who is Hurt by Inflation PEOPLE ON FIXED INCOMES LENDERS/CREDITORS

26. Who is Hurt by Inflation: People on Fixed Incomes Nominal Income Real Income

27. Who is Hurt by Inflation: Nominal vs. Real Income NOMINAL INCOME = face value of your income REAL INCOME = nominal income adjusted for inflation with price indexes

28. Who is Hurt by Inflation: Nominal vs. Real Income % CHANGE IN REAL INCOME = %Change Nominal Income- % Change Price Level

29. Who is Hurt by Inflation: Nominal vs. Real Income Fixed income receivers Anyone who income is fixed over time finds that their real income falls at the same rate that inflation rises.

30. Who is Hurt by Inflation: Lenders/creditors Lenders, such as banks and credit card companies, lend money to earn a profit. –To earn a profit, the interest they charge must cover all costs, and be higher than the rate of inflation.

31. Who is Hurt by Inflation: Lenders/creditors When lenders lend money, they have an expected rate of inflation at the time of the loan. –This expected rate of inflation is based on current rate of inflation, plus a guess about the future.

32. Who is Hurt by Inflation: Lenders/creditors –If lenders guess right about inflation, they earn a profit. –If lenders guess wrong, they lose money.

33. Who is Hurt by Inflation: Lenders/creditors Nominal interest rate = the observed interest rate Real interest rate = nominal interest rate – rate of inflation

34. Who is Hurt by Inflation: Lenders/creditors If inflation is less than the nominal interest rate, lenders earn a profit. If inflation is greater than the nominal interest rate, lenders suffer a loss.

35. Inflation: Any Winners? Not everyone loses with low and moderate rates of inflation. - People whose income is flexible. - Borrowers (debtors).

36. Inflation: Any Winners? Borrowers win because the real value of their loan repayments decreases at the same rate as inflation rises. If their incomes rise as well, they are double winners.

37. Inflation Problems Suppose your income rose by 4.6%, and inflation rose by 1.6%. Suppose your income rose by 4.0%, and inflation rose by 3.0%. Suppose your income rose by 4.0%, and inflation rose by 5.0%.

38. Inflation Problems Suppose a lender made a loan with 7.0% interest, and inflation was 3.1%. Suppose a lender made a loan with 6.0% interest, and inflation was 4.2%. Suppose a lender made a loan with 4.75% interest, and inflation was 5.1%.

39. Inflation Problems Suppose you invested in a bank CD that paid 4.75% interest, and inflation was 3.1%. Suppose you invested in a bank CD that paid 4.75% interest, and inflation was 4.6%. Suppose you invested in a bank CD that paid 4.75% interest, and inflation was 5.1%.

40. Problems with Inflation Much of the United States Federal government’s monetary policy, and the focus of most introductory econ textbooks, is on the evils of inflation. In the dispute between lenders and borrowers, which side are they on?