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Inflation

Another economic instability problem

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Meaning of Inflation

Is the rise in general piece level. Not necessary that all prices are

increasing In periods of inflation, some prices are

rising while some are declining The most important: general price

level, and the increase to have an affect

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Measuring Inflation

Using CPI when price index measures the general level of prices in the economy.

CPI year A=(basket yearA)/(basket in base year) X100

Therefore, inflation rate2000 =CPI2000-CPI1999 X100

CPI1999

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Types of Inflation

1. Demand Pull Inflation: assume that the economy is at its full

capacity of production. Assume that total spending is greater

than production level… what will happen to price level?

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Since all resources are fully employed, production cannot respond to this increase in demand.

Therefore, outputs cannot be expanded to meet demand

This excess demand will bid up prices, causing “demand-pull inflation”.

“Too much spending for too few goods”

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2. Cost-Push Inflation: This is an increase in per-unit

production costs. Per-unit production cost =

Total input cost / units of outputs This will reduce profits and reduce

outputs firms willing to produce.

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Thus, the economy’s supply of goods and services declines and the price level rises.

Costs are pushing the price level upward

Sources: supply shocks: increase in costs or raw materials, energy inputs, wages…

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Redistribution Effects of Inflation

Inflation hurts some, leaves others unaffected

That is, inflation redistributes real income from some to others

Who benefits and who gets hurt?

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terminology

Nominal and real income:Real income =

nominal income/price index Real wage: purchasing power of

nominal wage (number of $$ received as wages, rent, interest, or profits)

Some people will be affected more than others as inflation occurs (redistribution effect)

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The following rule tells us approximately by how much real income will change:

%ΔReal in Income = %Δ in nominal income - %Δ in price level

Anticipation and the effect of inflation?

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Who is Affected by Inflation?

Unanticipated inflation hurts:1. Fixed income receivers2. Savers3. Creditors Who is Unaffected by Inflation?1. Flexible income receivers2. Debtors

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Anticipated Inflation

The redistribution effects of inflation are less sever or can be eliminated when people can expect inflation and can adjust their nominal incomes to reflect the expected price-level increases.

Save more now (consume less)

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Hyperinflation

Is an extremely high rate of inflation. Agents expect inflation rate to even

gets higher, leading them to “spend now”.

May cause economic collapse Uncertainty about future prices