What about the other evil?
Inflation and Deflation
– A sustained increase in the average of all prices of
goods and services in an economy
– A sustained decrease in the average of all prices
of goods and services in an economy
• In 1923 prices in Germany more than doubled
– No one saved, invested, or made long-run plans.
– Production came to a halt; unemployment increased
by a factor of 10.
– The economy collapsed.
– Ultimately Hitler came to power.
• Zimbabwe experienced a similar economic
disaster between 2007 and 2010.
Inflation…is bad…is bad..is bad!
What is inflation?
A continuing rise in the average level of
prices.(it costs more to purchase the typical
“bundle” of goods and services that is
produced or consumed or both.)
Bottom line: Too many $$$$ chasing too few
• The current price of a good is $1.
• If its price doubles every day, what will its
price be in 10 days? 20 days?
• In 10 days, $512.
• In 20 days, $524,288.
CPI measures average family’s price
• The CPI is based on what it costs an average
family to live.
• Just think… Inflation enables us to live in
more expensive neighborhoods without
having to move
Inflation is bad… see???
Shortened Time Horizons
• During the German hyperinflation, workers were paid two
or three times a day so that they could buy goods in the
morning before prices increased in the afternoon.
People may be encouraged to withhold resources from the
production process, hoping to sell them later at higher
• Under our progressive tax system, taxes go up when prices
• Savings, investment, and work effort decline.
Notice we said an increase in the Average Level of prices. Not a
change in any specific price…
Statisticians calculate the average then look for changes in the
average. The Consumer Price Index for All Urban Consumers (CPI-
U) decreased 0.4 percent in August, before seasonal adjustment, the
Bureau of Labor Statistics of the U.S. Department of Labor reported
today. The August level of 219.086 (1982-84=100) was 5.4 percent
higher than in August 2007.
A decline in average prices = deflation.
Relative price means an increase in the price of apples (relative to
other fruits) apples cost more than pears. Buyers switch from one
good to another when their relative prices diverge.
Inflation does not make ALL persons worse off.
Effects of Inflation
• Some prices rise and some fall.
• Rising prices require you to reallocate your
purchasing power to ensure that you get the
most satisfaction per dollar spent.
– You might reduce buying goods with higher prices
and increase buying goods with lower prices.
• This can be seen by the difference between
nominal income and real income.
Nominal Income vs. Real Income
What is the difference between nominal income and real
Nominal = income you receive in a particular period
Real income = what you can use for purchasing stuff.
***If you nominal income does not change and there is an
increase in the average level of prices….. You cannot buy as
If the number of dollars you receive every year is always the
same, your nominal income doesn’t change- but your real
income will rise or fall with price changes.
• If you put your money into savings and
keep it there rather than spending it, and
inflation comes along…
• your money in savings will not buy as much
as it would prior to the wave of inflation
Uncertainty and Misconception
Money Illusion (feels like they have more than they do)
• Even people whose nominal incomes keep up with
inflation often feel oppressed by rising prices.
• They feel cheated when they discover that their higher
nominal wages don’t buy additional goods.
• One of the most immediate consequences of inflation is
• Uncertainties created by changing price levels affect
consumption and production decisions.
Uncertainty on the part of the
consumer in trying to outguess
the price of goods and services.
• What Causes Inflation?
• Nearly all economists
If consumers or producers believe that rapid
postpone or cancel their expansion in the supply
expenditure plans, the demand of money is the cause
for g & s will fall. Eventually of inflation.
production falls, and
What happens if incomes go up to
keep pace with inflation?
• Bracket creep is the movement of
taxpayers into higher tax brackets (rates) as
nominal incomes grow.
• Deflation — a falling price level — might
not make people happy either.
• Deflation reverses the redistributions
caused by inflation. (Example: people today
– upside down on their houses.)
Speculations from consumption and production
• If you expect prices to rise, it makes sense
to buy things now for resale later.
• People may be encouraged to withhold
resources from the production process,
hoping to sell them later at higher price
• As such behavior becomes widespread,
production declines and unemployment
Measuring inflation serves two purposes:
– Gauges the average rate of inflation.
– Identifies its principal victims.
• Consumer Price Index (CPI)
• The CPI is the most common measure of
• The consumer price index (CPI) is a measure
(index) of changes in the average price of
consumer goods and services.
Macroeconomic Measures - Prices
Price Level - A weighted average of the prices of all goods
Price Index - A measure of the price level.
Consumer Price Index (CPI) - A widely cited index
number for the price level; the weighted average of
prices of a specific set of goods and services purchased
by a typical household.
How to measure rate of inflation
Measuring the Rate of Inflation
• Market Basket
– Representative bundle of goods and services
• Base Year
– The point of reference for comparison of prices in
Macroeconomic Measures - Prices
Base Year - The year chosen as a point of
reference or basis of comparison for prices in
other years; a benchmark year.
Computing the Consumer Price Index
Consumer Price Index (CPI)
• By observing the extent of price increases, we
can calculate the inflation rate.
The inflation rate is the annual
percentage rate of increase in the
average price level.
Changes in Prices
Percentage change in prices = Current year - later year x100
In 2005 the CPI was 195.3; in 2006 the index was
201.6. What was the percentage change in prices
Click below for answer.
Here’s a little hint if you forget…C-L/L
Calculates the inflation rate
Market basket of goods and services
(same each year.) • CPI expressed in base
Bureau of Labor Statistics
determines cost in 85 cities by Constructing the CPI
shopping 184 items. • The base period is the
19,000 stores visited and 60,000 time period used for
landlords,renters and homeowners comparative analysis —
surveyed each month the basis of indexing, for
Statistics released each month. example, of price
Yearly average compiled. changes.
Shopping for CPI
CPI is constructed by identifying a typical bundle of goods
that the average consumer buys. This bundle stays the
same each year.
The base year is changed periodically. The base year used
is ’82-’84 and prior to that it was ’63.The price level in the
base period is designated as 100.
The market basket (bundle) can be changed if BLS
research shows that the “average” consumer no longer is
purchasing that good or service.
Each item in the bundle is weighted percent-wise in the
market basket figures.
The Market Basket
Insurance and pensions 9.3% Clothing 4.7%
Health care 5.3%
What is the difference?
So………if it cost you $225 in 2002 to buy the
same bundle of goods that you bought in
1983, you would be paying 225% more for the
Look at the inflationary costs of: cars, health
care, housing, (house 4 bedrooms, 2 baths, in
Highland Park in 1960 cost approximately
Rate of Inflation = % of PI(price index) from one year to
When prices are rising, on average, the price index will rise.
i = This year’s PI – Last year’s PI
Last year’s PI x100
If price index this year was 220 compared to 200 last year,
the inflation rate would equal 10%
220 – 200
200 x 100 = 10
Formula hint: c-l/l x 100 (current-last/last x 100)
Let’s try another calculation
In 2008 – CPI measured 215.3
In 2004 – CPI measured 188.9
What was the rate of inflation from 04 – 08?
Is there a safety shield against inflation?
Answer: not much!!!
But Congress has passed the Cost-of-living
adjustment (COLA) provision for those
receiving Social Security Checks.
Checks are indexed each January…in the
amount equal to inflation the previous year.
If inflation was 3% then the checks are
Unions also negotiate for this COLA in their
Bankers in business to make a profit.
Some bankers build in that same philosophy- Adjustable-rate
mortgage (ARM) stipulates an interest rate that changes
during the term of the loan.
Actually, banks build the inflation factor into all their
loans…the number of points depends on many variables
we will discuss later.
• The real interest rate is the nominal interest rate minus
the anticipated inflation rate.
Inflation and Deflation (cont'd)
• Real-world price indexes
– Consumer Price Index (CPI)
– Producer Price Index (PPI)
– GDP deflator
– Personal Consumption Expenditure (PCE)
What is stagflation?
High inflation and high unemployment….
A period during which an economy is
experiencing both substantial inflation and
either declining or slow growth in output.
Economists used to say this would and could
never happen… it did in the 80’s
Paul Volker entered the scene as Fed
chairman and held court on monetary
policy.. More of this story later…
CAUSES of inflation
• 1. Demand pull (too much aggregate
demand and not enough aggregate supply.
• Cost Push (production costs rise) supply
• Economy producing at capacity
• Consumers willing and able to buy more goods
• Can buy goods because of accumulated savings or easy
access to credit (refinancing the house, second mortgages
in Texas, low interest loans, credit card interest rates low,
prime rate very low.)
• Pull to have more goods and only limited amount of goods
available… causes prices to rise!
• Hence, a demand-driven rise in average prices or demand-
• When producers have to pay more for inputs (resources
for production), the price of the good produced increases.
OPEC- prices of crude escalates any product dependent on
crude (including heating costs, increases).-News Flash!
Winter of 2007-2008 heating home costs rose 22%
Winter of 2012-2013 is predicted to be 11% higher.
Explanation of Dollars in Cost-push
Labor has generally been the most expensive of inputs for
production up till now in our economy.
If wage rates are pushed upward…. The good or service
would have an increase in price (longshoreman’s union,
pilots,) Note that most of these are union connected.
Tech industry workers took about a 50% cut to get jobs in
2002 as opposed to their salaries in 1999.
If the Fed releases too much money in the economy
(continually pushing down interest rates, the value of
that money is not as solid as if there were less
circulating… more later on that)
Check the current inflation rate………..
Bureau of Labor Statistics
Another way to measure U.S. economic
Producer Price Index:
The PPIs keep track of average prices received by
October 20, 2005….PPI up highest in 15 years.
3 indices…crude materials, intermediate goods, finished
Identified in monthly surveys just like CPI is.
In SR, PPI increases before CPI (takes a little while for the
prices to be reflected in products we buy.
Is the Growth of GDP real or inflated?
This is the real test!!!!!!!
Was there actual increase in production and
services or did the prices just skew the GDP
statistics when C+I+G was added?
Have to correct GDP for price changes so we
can measure actual production.
CPI tells the consumer if they have to spend
more dollars to get that loaf of bread… but
other measures have to be evaluated.
Still another way to test the health of the U.S.
The GDP Deflator…. The broadest price index and covers all
output including consumer goods, investment goods and
government services. (C+I+G)
The GDP deflator isn’t a pure measure of price change. Its
value reflects both price changes AND market responses
to those price changes as reflected in new expenditure
The GDP deflator typically registers a lower inflation rate
than CPI and the government watchdogs use this
barometer more readily than current CPI
Year Price of good Quantity GDP Real GDP
1 $10 100 $1,000 $1,000
2 $12 120 12x120 10 x 120
= $1,440 = $1,200
3 $14 140 14 x 140 10 x 140
= $1,960 = $1,400
Can you calculate the percentage change from year 2 and 3?
CPI is designed to measure the impact of price changes on
the cost of a typical bundle of goods purchased by
households(remember, market basket and only for urban
GDP deflator is a broader price index and is designed to
measure the change in the average price of the market
basket of goods included in GDP (in addition to consumer
goods it includes capital goods, & g & s by government.)
CPI measures money income of consumers in relation to
rising prices (only consumer goods.)
GDP deflator measures economy wide inflation- more g & s
included in measurement.
Personal Consumption Expenditure
More accurate than CPI
Quantifies changing expenditure patterns for
Is a weighted measure
Doesn’t always have same items calculated
BEA uses continually updated surveys of
consumer purchases to determine index
Federal Reserve uses this measure for their
predictions and assessments.
Historical Record Graph
1920 1930 1940 1950 1960 1970 1980 1990 2000
Inflation 2011 to 7/2012
What really is the goal of fiscal and monetary
The CPI’s market basket of goods and services was
overhauled in 1998.
Major changes in the general level of prices indicate
upsets in the economic system.
Prices act as allocators of economic goods, they are the
mechanism that determines the answer to the three basic
questions, What, How and For Whom.
Prices act as the basic force in a capitalistic economy
What does a pair of Nike shoes cost
compared to a pair of Keds?