CHAPTER 7 Inflation

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CHAPTER 7Inflation
ECONOMICS EXPLORE APPLYEnhanced Edition
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Learning Objectives

1. Describe inflation rates in the U.S. and other
   countries.
2. Discuss the cost of inflation that cause low
   inflation to be a macroeconomic goal.
3. Compute, interpret, and use a price index to
   compute a real value.

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Learning Objectives

1. Identify problems with price indexes and efforts
   to improve them.
2. (EA) Explain how people respond to inflation,
   and how that affects its measurement.

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7.1THE GOAL OF LOW INFLATION

• Along with economic growth and high employment,
  low inflation is the third fundamental goal of
  the economy.
• Inflation is a persistent increase in the price
  level.
• The price level refers to the prices of goods and
  services, when considered in the aggregate.

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The Goal of Low Inflation

• The inflation rate is the annual percentage
  increase in the price level.
• In the U.S., as long as the inflation rate from
  year to year stays at around 3 per year,
  Americans are satisfied that the goal of low
  inflation has been accomplished.
• If the inflation rate is above 3, people expect
  the government to take action to fight
  inflation.

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The U.S. Inflation RateSelected Years
Year Inflation Rate
1945 2.3
1946 8.3
1947 14.4
1948 8.1
1949 -1.2
1950 1.3
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The U.S. Inflation RateSelected Years
Year Inflation Rate
1955 -.4
1960 1.7
1965 1.6
1970 5.7
1975 9.1
1980 13.5
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The U.S. Inflation RateSelected Years
Year Inflation Rate
1985 3.6
1990 5.4
1991 4.2
1992 3.0
1993 3.0
1994 2.6
2002 1.6
2003 2.1
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Inflation A World-WidePhenomenon

• The CIA estimates that the average inflation in
  the world in 2002 was 3.3.
• Most of these severely high rates occurred in
  developing countries.
• The developing countries inflation rates ranged
  between 5 and 60 as compared to the range in
  developed countries which was between 1 and 3.
• Political instability can result from severe
  inflation

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Inflation Rates in Selected Countries
Country - Year 2003 Inflation Rate
Ecuador 12.5
Zimbabwe 134.5
Yugoslavia (Slovakia Montenegro) 19
Ukraine -1.2
Russia 15
Venezuela 31.2
Mexico 6.4
Brazil 8.3
China -.08
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Inflation Rates in Selected Countries
Country - Year 2003 Inflation Rate
Bolivia 2
U.S. 1.6
U.K. 2.1
Germany 1.3
Japan -0.99
Argentina -0.9
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Deflation and Disinflation

• When the inflation rate is negative, deflation is
  said to occur.
• This would happen if the price level declined
  from one year to the next.
• Deflation is not an economic goal.
• Historically, widespread falling prices and poor
  economic performance seem to go hand in hand.
• Disinflation means that the rate of inflation
  declines, and is different than both inflation,
  and deflation.

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7.2THE HARM FROM INFLATION

• Energy and food prices are subject to wide
  fluctuations caused by temporary shifts in their
  supply.
• Excluding food and energy prices from the
  computation of the inflation rate reveals what is
  termed core inflation.

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The Core Rate of Inflation
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The Harm from Inflation

• Inflation hurts those on fixed incomes.
• Inflation hurts lenders.
• Inflation increases the opportunity cost of
  search time for cheaper substitute goods.

• Inflation motivates businesses to offer new
  products.
• Inflation might motivate business to trim the
  amount of product rather than raise its price.

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Anticipated and Unanticipated Inflation

• Anticipated inflation is expected by the public.
• In theory, everyone is able to defend themselves
  against losses imposed by anticipated inflation.
• Unanticipated inflation is inflation that catches
  the public by surprise.
• Borrowers gain by unanticipated inflation, while
  lenders lose.

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Indexing to Offset Inflations Effects

• Indexing is a solution to offset the problems
  created by unanticipated inflation.
• Automatically adjusting the terms of an agreement
  to account for inflation is referred to as
  indexing.

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7.3MEASURING INFLATION

• A price index measures the average level of
  prices in the economy.
• There are several price indexes.
• The consumer price index.
• The producer price index.
• The GDP chain-type price index
• The GDP deflator.

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Measuring Inflation The Consumer Price Index

• The CPI measures prices of typical purchases made
  by consumers living in urban areas.
• The base period used in the CPI is an arbitrary
  selected initial time period against which other
  time periods are compared.
• The base period index number always equals 100.

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Measuring Inflation The Consumer Price Index
The Inflation rate is calculated by taking the
percentage change in the CPI as follows
Inflation Rate change in price index /
initial price index multiplied by 100
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Measuring Inflation The Consumer Price Index

• The collection of goods and services used in the
  calculation of the CPI is called the market
  basket.
• The market basket represents a sampling of the
  items that consumers buy that make up a
  significant portion of their budget.
• There are 200 specific items that make up the
  CPI.
• Each item is assigned a weight that reflects its
  importance in the consumers budgets.

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CPI Market Basket Expenditure Categories
Expenditure Category Weight (in )
Food and beverages 15.7
Housing 40.9
Apparel 4.4
Transportation 17.1
Medical care 5.8
Recreation 6.0
Education and communication 5.8
Other goods and services 4.3
Total 100.0
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The Consumer Price Index, Selected Years
Averages to 100, base period value.
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Computing a Price Index

• The CPI measure the increase in the price of the
  market basket between the current year and the
  base period.
• The simplified formula for the CPI is

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Nominal Versus Real Values

• A nominal interest rate is the payment from a
  borrower to a lender, expressed in percentage
  terms.
• A real interest rate measure the percentage
  payment in terms of purchasing power.

Real interest rate nominal interest rate
inflation rate
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Price Indexes for Other Purposes

• The Producer Price Index (PPI) focuses on the
  prices received by U.S. producers, as measured by
  the revenue they receive.
• The prices in the PPI are those received by
  producers no matter who makes the initial
  purchase, whether it be another firm or consumer.

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Price Indexes for Other Purposes

• The GDP chain-type price index is computed in a
  manner similar to the GDP deflator.
• The difference is that the real chained GDP is
  used in the calculation.

GDP chain-type nominal GDP/real chained GDP
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Price Indexes for Other Purposes

• The term chain weight comes about because the GDP
  chain-type price index links quantities (weights)
  in two successive years.
• It then moves forward a year and does that link
  again, and so forth.
• This continuous linking , for two years at a time
  forms a chain, hence the name.

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Price Indexes for Other Purposes

• The GDP deflator is a type of price index called
  an implicit price deflator.
• An implicit price deflator takes current
  quantities and calculates what they would have
  cost at prices prevailing during the base period.

GDP deflator Value of current quantities at
current period prices Value of current quantities
at base period prices
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Recent Changes to the CPI

• Prior to 1999, the CPI was calculated using
  fixed-weights throughout the market basket.
• Fixed-weights do not take into account that
  people change their consumption patterns when
  prices rise.
• When the price level rises people substitute
  relatively cheaper goods for goods that have
  become relatively more expensive.

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Recent Changes to the CPI

• The inaccuracy in the CPI cause by using fixed
  weights is termed the substitution bias.
• The substitution bias causes inflation to be
  overstated.
• A new CPI was established in 2002 called the
  Chained weight CPI (C-CPI).

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7.4 EXPLORE APPLYAdjusting to Price Changes

• The CPI is used in three ways.
• As an economic indicator.
• To convert nominal values to real values.
• To adjust selected monetary payments upward as
  prices increase.
• Hyperinflation is inflation that is out of
  control.

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How the CPI Measures the Price Level

• The rule of 72 is used to compute the approximate
  time it takes for a rate to double.
• To compute how long it would take for an
  inflation rate to double the equation would be
• 72/the inflation rate

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How the CPI Measures the Price Level
Annual Inflation Rate Estimated of Years for Price Level to double
1 72
2 36
4 18
8 9
10 7.2
16 4.5
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Key Terms

• inflation
• inflation rate
• indexing
• Consumer Price Index
• Producer Price Index

• GDP chain-type index
• GDP deflator
• nominal value
• real value

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Test Yourself

• Which of the following best fits the definition
  of inflation?
• A one-time increase in a few prices.
• A one-time increase in many prices.
• A sustained increase in a few prices.
• A sustained increase in many prices.

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Test Yourself

• 2. The core inflation rate excludes
• energy prices.
• the price of medical care.
• food prices.
• both food and energy prices.

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Test Yourself

• 3. The goods and services included in the
  computation of the CPI are referred to as the
  _____________________ .
• base year.
• fixed weights.
• market basket.
• price level.

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Test Yourself

• 4. How is inflation computed?
• The inflation rate equals the value of a price
  index.
• The inflation rate equals the value of a price
  index.
• By the following computation
  (change in price index/initial value of price
  index multiplied by 100).
• By the following computation
• change in price index multiplied by the initial
  value of price index.

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Test Yourself

• 5. When the real value of GDP is computed by the
  government
• the CPI is used.
• the PPI is used.
• The GDP deflator or the chained-type price index
  is used.
• no price index is necessary because the real and
  nominal values of GDP are always identical.

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Test Yourself

• 6. The substitution bias causes the CPI to?
• overstate the effects of inflation.
• understate the effects of inflation.
• more accurately reflect the effects of inflation.
• be nearly useless as a measure of inflation.

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The End! Next Chapter 8 A Framework for
Macroeconomic Analysis