Chapter 21: The Price Level and Inflation

What's in that basket?

In addition to groceries, there is clothing, transportation, housing, medical care, education, and many other goods and services. The idea is to include everything a typical consumer buys.

Equation of exchange

MxV=PxY

The BLS's goals are to:

(1) determine the prices of all the goods and services that a typical consumer buys and (2) identify how much of a typical consumer's budget is spent on these particular items.

What problems does inflation bring?

-Inflation imposes shoe-leather costs: it causes people to waste resources as they seek to avoid holding money. -Inflation can cause people to make decisions based on nominal rather than real monetary values, a problem known as money illusion. -Inflation adds menu costs, as sellers need to physically change prices. -Inflation introduces uncertainty about future price levels. Because uncertainty makes it difficult for consumers and producers to plan, it impedes economic progress. -Unexpected inflation redistributes wealth from lenders to borrowers. -Inflation creates price confusion: that is, it makes it difficult for producers to read price signals correctly. The result may be a misallocation of resources. -Inflation distorts people's tax obligations.

When the overall price rises and falls.

When overall prices rise, this affects our budget; it limits how much we can buy with our income. On the other hand, when overall prices fall, our income goes farther and we can buy more goods.

chained CPI

a measure of the CPI in which the typical consumer's "basket" of goods and services considered is updated monthly.

consumer price index (CPI)

a measure of the price level based on the consumption patterns of a typical consumer.

A worker's ________ is his or her wage expressed in current dollars.

nominal wage

deflation

occurs when overall prices fall; it is negative inflation.

money illusion

occurs when people interpret nominal changes in wages or prices as real changes.

equation of exchange

specifies the long-run relationship between the money supply, the price level, real GDP, and the velocity of money.

capital gains taxes

taxes on the gains realized by selling an asset for more than its purchase price.

What is the cause of inflation?

-Inflation is caused by increases in a nation's money supply relative to the quantity of real goods and services in the economy. -Governments often increase the money supply too quickly when they are in debt or when they desire a short-run stimulus for the economy. -The equation of exchange offers a simple summary of the long-run relationship between the inflation rate and quantity of money in an economy.

How is inflation measured?

-The inflation rate is calculated as the percentage change in the overall level of prices. -Economists use the consumer price index (CPI) to determine the general level of prices in the economy. -Determining which prices to include in the CPI can be challenging for several reasons: consumers change what they buy over time; the quality of goods and services changes; and new goods, services, and sales locations are introduced.

Question: in what situation would a 3% raise signify a lower real wage?

Answer: If the inflation rate is greater than 3%, then a 3% raise would actually be a decline in your real wage.

Question: What inflation problem must you overcome to correctly see the value of your raise?

Answer: Money illusion. You must evaluate the real, rather than the nominal, value of your pay.

Measuring inflation is straightforward but requires great care.

First, prices don't all move together; some prices fall even when most others rise. Second, some prices affect consumers more than others. For example, a 10% increase in the price of housing is significantly more painful than a 10% increase in the price of hot dogs. Before we arrive at a useful measure of inflation, we have to agree on what prices to monitor and how much weight we'll give to each price. In the United States, the Bureau of Labor Statistics (BLS) measures and reports inflation data. In this section, we describe how the BLS estimates the overall price level.

Conclusion

This chapter began with a common misconception—that inflation is no big deal. But we have seen that inflation and the problems it imposes can be severe. And while inflation rates have been low in the United States for sev- eral years now, at times in the past they have been very high—such as during the 1970s. In addition, inflation rates in some other nations remain high. Inflation, along with the unemployment rate and changes in real GDP, is an important indicator of overall macroeconomic conditions. Now that we have covered these three, we move next to savings and the determination of interest rates.

hyperinflation

an extremely high rate of inflation, and it completely stymies economic activity.

The CPI

based on prices from a typical "basket" of all consumer goods and services.

menu costs

the costs of changing prices.

real wage

the nominal wage adjusted for changes in the price level.

velocity of money

the number of times a unit of money exchanges hands in a given year.

output

the product that the firm creates.

shoe-leather costs

the resources that are wasted when people change their behavior to avoid holding money.

There are three reasons for this concern:

the substitution of different goods and services, changes in quality, and the availability of new goods, services, and locations.