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Title: Inflation and the Price Level
Description: These notes are very helpful for micro and macroeconomics classes. These are college level notes but they can also be used for high school classes and AP courses.
Description: These notes are very helpful for micro and macroeconomics classes. These are college level notes but they can also be used for high school classes and AP courses.
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Inflation and the Price Level
Thursday, February 11, 2016
12:00 PM
The Consumer Price Index and Inflation
• Quantities that are measured in dollars (or other currency units) and then
adjusted for inflation are called real quantities
• Consumer Price Index (CPI): for any period, a measure of the cost in that period
of a standard basket of foods and services relative to the cost of the same
basket of goods and services in a fixed year, called the base year
○ CPI = (Cost of base-year basket of goods and services in current
year)/(Cost of base-year basket of goods and services in base year)
○ The base-year CPI is always equal to 1
○ No unit of measurement
• Price Index: a measure of the average price of a given quality of goods or
services relative to the price of the same goods or services in a base year
• Rate of Inflation: the annual percentage rate of change in the price level, as
measured, for example, by the CPI
○ (New CPI - Old CPI)/Old CPI
• Deflation: a situation in which the prices of most goods and services are falling
over time so that inflation is negative
• Core Rate of Inflation: the rate of increase of all prices except energy and food
○ Energy and food are frequently responsible for short-run fluctuations in
the inflation rate
○ Core inflation excludes the sources of the most volatile price changes, so
is a long-term measure of the inflation trend
Adjusting for Inflation
• CPI can be used to convert quantities measured at current dollar values into real
terms, a process called deflating
• CPI can also be used to convert real quantities into current-dollar terms, a
process called indexing
• Nominal Quantity: a quantity that is measured in terms of its current dollar
value
• Real Quantity: a quantity that is measured in physical terms - for example, in
terms of quantities of goods and services
○ Sometimes a rise in income does not keep up with rises in prices
• Deflating (a nominal quantity): the process of dividing a nominal quantity by a
price index (such as the CPI) to express the quantity in real terms
• Real Quantity: a quantity that is measured in physical terms - for example, in
terms of quantities of goods and services
○ Sometimes a rise in income does not keep up with rises in prices
• Deflating (a nominal quantity): the process of dividing a nominal quantity by a
price index (such as the CPI) to express the quantity in real terms
• Real Wage: the wage paid to workers measured in terms of purchasing power
○ The real wage for any given period is calculated by dividing the nominal
(dollar) wage by the CPI for that period
• Indexing: the practice of increasing a nominal quantity each period by an
amount equal to the percentage increase in a specified price index
○ Indexing prevents the purchasing power of the nominal quantity from
being eroded by inflation
○ Because the minimum wage is not indexed to inflation, its purchasing
power falls as prices rise
Does the CPI Measure "True" Inflation
• An overstated rate of inflation could lead to an underestimation of the true
improvement in living standards over time
• In practice, government statisticians cannot always adjust adequately for
changes in the quality of goods and services
• Other problem is that the CPI is calculated for a fixed basket of goods and
services
○ Ignores fact that consumers can switch from more expensive to less
expensive goods
The Costs of Inflation
• Price Level: a measure of the overall level of prices at a particular point in time
as measured by a price index such as the CPI
○ To counteract inflation, the government must make monetary or fiscal
policies
• Relative price: the price of a specific good or service in comparison to the price
of other goods and services
○ To counteract changes in relative price, the government would need to
implement policies that affect the supply and demand for specific goods
• Inflation is an increase in the overall price level, not an increase in a specific
relative price
• Changes in relative prices do not necessarily imply a significant amount of
inflation
• When inflation is high, signals sent through the price system become more
difficult to interpret
○ If inflation is high, the supplier must ask whether a price increase
represents a true increase in demand or just a result of general inflation
• Without indexing, an inflation that raises people's nominal incomes would force
them to pay an increasing percentage of their income in taxes (bracket creep)
○ Although income taxes are indexed, many are not
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•
•
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difficult to interpret
○ If inflation is high, the supplier must ask whether a price increase
represents a true increase in demand or just a result of general inflation
Without indexing, an inflation that raises people's nominal incomes would force
them to pay an increasing percentage of their income in taxes (bracket creep)
○ Although income taxes are indexed, many are not
Inflation raises the cost of holding cash to consumers and businesses
○ Shoe-leather costs are those from making the inconvenient trips to the
bank to minimize one's cash holdings
Inflation doesn't destroy purchasing power, but redistributes it
○ In general, unexpectedly high inflation rates help borrowers at the
expense of lenders
○ Low inflation rates help lenders and hurt borrowers (must pay in dollars
worth more than they were when loan was made)
Inflation makes long-term planning difficult
Hyperinflation: a situation in which the inflation rate is extremely high
Inflation and Interest Rates
• Real Interest Rate: the annual percentage increase in the purchasing power of a
financial asset; the real interest rate on any asset equals the nominal interest
rate on that asset minus the inflation rate
• Nominal Interest Rate: the annual percentage increase in the nominal value of a
financial asset
• R = i - pi
○ R = the real interest rate
○ i = the nominal interest rate
○ Pi = the current inflation rate
• Inflation-Protected Bonds: bonds that pay a nominal interest rate each year
equal to a fixed real rate plus the actual rate of inflation during that year
• Fisher Effect: the tendency for nominal interest rates to be high when inflation
is high and low when inflation is low
Title: Inflation and the Price Level
Description: These notes are very helpful for micro and macroeconomics classes. These are college level notes but they can also be used for high school classes and AP courses.
Description: These notes are very helpful for micro and macroeconomics classes. These are college level notes but they can also be used for high school classes and AP courses.