Chapter 8Chapter 8

Inflation

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning ObjectivesLearning Objectives

• Define inflation and calculate the inflation rate using the consumer price index (CPI).

• Explain the difference between relative price shifts and the overall inflation rate.

• Calculate and show how incomes and wages can be adjusted for inflation.

• Discuss the impact of unexpected and expected inflation.

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Basics of InflationBasics of Inflation

• Inflation is the rise and fall in the overall level of prices in the economy as a whole.– The overall price level is an average of

millions of prices of different goods and services.

• Inflation is one of the key measures of the health of the economy.– The economy is in trouble if prices are rising

or falling too fast.

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Basics of InflationBasics of Inflation

• The goal of economic policymakers is to keep inflation under control.

• Inflation is a problem since it reduces consumers’ purchasing power.– If inflation increases, your money buys less and

less.

• The situation where prices are falling is known as deflation.

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Average Price LevelAverage Price Level

• At any time in the economy, the price of some goods and services will be rising, while others will be falling.

• So when we measure inflation, we are concerned with the extent that overall prices (prices across the economy) are rising or falling, not with the rise or fall of any particular good or service.

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Average Price LevelAverage Price Level

• The average price level in the economy measures how much it costs to buy a market basket of common goods and services.

• The U.S. Bureau of Labor Statistics (BLS) selects the contents of the market basket which represents the goods and services that the typical U.S. household will buy.

• The BLS gives each item in the market basket a certain weight to represent its relative importance in the typical budget.

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Market BasketMarket Basket

• The two largest items in the market basket:– The cost of housing measured by the owners’

equivalent rent of primary residence. This is the single biggest part of the market basket.

– Food consumed at home. This is the second largest part of the market basket, and is followed by medical care.

• The market basket, while not perfect, is a reasonable representation of the spending pattern of an average U.S. household.

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Contributors to the Consumer Contributors to the Consumer Market BasketMarket Basket

Category of Spending Percentage of Market Basket,2010

Category of Spending % of Market Basket, 2010 Owners’ equivalent rent of primary residence

23.3

Food at home 7.8

Medical care 6.6

Recreation 6.3

Food away from home 5.9

Rent of primary residence 5.9

Gasoline 4.9

Apparel 3.6

New vehicles 3.5

Communication 3.3

Education 3.1

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Consumer Price Index (CPI)Consumer Price Index (CPI)

• The consumer price index (CPI) is a measure that tracks the average price level in the U.S.

• CPI is based on a market basket of goods.• BLS selected the average 1982-84 price level

as the base year. – The base year is assigned a value of 100.

• The CPI measures all other years relative to this base period.

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Consumer Price Index (CPI)Consumer Price Index (CPI)

1984 103.9

196029.6

0

50

100

150

200

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

200

2004

2007

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Inflation RateInflation Rate

• Inflation is defined as a sustained upward movement in the average level of prices.

• The inflation rate is the annual percentage change in the average price level.– Since the CPI tracks the average price level,

the inflation rate is also the annual percentage change in the CPI.

• CPI is published each month by the BLS.

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Inflation RateInflation Rate

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Calculating Percentage Calculating Percentage ChangeChange

• Economists are concerned with the speed of change over time.

• The inflation rate measures how fast prices are rising.

• The rate of change is measured as an annual percentage change, which is calculated as follows: Percentage change = [(Original number –

New number)/Original number] x 100

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Relative Price ShiftsRelative Price Shifts

• BLS not only reports the overall inflation rate, but also the inflation for subcategories of goods and services.

• A relative price shift happens when the inflation rate of a good or service is significantly higher or lower than the overall inflation rate.– If it’s higher, then that good or service is getting more

expensive over time relative to other possible purchases.– If it’s lower than the overall inflation rate, then it’s getting

relatively cheaper.• The annual inflation rate for all items averaged 2.4 percent in 10

years from 2000 to 2010.• But, over this period, prices of college tuition and medical care

increased 6.8% and 4.1%, respectively, while prices of personal computers and televisions declined by 16.4% and 16.7%, respectively.

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Globalization and InflationGlobalization and Inflation

• The inflation rate has been higher for services compared to goods.

• The main reason goods have become cheaper is globalization.

• Production of goods has shifted from the U.S. to lower-cost countries such as China.

• It is much harder to shift the production of services overseas.

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Quality Improvements and InflationQuality Improvements and Inflation

• A difficulty involved in measuring inflation is that the quality and features of a product change over time.

• When the price of a good or service goes up because of an improvement in quality, the BLS does not count that price increase as part of the inflation rate. – Rapid technological change makes the job

of measuring inflation especially difficult since the product changes are rapid and it’s hard to compare them to the original.

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Adjusting for InflationAdjusting for Inflation

• To compare household income over time, we must adjust the income for the impact of inflation.

• Otherwise, we run the risk of suffering from money illusion.

• Money illusion happens when we compare dollar amounts in different time periods without adjusting for inflation.

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Real versus Nominal DollarsReal versus Nominal Dollars

• To avoid money illusion, we should use the real or inflation-adjusted increase.– This is calculated as the percentage

increase in dollars minus the inflation rate.

• The increase without the adjustment for inflation is called the nominal increase.

• The real or inflation-adjusted increase is the nominal percentage change minus the inflation rate.

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Expectations and InflationExpectations and Inflation

• Expected inflation is the inflation rate that consumers and businesses expect will hold for some future period.

• Expected inflation forms the basis for pricing and wage decisions that businesses make.

• If people expect that the higher rate of inflation will continue, a wage-price spiral may occur.– Businesses now boost prices and wages faster

and faster to stay ahead of expected inflation.– The worst possible case of a wage–price spiral is

hyperinflation.

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Harm from InflationHarm from Inflation

• The harm from inflation depends on two cases:– First is the case of unexpected inflation,

which occurs when the actual inflation rate is above the expected inflation rate.

• In this case, lenders are harmed since they’re being paid back with less valuable dollars.

• Borrowers benefit from unanticipated inflation.

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Harm from InflationHarm from Inflation

– Second is the case of expected inflation, where the actual rate of inflation is equal to the expected rate of inflation.

• The problem with anticipated inflation is that it leads to cost-of-living adjustments (COLA) in union contracts and certain government programs.

• High levels of inflation increase the cost of transactions - the time and effort that goes into managing your spending.

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DeflationDeflation

• Deflation is an actual fall in the average price level.

• In contrast, disinflation is a reduction in the inflation rate.

• Deflation is a problem for two reasons:– First, deflation usually means demand is

so weak that businesses cannot raise their prices.

– Second, deflation hurts borrowers because they are paying back their loans with more expensive dollars.

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