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
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
Real costs of changing listed prices
In hyperinflation, countries will avoid changing prices.
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
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
- Hypothetical set of consumer purchases of goods and services
Measures the cost of purchasing a given market basket in a given year
(index value is set to 100 in the base year)
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
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
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
GDP Deflator: changes every year