Ch. 9 Inflation

Cause of inflation

"too many dollars chasing too few goods" if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation.

In 2017, $1 had about the same purchasing power in overall terms of goods and services as

18 cents did in 1972, b/c of the amount of inflation that has occurred over that period of time.

Which of the examples provides the best evidence that inflation has occurred?

A person whose salary has increased is able to purchase fewer goods and services.

What's the best measure of cost of living?

CPI

What are Unintended Re-distributions of Purchasing Power?

Can hurt some and help others.

What is the difference between measures of inflation which only use CPI and the core measurements of inflation?

Core inflation does not include goods and services, included in the CPI, that experience frequent price shocks.

Indexing in Private Markets

Cost of living (COLA) Adjustable rate mortgage (ARM)

T/F Deflation means that the overall price level is increasing at a decreasing rate.

F

T/F While theoretically possible, deflation has never been observed in the US

F

What are the major categories in the CPI? (8)

Food and Beverage Housing Apparel Transportation Medical Care Recreation Education and Communication Other

What's the best measure of inflation?

GDP deflator

What's the best measure of inflation?

GDP deflator as it picks up the prices of goods and services produced. not a good measure of the cost living as it includes prices of many products not purchased by households.

The BLS calculates several price indices that are not based on based of consumer goods:

Producer Price Index International Price Index Employment Cost Index GDP Deflator

T/F A negative rate of inflation implies that deflation has taken place.

T

T/F Deflation means that the overall price level is decreasing.

T

The Consumer Price Index (CPI) is used to calculate what?

US inflation rates

What is Inflation?

a general and ongoing rise in the level of prices in an entire economy.

Inflation and the effect on lenders.

a lender receiving a fixed interest rate, suffers from inflation.

What is the Consumer Price Index?

a measure of the overall cost of the goods and services BOUGHT by a typical consumer

What is the Core Inflation Index?

a preferred gauge from which to make important government changes, where as CPI helps households understand their overall cost of living from month to month.

What is the GDP Deflator?

a price index that includes all the GDP components.

What is Inflation?

an increase in the overall price level

What does Inflation imply?

an ongoing rise in prices.

Which most accurately characterizes the method used to calculate inflation?

analysts measure the cost of a bundle of goods representative of overall spending at two points in time and compare the difference in cost.

Indexing in government programs: US income tax code

b/c of many complex provisions in the rest of the tax code, difficult to determine exactly the taxes an individual owes the government based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises.

What is Producer Price Index?

based on prices paid for supplies and inputs by produced goods and services.

What is the Employment Cost Index?

based on the measures of wage inflation in the labor market.

What is the International Price Index?

based on the prices of merchandise that is exported or imported.

The power of inflation does not affect just goods and services,

but wages and income levels too

How do these price change over time?

calculating the annual rate of inflation based on products.

Inflation and the effect on borrowers

consider someone who borrows $10,000 to buy a car at a fixed interest rate of 9%. if inflation is 3% at the time the loan is made, then they must repay the loan at a real interest rate of 6%. however, if inflation rises to 9%, the real interest rate on the loan is 0%. in this case the borrowers benefit form inflation is the lender's loss.

The Cost of Living is measured using (5)

consumer Price Index (CPI) producer price index (PPI) the international price index the employment cost index GDP deflator

Why is a hypothetical basket of goods used to measure inflation?

consumers can see the general increase in price over time by using a basket of goods.

When inflation happens, the buying power of cash

diminishes

How and why is money spent on the basket converted to an index number?

economists arbitrarily (randomly) choose one year to be the base year (or starting point) to measure changes in prices.

Other Price Indices: If the CPI does not serve the desired purpose, then invent another index, based on a basket of goods appropriate for the group of interest like:

elderly poor single-parent families w/children hispanic-americans (these are specific situations).

Economists typically calculate a core inflation index by taking the CPI and excluding volatile economic variables. What is a variables example?

energy and food prices, which can jump around from month to month b/c of weather.

Some products matter more than others:

goods for which people spend a larger share of their incomes will matter more than changes in the price of goods for which people spend a smaller share of their incomes.

What is Stagflation?

high inflation and high unemployment

Two things to remember about index numbers:

index numbers have no dollar signs or other units attached to them. the year that is automatically set to equal 100 is arbitrary.

Loans often have built in

inflation adjustments

Problems of long-term planning

inflation can make long-term planning difficult. trying to save for retirement, b/c they must consider what their money will really buy several decades in the future when we cannot know the rate of future inflation.

Indexes work to track what?

inflation.

What is COLA?

labor unions commonly negotiated wage contracts that had COLAs which guaranteed that their wages would keep up with inflation.

Inflation has consequences for people and firms throughout the economy in their roles as

lenders and borrowers wage-earners taxpayers consumers

What is the calculation for the Inflation Rate Since Previous Period (or the Percentage Change)?

level in new year MINUS level in previous year DIVIDED BY level in previous year x 100

What are Bonds?

means by with the US government borrows money - investors buy the bonds, and the government repays the money with interest

Real Interest Rate =

nominal interest rate - inflation

Social Security Program

offer two examples of indexing: level of SS benefits increases each year along with the CPI. SS is funded by payroll taxes, which the government imposes on the income earned up to a certain amount.

A low rate of inflation serves as

oil for the gears of the labor market

What is Hyperinflation?

outburst of high inflation. can rip an economy and a society apart

If an economy experiences deflation, then the

overall price level is declining

Inflation is often measured by evaluating changes in the cost of a fixed basket of goods and services. This method __________ inflation b/c it does not account for the changes in spending patterns that result from relative price changes. This problem is known as __________.

overestimates substitution bias

Substitution Bias - the rise in the price of a fixed basket of goods over time - tends to

overstate the rise in a consumer's true cost of living, b/c it does not take into account that the person can substitute away from goods whose relative prices have risen.

What is Defined Contribution?

pensions and other defined benefits retirement plans are being replaced by defined contributions plans, such as 401(k)s and 403(b)s. the employer contributes a fixed amount to the worker's retirement account on a regular basis (usually every pay check). employee contributes also.

What are Defined Benefits?

pensions received from a private company for retirees. Even if inflation is low, the combo of inflation and a fixed income create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1% to 2% of buying power per year to inflation compounds to a considerable loss of buying power after a decade or two.

What are some examples that inflation can hurt some?

people who are hurt by inflation include those who are holding considerable cash, like in a pencil pouch in the sock drawer. Anyone who has financial assets invested in a way that the nominal return does not keep up with inflation will tend to suffer from inflation. example - a person has money in a bank account that pays 4% interest, but inflation rises to 5%, then the real rate of return for the money invested is -1%.

The inflation rate is simply the

percentage change in the price level

What is the effect on price signal?

prices are the messengers in a market economy. Inflation blurs those prices messages. Inflation means that we perceive signals more vaguely, like a radio program received w/considerable static. If the the static becomes too severe, it is hard to tell what is happening

Another problem with this technique is that it fails to recognize changes in the caliber of goods over time. As an example, consider cable television service. Although the cost has remained relatively constant over time, high-definition programming and more channels implies a substantial difference in caliber. This problem is known as __________

quality or new goods bias

What is a Price Index?

reported price level in each period (or year), rather than as the dollar amount for buying the basket of goods.

What is Deflation?

severe negative inflation The deep 1920-21 recession and great depression.

Economists combine prices of a variety of goods and services into a

single price level

Benefits of inflation

someone who borrowed at a fixed interest rate benefits from inflation. homeowners - price of home rises, while renters suffer b/c they are paying higher rent.

What two problems arise with the CPI?

substitution bias and quality new goods bias

The problem of a good looking nominal interest rate transforming into an ugly looking real interest rate can be worsened by

taxes.

What is Quality/New Goods Bias?

the arrival of new goods creates problems with respect to the accuracy of measuring inflation.

What statement is an objection of using the CPI to measure changes in the cost of living?

the calculated inflation rate is only accurate for an individual who purchases all the goods and services in the basket.

Economists not only track inflation, but they also measure

the cost of living.

What is purchasing power?

the financial ability to buy products and services.

Why do people buy new goods?

the new goods offer better value for money than existing goods.

Why is Quality/New Goods Bias a problem?

the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer's true cost of living, b/c it does not account for how improvements in the quality of existing goods or the invention of new goods improves the standard of living.

Inflation also means that

there is pressure for prices to rise in the supply and demand model making the equilibrium shift to a new one.

Why do Economists create price indices (price index's)?

to calculate an overall average change in relative prices over time. to convert the money spent on the basket to an index number.

What is a Basket of Goods and Services?

to calculate the price level, consisting of different items individuals, businesses, or organizations typically buy.

What is ARM?

type of loan that one can use to purchase a home in which the interest rate varies w/ the rate of inflation. often a borrower will be able to receive a lower interest rate of borrowing with and ARM, compared to a fixed rate loan.

Unintended redistributions for wge earners

wages do typically creep up with inflation over time, eventually

Indexing

when a price, wage, or interest rate is adjusted automatically with inflation.

What is the lesson of inflation and the effect of borrowing and lending?

when interest rates are fixed, rises in the rate of inflation tend penalize suppliers of financial capital (who receive repayment in dollars that are worth less b/c of inflation) while demanders of financial capital end up better off, b/c they can repay their loans in dollars that are worth less than originally expected.

What is Substitution Bias?

when the price of goods rises, consumers tend to purchase less of it and to seek out substitutes.