# 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

• 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

• 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