Inflation
Chapter 13 Section 1
Objectives
1. What is inflation?
2. How is inflation measured?
3. What causes inflation?
4. What are the effects of
inflation?
Question
What causes prices to go
up and down?
Inflation:
An INCREASE in …
the price level (average level
of prices)
The average of all prices is called
the price level.
How Do We Measure Inflation?
• Calculate the percentage
change of the …
Consumer Price Index (CPI)
Calculate the Inflation Rate
• Last Year CPI = 110
• This Year = 121
CPI - CPI
Inflation (Later Year) (Earlier Year)
= X 100
Rate CPI
(Earlier Year)
121 - 110
= X 100
110
= 10 %
Demand Side Inflation
• An increase in the price level originates
on the demand side of the economy
Price
Level
P2 AS
P1
AD’
AD
Quantity
(Goods & Services)
Supply Side Inflation
• An increase in the price level originates
on the supply side of the economy
Price
Level AS’
P2 AS
P1
AD
Quantity
(Goods & Services)
Aggregate Aggregate
Demand > Supply
Price
Level AS AS’
P2
P1
AD AD’
Quantity
(Goods & Services)
When aggregate demand increases by more
than aggregate supply, the price level…
increases and inflation occurs.
The Simple
Quantity Theory of Money
The simple quantity theory of money
presents a clear picture of what causes
inflation.
Before examining the theory, we
need to understand two terms:
• Velocity
• Exchange Equation
Velocity:
• Average number of times a dollar is
spent to buy final goods and services.
3 + 5 + 6 + 3 + 3 = 20 times
5
= Velocity of 4
The Exchange Equation
M X V= P X Q
Money X Velocity Price Quantity
Supply = Level X
of Output
A Little Algebra
2x6=4x3
12 = 12
Double Double
4 x 6 = 8 x 3
24 = 24
The Simple Quantity Theory of
Money Explanation
Double Double
MxV=PxQ
If V and Q are held constant,
a change in money supply (M)
will lead to a proportional change in
the price level (P).
Rates of Growth in the Money Supply
and the Inflation Rate
• The simple quantity theory of money
predicts that changes in the money
supply will bring about …
proportional changes in the price level.
• The greater the increase in the money
supply, the greater the increase in the…
price level.
The Effects of Inflation
Individuals on Fixed Incomes
Income stays the same, but prices
go up.
Savers (saving accounts)
If inflation rate surpasses interest rate,
you suffer a decrease in buying power.
Past Decisions
Costly mistakes in bidding contracts
Hedging against Inflation
We use resources to hedge against
inflation when we could be using them
to increase productivity.
Assessment
1. What is inflation?
2. How is inflation measured?
3. What causes inflation?
4. What are the effects of
inflation?
Small Groups
1. What is inflation & how is it
measured? Give an example.
2. Explain 3 causes of inflation?
3. Explain the Simple Quantity
Theory of Money.
4. Explain 4 effects of inflation.