Inflation
A continuous rise in the price of goods and services
How is inflation measured?
Is measured as the rate of growth of a price
... [Show More] index
CPI
Consumer Price Index
What is the CPI used to calculate?
The inflation rate reported in the popular press
Inflation rate equation
(The change in price index)/(the starting price index)
Equation for inflation rate from one period to the next
(New value - old value)/(old value)
Substitution Bias
People substitute cheaper goods for more expensive goods when relative prices change. But the market basket doesn't change.
Quality changes
Higher price due to improvements
The "core" inflation rate
The inflation rate calculated using the CPI with the market basket, excluding energy and food
PPI
Producer Price Index
producer price index
Calculated like CPI except that it's market basket contains raw material, intermediate goods, and wage rates
GDP deflator
Measures the prices of all final goods and services produced domestically
The Quantity Theory
There is an inverse relationship between quantity of money as the value of money
The Quantity Equation
MV = PY
If inflation is so simple, why do some countries struggle with it??
A. Governments that spend more than they can collect in taxes or borrow
B. Have a central bank that is not politically independent
Lower then expected inflation =
Helps lender and harms borrowers
Higher than expected inflation=
Helps borrowers and harms lenders
Problems with deflation
Random income redistribution
Blurred price signals
Hyperinflation
A very high rate of inflation (50% + per month)
What are the cost of inflation?
1.random distribution
2.people on fixed incomes are always hurt
3. Distortions cause by us tax laws
4. Blurred price signals
Ex ante
Before hand
Ex post
Afterwards
Deflation
When the inflation is negative
Constructing a price index
pick a base year
once you've picked a base year those values are 100%
divide all of the final year values by the base year
multiply by 100 to get the percent
Computing the inflation rate
is calculated as the present change in the price index from year to year
(new index - old index)/old index
What is the best price index to use ?
CPI
Why are index numbers used to measure the price level rather than the dollar value of goods?
for a large, realistic basket of goods, solar values will get large and messy. An index number actually makes it easier to compare price levels over time.
How is a basket of goods and services used to measure the price level?
Once you have picked a basket of goods, you can keep track of how much it cost to buy that particular basket over time. To see if it is increasing or decreasing.
what is the difference between price value and the rate of inflation ?
price level is represented by and index number
rate of inflation is the rate of growth of the price level
why does the "Substitution bias" arise if the inflation rate is calculated based on a fixed basket of goods?
Substitution bias arises precisely because the basket is fixed
Why does the "quantity/new goods" bias arise if the inflation rate is calculated based on the fixed basket of goods?
because if something is improved, but the price does not change the object is technically cheaper than it used to be
what has been a typical range of inflation in the U.S economy in the last decade?
0.1% to 3.8%
over the last century, during what periods was the U.S inflation rate the highest and lowest?
the U.S inflation rate was the highest in 1917 and the lowest in 1921
What is deflation?
it is cause by too rapid increase in the money supply. If the money supply rises faster than the quantity of goods to buy, there will be too much money chasing too few goods. PRICES WILL RISE
Why might the government print too much money?
does not have enough tax revenue to pay for its spending, and its unable to borrow what it needs.
Given the federal budget deficit in recent years, some economists have argued that by adjusting Social Security payments for inflation using the CPI, Social Security is overpaying recipients. What is the argument being made, and do you agree or disagree with it?
Because of substitution bias and quality/new goods bias, the CPI overstates the rate of inflation. The purpose of adjusting Social Security payments for inflation is to keep the purchasing power of Social Security payments the same. If they are adjusted using the CPI, the payments increase by more than the overall price level. On the other hand, the basket of goods used to calculate the CPI may not reflect the basket of goods purchased by retired people. In particular, retired people tend to buy more health care, and the price of health care has been rising faster than the overall inflation rate as measured by the CPI.
Imagine that the government statisticians who calculate the inflation rate have been updating the basic basket of goods once every 10 years, but now they decide to update it every five years. How will this change affect the amount of substitution bias and quality/new goods bias?
It should reduce substitution bias because the basket will better reflect what people are actually buying.
Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the CPI to convert from nominal to real would be more appropriate than using the GDP deflator.
The CPI would be more appropriate in any situation that involves a typical consumer. Examples include calculating changes in the real wage, changes in real college tuition, and changes in real gasoline prices.
Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the GDP deflator to convert from nominal to real would be more appropriate than using the CPI.
The GDP deflator would be more appropriate for determining the inflation rate for the economy as a whole. This is because, in addition to consumer goods, it includes the prices of things like factories, machines, weapons for the army, highways, and other things that consumers do not buy. Thus, the GDP deflator is important for policy makers concerned about the price level in general, not just for consumers. [Show Less]