Macroeconomics

Unit 7
Inflation
Top Five Concepts

Introduction
Is inflation really an economic problem today? How does
inflation affect your life, your earnings, and your future?
What about deflation? Why should we be worried about prices
falling? Isnt this better than prices increasing?
Both inflation and deflation are discussed in the unit along with
the causes and effects of both.
Methods used to measure inflation are also discussed.

Concept 1: Inflation/Deflation
In the past, one of our greatest economic concerns was
inflation. Inflation is an increase in the average level of prices
of goods and services.
It is based on an increase in average prices, not on a change in
any specific price. A survey is taken of all output and price
changes are averaged by the U.S. government.
Inflation is an economic concern because it reduces the value
of money and increases the cost of purchasing goods and
services.

Concept 1: Inflation/Deflation
Deflation is a decrease in the average level of prices of goods
and services. Deflation is rare in the U.S. and other countries.
It last happened in the U.S. in 1940, and in Japan in 1995 and
2000.
Deflation is an economic concern because even though prices
may be declining, the value or price of investments or real
estate may also decline.
Imagine buying a home for $150,000 and three years later
discovering that it is only worth $125,000. That is the danger of
deflation.

Relative Price
Inflation and deflation are measured using average prices.
However it is likely that prices of some items rise while others
fall or remain the same. Sometimes we compare prices by
using relative prices. The relative price is the price of one
good in comparison with the price of other goods.
Since inflation and deflation are measured using averages,
prices could be increasing or decreasing on some items, and
yet the inflation rate may be unchanged.
Relative prices can change without affecting the overall rate of
inflation or deflation.

Concept 2: Effects of Inflation

Inflation can make some people better or worse off in terms of
income, expenses, or wealth.
How can some people be better off during times of inflation?
The effect of inflation on an individual will depend upon the
combination of goods and services the individual purchases.
Individual wealth and income can increase or decrease due to
inflation. It depends upon whether your income or wealth
follows the rate of inflation.

Concept 2: Price Effects of Inflation

The first way that inflation can affect you is through rising
prices. Price effects of inflation relate to the effect of rising
prices for goods and services on individuals.
The extent to which price effects will affect your ability to
purchase goods and services depends upon your real vs.
nominal income.
Nominal income is the amount of income received in a given
time period, measured in current dollars.

Concept 2: Price Effects of Inflation

Real income is income in constant dollars; nominal income that
is adjusted for inflation using a price index.
If your nominal income does not change during the year, yet
average prices have risen 5%, your real income has declined
around 5%.
For example if your salary was $30,000/year, and average
prices increased 5% during the year, you have lost $1500 in
purchasing power ($30,000 X .05). Your income does not
purchase as many goods and services due to inflation by the
end of the year.

Concept 2: Price Effects of Inflation

Not all prices of goods and services rise at the same rate.
Therefore you could experience a higher loss of real income if
the items you purchase rise at a faster rate.
Individuals who purchase items that have increases in price
lower than the average will not suffer as much, if at all.
How can individuals retain their ability to purchase the same
amount of goods and services during times of inflation? It
depends upon whether their income or wealth increases too.

Concept 2: Income Effects of Inflation

The Income effects of inflation refers to the rate at which
individual income rises during inflation. Ideally during times of
inflation, your income rises at a rate that at least matches the
inflation rate.
Individuals on fixed incomes (Social Security, pensions, and
Unemployment for example) are affected more by inflation than
those whose income keeps pace.
Generally when prices rise so do incomes, on average. Many
people receive cost of living adjustments (COLA) to their
incomes which helps protect income against inflation.

Concept 2: Wealth Effects of Inflation

Wealth effects of inflation refer to the
rate at which your assets increase in
value compared to inflation.
If your assets increase in value at a rate
higher than inflation, you are better off.
Examples of assets include savings
accounts, homes, stocks, bonds,
precious metals, jewelry, etc.

Concept 2: Redistributive Effects of Inflation

Lets examine how inflation redistributes income and wealth.
Price effects: People who buy goods and services that are
increasing in price at a slower rate end up with a larger share of
real income.
Income effects: People whose nominal incomes rise faster
than the rate of inflation end up with a larger share of total
income.
Wealth effects: People who own assets that are increasing in
real value at a greater rate than inflation increase their real
wealth.

Money Illusion
Often people believe that they have been affected by inflation
even though their income has risen as fast as inflation.
The money illusion is the use of nominal dollars rather than
real dollars to gauge changes in ones income or wealth.
People affected by the money illusion remember the cost of
items say 30 or 40 years ago but not their incomes or wealth in
the past. Remember when gasoline was $0.30 a gallon or
bread was $0.50 a loaf?

Concept 3: Macro Effects of Inflation

Individual and business decisions are often affected by inflation.
The first consequence of inflation is called uncertainty. Under
economic conditions of uncertainty, people and businesses
tend to make short-term decisions only.
People will postpone major purchases. Companies delay
capital expansion projects, investments in technology.
The result of the reduction in spending by consumers and
business is an increase in unemployment as demand falls.

Concept 3: Macro Effects of Inflation

An extreme level of inflation is called hyperinflation. During
hyperinflation the inflation rate is above 200 percent for at
least a year or more.
Hyperinflation recently occurred in Russia during the early
1990s. The currency essentially becomes worthless and
spending declines.
The second consequence of inflation is speculation. Under
speculation people and companies will alter buying and
spending activity if higher rates of inflation are anticipated.

Concept 3: Macro Effects of Inflation

Under speculation people will buy necessary goods now to
avoid price increases. Businesses will increase production now
and increase inventories to be sold later at a higher profit.
Another result of inflation is bracket creep. This is the
movement of taxpayers into higher tax brackets (rates) as
nominal incomes grow. If incomes rise under inflation, more
taxpayers enter higher federal tax brackets and pay more taxes
resulting in an increase in federal tax collections.

Concept 4: Measuring Inflation

The Consumer Price Index (CPI) is a common index used to
measure the change in the average price of consumer goods
and services.
The CPI is commonly used to measure changes in the inflation
rate, which is the annual percentage rate of increase in the
average price level.
The CPI consists of a base period, set to equal 100. As prices
increase the number increases (for example, to 102.5, to reflect
a 2.5% increase).

Concept 4: Measuring Inflation

Consumer surveys are conducted by the government on the
typical goods consumers purchase. Each category of items
has a weight which is used to produce the index.
Housing, transportation, and food costs have more importance
than other costs like entertainment, health care, clothing.
The item weight is multiplied by the percentage change in price,
and all items are added together to produce the CPI.

Consumer Spending by Category

Used to Compute the CPI
Source: Bureau of Labor Statistics, 2002 data

Notice that housing,

transportation, and
food costs have the
highest weights
when calculating the
CPI.

Transportation
19.1%
Housing
32.7%

Insurance and pensions 9.6%

Food
13.2%

Clothing 4.3%

Miscellaneous 10.3%
Entertainment 5.1%
Health care 5.8%

Concept 4: Measuring Inflation

The producer price index (PPI) is another index used to track
inflation. This index actually contains three different price
indexes that cover producer (manufacturer) costs for raw
materials, intermediate goods, and finished goods.
The producer price index will increase before the CPI.
Note that the PPI does not cover all producers mostly those
in manufacturing, mining, and agriculture. The service sector
is not included in the PPI.

Concept 4: Measuring Inflation

The GDP Deflator is used by the government as a price index
for all output (GDP).
It includes all output including consumer goods, investment
goods, and government services.
It is used to adjust nominal GDP values to reflect price
changes.
The components of the GDP deflator tend to have more price
stability and less volatility than other indexes.

Concept 4: Measuring Inflation

The calculation to use the GDP Deflator is similar to the one
used for calculating Real GDP.
Real GDP = nominal GDP / GDP Deflator
Note: GDP Deflator values may be stated as a percent (24%)
or an index (134.7). If an index is used, you must either divide
the nominal GDP by the index and multiply the result by 100, or
if a percent is used, divide nominal GDP by 1 + the decimal
equivalent of the percentage.

Concept 4: Measuring Inflation

If nominal GDP = $10 trillion in 2000, and $5.7 trillion in 1990,
what is the real GDP in 2000 based upon 1990 prices?
If the value for the GDP Deflator is 24%, then
Real GDP
= $10 trillion / 1.24 = $8.06 trillion
(1990 prices)
Now you can compare the 1990 nominal GDP of $5.7 trillion
with the real GDP in 2000 of $8.06 trillion to measure true
growth.

Concept 4: Measuring Inflation

Another GDP deflator problem:
If nominal GDP is $6,225.6 billion and the GDP deflator is
134.7, then real GDP is:
($6,225.6 billion/134.7) X 100 = $4,621.8 billion

Inflation Goals
The governments goal with inflation is to keep it below 3% per
year. This leads to price stability.
Similar to an unemployment rate of 4 6 percent for full
employment, an inflation rate of 3% or less is viewed as
maintaining stable prices.
CPI and other measurements do not accurately account for
technological improvements in the quality and features of
products (VCRs, PCs). By allowing some inflation to exist, this
reduces the potential error in the CPI which does not account
for technological improvements.

Historical Inflation Rates

Historically, inflation has varied considerably over time.
The most recent incident of high inflation was in the late 1970s
and 1980 with a peak rate of 13.5% in 1980.
In any given year inflation rates for other countries can vary
significantly from the U.S.

Concept 5: Causes of Inflation

Demand-Pull inflation is caused by
excessive consumer demand for goods
and services. This occurs when
consumers have plenty of savings,
higher incomes, easy credit and low
interest rates.
The high demand for goods and
services produces an increase in prices
as inventories are depleted and
production is increased.

Concept 5: Causes of Inflation

Cost-Push inflation is not caused by excessive consumer
demand but by rising factor costs (land, labor, capital) for
companies.
The increase in factor costs is passed to consumers by
increasing the selling price of the good or service.
Common dramatic factor cost increases include natural
disasters like droughts, hurricanes, floods. Also OPEC
increases in crude oil prices and significant wage increases for
workers can cause cost-push inflation.

Inflation Protection
To protect wages from inflation, many employees have cost-ofliving adjustments (COLA) to their wages. COLA is an
automatic adjustment to the nominal income based upon the
rate of inflation.
Union contracts frequently have COLA as part of the contract.
Many employers provide COLA protection to their workers
outside of union contracts.
Social Security benefits are now subject to COLA adjustments
on an annual basis.

Inflation Protection
Cost-of-living adjustments also occur in many loan agreements.
Mortgages, car loans, lines of credit can be tied to the rate of
inflation.
An example is the adjustable rate mortgage (ARM) which
automatically increases or decreases its interest rate and
payment amount based upon the rate of inflation.
Adjustments in interest rates and payment amounts can occur
on an annual basis or more frequently depending upon the
terms of the loan.

Inflation Protection
Banks and other financial entities are highly concerned about
interest rates and their loan portfolios.
Often the Real Interest Rate is calculated as a tool for
comparison.
Real interest rate = nominal interest rate anticipated rate of
inflation.
This calculation is important when setting rates for long-term
loans. A positive real interest rate is desired to ensure
profitability.

Inflation Protection
For example:
If the future expected rate of inflation is 4% and nominal interest
rates are 6%, the real interest rate is:
6% - 4% = 2%
2% is the real rate of interest.

Summary

Inflation, deflation.
Relative price.
Price, income, wealth effects of inflation.
Money Illusion.
Hyperinflation, bracket creep.
CPI and its components.
PPI
GDP Deflator
Demand-Pull and Cost-Push Inflation
COLAs, ARMs, Real Interest Rate