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AP Economics – Inflation, GDP Changes, & Interest Rates
I.
INFLATON:
General increase in the weighted average _price_____ level of the
economy. Inflation is a problem because the economy depends on
prices to __allocate_______ resources _efficiently_________. If
prices are _inflated___________ then it is more costly to plan,
which results in a less efficient __economy_________.
Real GDP = _Nominal GDP_________ minus __inflation_______
A. DEMAND-PULL INFLATION:
Occurs when consumer __demand_________ outpaces
supplier’s ability to __supply__________ goods and services in
the market.
Have them draw an AD/AS graph at full-employment equilibrium
and then shift the AD curve to the right. Have them note that the
PL or inflation has increased and the u% has decreased (under 5%)
Also have them add that this inflation will continue as long as there
is excessive AD.
B. COST-PUSH INFLATION:
Occurs when producers supply _fewer________ goods
because of increased cost of
__production___________.
Here have them draw an AD/AS graph beginning at fullemployment equilibrium and then shift the AS curve to the left.
Have them note that both the inflation and unemployment rates
will increase (“stagflation”). Also have them note the following
causes for Cost Push Inflation: 1. Negative Supply Shocks (oil
prices rising), 2. Oligopolies or Monopolies increasing prices as
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they control the market. 3. Labor Unions negotiating wage
increases.
Also, I have them note that Cost Push Inflation is self-correcting
for the following reason: When the AS curve shifts left, the
unemployment rate goes down. Consumer purchases decline, thus
causing prices to decrease. When prices decrease, the per-unit cost
of production goes down. When this happens, the AS curve shifts
right, restoring full-employment (however, this is a long-term
phenomenon) The problem is that politicians want to solve the
unemployment problem (in order to get re-elected) and this just
makes the inflation worse (by increasing G or reducing taxes). The
best thing to do is control the inflation. That is what former Fed
Chairman Paul Volker did in 1982, when he chose to decrease the
money supply and raise interest rates. He knew it would hurt
people and increase unemployment, but it was the only way to
improve the economy. By decreasing the money supply, the prime
rate increased to 22%, car loans/home loans were over 20% and
the economy slowed down. It worked, however, and the inflation
rate dropped to 4 or 5% within the year from 11% in 1982 (by the
way u% was 12% before he took the action). After that businesses
and consumers could plan again and the economy had the longest
growth period (6 years) post WWII.
C. QUANTITY THEORY OF INFLATION:
Occurs when too much money is printed in the economy,
thus causing the buying power of a nation’s currency to go
down (inflation). It is based on the Quantity Theory of
Money, which states that there is a direct relationship
between the amount of money in an economy and the prices
of products sold. The foundation for the Quantity Theory is
the Fischer Equation or Equation of Exchange shown below:
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MV = PQ
Where:
M = Money Supply
V = Velocity of Money (how many times a dollar is spent in
a year)
P = Today’s prices
Q = Quantity or output
PS. PQ = Nominal GDP and Q = Real GDP
D. WHO IS HURT BY INFLATION?
Inflation reduces the dollar’s __buying_______ power.
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Lenders (creditors) are hurt by inflation if it
_erodes______ their _earnings_. Inflation erodes
the interest they are earning on _fixed____ rate
loans.
2.
Savers are hurt when unexpected inflation
_reduces___ returns on investment. If inflation is
expected, then savers will be compensated with
higher rates of return, which offsets the inflation
effect. The higher rate reflects an inflation
premium.
3.
People on fixed incomes are hurt, because their
buying power is reduced by inflation. The only
exception is if they have a COLA (Cost of Living
Adjustment) which keeps up with the inflation
rate.
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E.
WHO IS HELPED BY INFLATION?
1.
Flexible Income Receivers. People who have
several _sources of income like _stocks__ and
bonds______, salaries, _real___ _estate, etc. can
overcome the effects of inflation.
2.
Debtors (borrowers): Borrowers with fixed rate
loans are helped because they pay back their loans
with money that costs them less (“cheaper
dollars“).
Inflation is a not a problem if prices and incomes rise at
the same rate. It’s all _anticipated__. If inflation
outpaces income, then standards of living
fall. One way to adjust for the effects of inflation is to
include ___COLA______ adjustments to those on
fixed incomes.
Expecting inflation can become a self-fulfilling
prophecy. Consumers expect prices to rise, therefore,
they buy more now, this, in turn results in demand-pull
inflation.
F.
MEASURING INFLATION:
1.
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CPI:
A _market _basket_ of goods determined by
the Bureau of Labor Statistics. This involves
_300___ commonly purchased goods/services
bought by _urban_ households. These items
are also weighted.
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Weakness of the CPI:
1. index is only adjusted periodically
2. the composition of the index is only adjusted
periodically
3. does not include I, G, or Xn spending
2.
PPI:
Index of goods used in the _production_
process. The PPI is a good early indicator of
consumer inflation.
3.
GDP DEFLATOR (or Price Index):
Measures changes in total _spending__. It is
adjusted _annually_ and includes
C, I, G, and Xn spending (preferred by
economists)
III. CHANGES IN REAL GDP, WAGES, & INTERST
RATES:
Once we know inflation, we can adjust nominal figures to
arrive at real figures.
1.
2.
3.
Real Income = __Nominal Income_____ minus
inflation.
Real Interest Rate = Nominal Interest Rate minus
inflation.
Real GDP = _Nominal GDP__ minus inflation.
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4.
Percentage Change in Real Income = %Change in
Nominal Income
minus % change in _price level (inflation).
Ex: if Joe’s nominal income rose by 5% and inflation rose by 3%,
what is his percentage change in real income (5% minus 3% or
2%). He is better off. (Nominal Income is what you get paid, Real
Income is what you can buy).
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