Inflation Inflation—An increase in the average

price level of all products in an economy.– Ex. 2011 2012

Bread = $3.00 $3.05 Automobiles= $20,000 $21,000 Wages = $16.00/Hour $ 16.31/Hour

2%-3% is considered normal

Measuring Inflation Measuring Inflation—when

economists measure the changes in the average price level of goods/services in nation.

The two measuring tools that economists use are

1) CPI (Consumer Price Index)

2) PPI (Producer Price Index)

Measuring Inflation Consumer Price Index (CPI)—is a

measure of the average change over time in the price of a fixed group of products.– Reported monthly– Reported against a fixed period (or base) time

period—currently 1982-1984.– Market basket—representative sample of

consumer goods. Food, clothing, housing, utilities, entertainment, transportation, health care. Measured each month in $.

– How much did it change? = CPI

Measuring InflationCalculating CPICPI = weighted current price x 100 weighted base period priceExample = $3.00 (loaf of bread in 2011) X 100 $1.32 (loaf of bread in 1983)

CPI 2011 = 227.3Or

Access this link from the BLS (U.S. Bureau of Labor Statistics

CPI Inflation Calculator

Inflation Rate Inflation Rate—the monthly or yearly

% change in prices.– The CPI is a tool that is used to calculate

Ex.Inflation rate= (CPI year A – CPI year B) x 100

CPI year B

Ex.Inflation Rate 145 – 140 x 100 = 3.57

140

Inflation Rate 3.57%

Inflation Rate Core Inflation Rate – The inflation rate

excluding effects of food and energy prices.

Question: Why take it out?

Answer: Is a better indicator of long term inflation because it takes out products that frequently experience volatile price changes due to foreign government and business decisions as well as unexpected short term crisises (i.e. drought, hurricane).

Measuring Inflation Hyperinflation—is the worst kind of

inflation; it is a situation where inflation is increasing at a rate of several hundred % per year.– Germany after WW 1; Germany printed more

money and by 1923, it took 4.2 trillion marks to equal $1!!!! Check out this link for more information on this history making event! Hyperinflation in Germany 1923

Measuring Inflation Producer Price Index (PPI)—is a

measure of the average change over time in the prices of goods and services bought by producers.– Prices are based on some 3,200 different

products.– The current base year is 1982.

Causes of Inflation

1. Changes in Aggregate Demand— changes in the total amount of spending by individuals and businesses throughout the economy.– Demand Pull Inflation—When aggregate

demand increases faster than the economy can produce the goods. The demand increases and “pulls” along higher

prices because demand is increasing faster than supply! (More people are chasing the same amount of goods; therefore people can charge more for their goods).

Causes of Inflation

2. Changes in Aggregate Supply— changes in the total amount of goods and services produced throughout the economy.

Cost Push Inflation—When producers raise prices to cover higher resources costs.– Producers must raise prices in order to cover

their higher costs.– If they do not do this, then their profits are

reduced or even eliminated!– Must be careful not to raise prices too high.

Causes of InflationExample-1)If there is low unemployment (such as in expansion or

peak), companies must offer higher wages to attract workers to their open positions and to keep their own workers from looking elsewhere.

2)However, this increases companies’ costs. Therefore the must raise the price of their products to keep there profits up.

3) If prices are higher across most products (inflation), then employers must raise wages again so that their employees’ wages buy as much as it did the year before.

4) But wait…the companies’ costs went up again so they raise the price of their products again.

5) And this continues on and on in an effect known asThe Wage-Price Spiral

Causes of Inflation3. Growth of the Money Supply

As more dollars enter the money supply in the U.S., the value of that dollar or it’s purchasing power (the amount it can buy) is less. So to keep prices “stable”, the money supply should increase at the same rate as the economy is growing.

- Note - There are more ways to increase the money supply than just printing new money.

Effects of Inflation Inflation causes changes in:

– The purchasing power of the $– The value of real wages– Interest rates– Saving and investing– Production costs

Effects on Purchasing Power

Decreased Purchasing Power—– The decreasing value of the dollar falls

and it buys less “stuff”.– It hurts people on fixed incomes

(retirees).– Many labor contracts have built in (COLA)

Effects on Income Decreased Value of Real Wages—

when the value of workers wages fail to keep pace with rising prices.– $20,000 per year in 1979– $40,000 per year today– Adjusted for inflation = the same $ today.

Effects on Interest Rates Increased Interest Rates— High unexpected rates

of inflation cause banks to raise interest rates. High interest rates can decrease consumer and business spending. Ex. Cars, houses etc.

Decreased Saving and Investing—Ex. Bank yield on savings 5% and inflation rate of 7%. Net loss of 2% per year! Inflation hurts savers, lenders. (however, it helps borrowers and debtors occassionally)

Increased Production Costs—Inflation increases businesses costs of production.

Inflation Deflation—A decrease in the average

price level of all goods and services in an economy.– Note: Aggregate demand decreases

more rapidly than aggregate supply.(Less people are chasing the same amount of goods and services).

Ex. The Great Depression