Econ 202: Chapter 7

13e
Chapter 07:
Inflation
McGraw-Hill/Irwin
Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Inflation
We recognize inflation as the second of
the two major macroeconomic
problems we can face.
The core problems:
What kind of price increases are referred to
as inflation?
Who is hurt and who is helped by inflation?
What is an appropriate goal for price
stability?
7-2
Learning Objectives
07-01. Know how inflation is measured.
07-02. Know why inflation is a
socioeconomic problem.
07-03. Know the meaning of price
stability.
07-04. Know the broad causes of
inflation.
7-3
Runaway Inflation
In 1923 prices in Germany more than
doubled every day.
No one saved, invested, or made long-run
plans.
Production came to a halt; unemployment
increased by a factor of 10.
The economy collapsed.
Ultimately Hitler came to power.
Zimbabwe experienced a similar economic

disaster between 2007 and 2010.
7-4
Exercise
The current price of a good is $1.
If its price doubles every day, what
will its price be in 10 days? 20 days?
In 10 days, $512.
In 20 days, $524,288.
7-5
What Is Inflation?
Inflation: an increase in the average
level of prices, not a change in any
specific price of a good.
The prices of specific basket of goods are
collected and computed into an average
price level for that basket in a year.
A rise in that average price level is inflation.
A decrease in that average price level is
deflation.
7-6
Relative Prices
The market mechanism causes the
prices of individual goods and services
to rise or fall an essential market
function.
Relative price: the price of one good
compared to the price of other goods.
Buyers switch from one good to another
when their relative prices diverge.
Inflation is a rise in the average price of

all goods.
It is not a market function.
7-7
Redistributive Effects of
Inflation
Inflation makes some people worse
off and others better off.
There are price effects, income
effects, and wealth effects.
7-8
Effects of Inflation
Some prices rise and some fall.
Rising prices require you to reallocate your
purchasing power to ensure that you get
the most satisfaction per dollar spent.
You might reduce buying goods with higher
prices and increase buying goods with lower
prices.
This can be seen by the difference between

nominal income and real income.
7-9
Effects of Inflation
Nominal income: the amount of money
income received in a given time period,
measured in current dollars.
Real income: income in constant dollars;
nominal income adjusted for inflation.
You may get a raise (nominal income
increases) but if it does not rise as fast
as inflation, your purchasing power
decreases (real income falls).
7-10
Redistribution of Income and

Wealth by Inflation
Price effects.
Those who buy products that are increasing
in price the fastest end up worse off.
Those who sell products that are increasing
in price the fastest end up better off.
Those who buy products that are increasing
in price the slowest end up better off.
Those who sell products that are increasing
in price the slowest end up worse off.
7-11

Wealth by Inflation
Income effects.
People with nominal incomes rising more
slowly than inflation end up worse off.
People with nominal incomes rising faster
than inflation end up better off.
7-12

Wealth by Inflation
Wealth effects.
Those who own assets that are declining
in real value end up worse off.
Those who own assets that are
increasing in real value end up better
off.
7-13
Money Illusion
Money illusion: using nominal dollars
rather than real dollars to gauge changes
in ones income or wealth.
Exercise:
In the good old days a movie ticket was 50
cents and the minimum wage was $1.00.
Compare the purchasing power of the
minimum wage today to the good old days.
You could buy two movie tickets with one
hours work before, but not now.
7-14
Exercise in Money Illusion
The inflation rate in 1980 was 13.5%.

In 1979 your income was $10,000.
In 1980 your income was $11,000.
Did your purchasing power increase?
Decrease? Stay the same?
Decrease! Your income went up 10%
while prices went up 13.5%.
7-15
Macro Consequences of
Inflation
Uncertainty: not knowing the prices of
goods in the future makes purchasing
and production decision making much
more difficult.
Speculation: decisions will shift from
standard economic activity to betting on
the future prices of goods.
Bracket creep: in a progressive tax
system, when nominal incomes rise, the
taxpayer gets pushed into a higher tax
bracket.
7-16
Hyperinflation
Hyperinflation: inflation rate in excess of

200 percent, lasting at least 1 year.
Spending accelerates and production declines.
7-17
Deflation
Deflation: a general decrease in average
prices.
This has redistribution effects that are just
the opposite of those for inflation.
This has macro consequences also.
Sellers are reluctant to stock inventory.
Buyers are reluctant to buy now.
Businesses are reluctant to borrow funds or
invest.
Incomes fall, and asset values decrease.
7-18
Measuring Inflation
Measuring inflation serves two
purposes.
Gauging the average rate of inflation.
Identifying its principal victims.
7-19
Consumer Price Index (CPI)

Consumer price index (CPI): a
measure (index) of the average price of
consumer goods and services.
Used to calculate the inflation rate.
Inflation rate: the annual percentage

rate of increase in the average price
level.
7-20
Creating a Price Index

Select a market basket of goods: a
standardized list of goods and
services customers usually buy.
Select a base year: the reference year
whose dollar value will be used.
Set the price index in the base year
always equal to 100.
Measure the prices for the basket of
goods in both the current year and in
the base year.
7-21
Computing a Price Index

Price index in current year
Price index base year
Basket price in current year

Basket price in base year
Basket price in the base year = $6,000.

Basket price in the current year = $6,600.
Compute the price index (CPI) for the current year:
X/100 = $6,600/$6,000
X = (6,600 x 100)/6,000
X = 110
CPI in the current year is 110.

A CPI of 110 indicates that prices in the current
year are 10% higher than prices in the base year.
7-22
Exercise
In 2006 CPI was about 200. *
* 1983 was the base year.
In 1983 CPI was about 100. *

These two CPI figures tell us that prices
doubled between 1983 and 2006.
In 1974 CPI was about 50.*
So prices doubled between 1974 and
1983.
If a good was priced at $10 in 1974, what
would you expect the price to be in 2006?
7-23
Other Measures of Inflation

Core inflation: changes in CPI,
excluding food and energy prices.
Producer price index (PPI):
changes in the average prices at
intermediate steps of production.
GDP deflator: changes in prices of all
goods and services included in GDP.
Used to correct nominal GDP to real GDP.
7-24
Computing Inflation Rate from

CPI
CPI
Inflation rate =
year 2
CPI
CPI
year 1
X 100
year 1
CPI in 2006 was 201.6.

CPI in 2005 was 195.3.
Compute the inflation rate for 2006:
Inflation rate = (201.6-195.3)x100/195.3
= 3.23%
7-25
The Goal: Price Stability

Price stability: the absence of
significant changes in the average
price level.
Officially defined as a rate of inflation of
less than 3 percent.
Established by Full Employment and
Balanced Growth Act of 1978.
7-26
The Goal: Price Stability

Measurement concerns.
We are seeking price stability at the
lowest rate of unemployment.
From year to year, there are quality
improvements in the basket of goods.
New products change the content of the
basket of goods we buy.
7-27
The Historical Record

highest
lowest
The highest and lowest annual inflation rates since WW2 are identified.
7-28
Causes of Inflation
Demand-pull inflation: results
from excessive pressure to buy on
the demand side of the economy.
A booming economy creates shortages.
Too much money pumped into the
economy by the Federal Reserve.
Cost-push inflation: due to higher

production costs putting pressure on
suppliers to push up prices.
7-29
Protective Mechanisms
Cost of living allowances (COLA):
nominal incomes are indexed to
automatically rise at the same rate as
inflation.
Adjustable-rate mortgage (ARM):
interest rate on a mortgage rises
along with inflation so that lenders do
not lose money.
7-30
The Real Interest Rate

Real interest rate: the nominal interest
rate minus the anticipated inflation rate.
The borrower pays the nominal rate.
The inflation-adjusted (real) rate of interest:
Real interest rate = Nominal interest rate Anticipated
rate of inflation
Protects the lenders. Hurts the borrowers.

Borrowers will pay back loan using more
lower-valued dollars, but lenders receive the
same purchasing power.
7-31
The Economy Tomorrow

The virtues of inflation.
A little inflation might be a good thing.
The challenge for tomorrow is to find

the optimal rate of inflation.
High enough to encourage more spending.
Low enough not to raise the specter of an
inflationary flashpoint.
Inflationary flashpoint: the rate of output
at which inflationary pressures intensify.
7-32
Revisiting the Learning

Objectives
07-01. Know how inflation is measured.
Inflation is measured by changes in a price
index such as the consumer price index
(CPI).
7-33

Objectives
07-02. Know why inflation is a
socioeconomic problem.
Inflation redistributes income by altering
relative prices, income, and wealth.
Some people actually gain from inflation,
whereas others suffer a loss of real income or
wealth.
Inflation creates uncertainty and speculation
and detracts from productive activity.
COLAs and ARMs help protect some people
from inflation.
7-34

Objectives
07-03. Know the meaning of price
stability.
The U.S. goal is an inflation rate of less
than 3 percent per year.
This goal must be integrated with a
potentially conflicting goal of full
employment.
7-35

Objectives
07-04. Know the broad causes of inflation.
Inflation is caused either by excessive
demand (demand-pull inflation) or by
structural changes in supply (cost-push
inflation).
7-36

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13e

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Zimbabwe experienced a similar economic

Inflation is a rise in the average price of

This can be seen by the difference between

Redistribution of Income and

Redistribution of Income and

Redistribution of Income and

Exercise in Money Illusion

The inflation rate in 1980 was 13.5%.

Hyperinflation: inflation rate in excess of

Consumer Price Index (CPI)

Inflation rate: the annual percentage

Creating a Price Index

Computing a Price Index

Basket price in current year

Basket price in the base year = $6,000.

CPI in the current year is 110.

In 1983 CPI was about 100. *

Other Measures of Inflation

Computing Inflation Rate from

CPI in 2006 was 201.6.

The Goal: Price Stability

The Goal: Price Stability

The Historical Record

Cost-push inflation: due to higher

The Real Interest Rate

Protects the lenders. Hurts the borrowers.

The Economy Tomorrow

The challenge for tomorrow is to find

Revisiting the Learning

Revisiting the Learning

Revisiting the Learning

Revisiting the Learning

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