What is Inflation

• General increase in prices, or more precise, the purchasing power of your money decreases

• Inflations isn't when only one particular product's price increases but when all prices increases

• In the late 1970s, Fed Chairman Paul Volcker made taming inflation his top priority

• By increasing interest rates, the Fed was able to tame inflation but, in the process, essentially created a recession

Costs of Inflation

• Shoe-Leather Costs

  • The increased costs of transactions due to inflation

  • Since people avoid holding onto money during periods of inflation, people waste time and energy marking transactions to avoid sitting on cash.

  • Banking sector increases

• Menu Costs

  • Real costs of changing listed prices

  • In hyperinflation, countries will avoid changing prices.

• Unit-of-Account Costs

  • Money becomes a less reliable unit of measurement

  • "Profit" due to inflation is still taxed and therefore investment is discouraged

  • This role of the dollar as a basis for contracts and calculation is called the unit-of-

  accountrole of money.

Winners & Losers from Inflation

• Nominal interest rate

  • the actual interest that is paid on a loan

• Real interest rate

  • Nominal interest rate - Expected inflation rate

• Nominal vs. Real

  • The nominal interest rate is the rate actually paid.

  • The real interest rate is actual return the lender receives net of inflation

• Borrowers win with inflation because they pay back in nominal dollars.

• Savers and lenders lose because the amount of money they receive is worth less.

• Countries with uncertain levels of inflation generally won't issue long-term loans

  

Wage-Price Spiral

• Combination of "cost-push" and "demand-pull" inflation leads to a wage-price spiral

• When there is too much money chasing too few goods, the price of products will tend to increase which leads to "demand-pull" inflation

• When workers demand higher wages as a result of inflated prices, prices of products consequently go up as well, leading to this "wage-price" spiral

• Increased price of products leads to higher wages leads to increased price of products and so on

• Keynesians tend to favor this model of how inflation works and that they prices are sticky downward or downward inflexible

  

Monetarist View of Inflation

• Milton Friedman viewed inflation as simply an issue of money supply

• The quantity theory of money is quite simple: an increase in the supply of money will correspondingly increase inflation

• The Austrian view argues that using the Consumer Price Index (or CPI) to measure inflation is inaccurate because inflation in unevenly spread through different goods and services

• Paul Krugman, a Nobel Prize winning, "Keynesian" economist, rejects this Austrian view of inflation stating that the monetary base tripled in 2011 and yet there was no widespread inflation

Measurement and Calculation of Inflation

• Aggregate Price Level

  • Measure of the overall prices in the economy

• Market Basket

  • Hypothetical set of consumer purchases of goods and services

• Price Index

  • Measures the cost of purchasing a given market basket in a given year

  • (index value is set to 100 in the base year)

  • $\text{Price index in a given year} = \dfrac{\text{Cost of market basket in a given year}}{\text{Cost of market basket in base year}} \times 100$

  • $\text{Inflation rate} = \dfrac{\text{Price index in year 2} - \text{Price index in year 1}}{\text{ Price index in year 1 }} \times 100$

CPI, PPI & GDP Deflator

• Consumer Price Index (CPI)

  • most commonly used measure of inflation, market basket of a typical urban American family

  • The Bureau of Labor Statistics sends employees out to survey prices on a multitude of items in food, apparel, recreation, medical care, transportation and other categories

  • CPI tends to overstate inflation (substitution bias and technological advances)

• Producer Price Index (PPI)

  • measures the cost of typical basket of goods and services that producers purchase

  • Tends to be used as the "early warning signal" of changes in the inflation rate

• GDP Deflator

  • $\text{GDP Deflator} = \dfrac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$

  • $\text{Real GDP} = \dfrac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100$

• Not exactly a price index but serves to show how much the aggregate price level has increased

• Unlike the CPI, GDP is not based on a fixed basket of goods and services.

• It's allowed to change with people's consumption and investment patterns

• The default "basket" in each year is the set of all goods that were produced in the country in that particular year.

• CPI, PPI, and GDP Deflator tend to move, generally, in the same direction

  

• Comparison

  • equation

  

• prices of capital good

  • included in GPD deflator (if produced domestically)

  • excluded from CPI

• prices of imported consumer goods

  • included in CPI

  • excluded from GDP deflator

• the basket of goods

  • CPI: fixed

  • GDP Deflator: changes every year