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Chapter 10 Part One – Inflation
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Blue -> examples
Red -> key terms
Inflation

The general _______ in the prices of goods and services in an entire
economy over a period of time
Canada's annual inflation rises 2.5% in total, therefore some prices may
remain unchanged or maybe less.
Deflation
- The general _______ in prices of goods and services in an entire economy over
a period of time
Canada's annual inflation decreases 2.5% in total
The Consumer Price Index (CPI)
- The tool most commonly used to measure ______ _______ in prices

Monitors price changes in a representative “________ ______” of consumer
products

Used to determine what Canadians typically buy

Item weights are the __________ of each good in the total cost of the
basket of consumer goods used to calculate CPI

Base year is a survey year used as a point of ________ in subsequent years
Figure 1a – Year 1
Consumer
Product
Prices
Qty
Expenditure/month Item weights
Consumed/month
Hamburgers $2.00
10
$20
20/50 = 0.4
Milkshakes
30
$30
30/50 = 0.6
$1.00
$50


Item weight indicates that 2/5 (0.4) of the consumer's total budget is spent
on hamburgers and 3/5 (0.6) on milkshakes
The base year is 1
Figure 1b – Year 2
Consumer Product
Prices
Year 2 price x year 1
quantity
Hamburgers
$2.20
$2.20 x 10 = $22.00
Milkshakes
$1.05
$1.05 x 30 = $31.50
$53.50
How to calculate the CPI of year 1 & 2

Step 1: calculate the difference of the total cost between year 2 & 1
$53.50 – $50.00 = $3.50

Step 2: Take the difference and divide it by year 1's total cost
$3.50 / $50.00 = 0.7
Step 3: Take the value of step 2 and multiply it by 100
0.7 x 100 = 7% or 7 (on CPI index)
Step 4: Compare the CPI from the base year to the current year and add the
value from step 3

year 1 CPI = 100 ($50.00 / $50.00 = 1 = 1 x 100 = 100)

year 1 CPI + year 2 CPI increase (100 + 7 = 107)


The change in the index is expressed as a percentage which is also the
inflation rate
Nominal versus Real Income
Nominal income is expressed in ________ dollars
Real income is expressed in ________ ____ _____ dollars
Real GDP is GDP expressed is constant dollars from a chosen reference



year


Real GDP gives an indication of the purchasing power of an entire
economy
to see how consumer's purchasing power is affected by inflation, we can
express nominal income and real income
Real income = nominal income / CPI (in hundredths)
To determine real income for a given year, the consumer's nominal income
($1050) is divided by the value of the CPI for that year expressed in hundredths
(1.10)
Real income = $1050 / (110 / 100 = 1.10)
= $954.55



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
for the consumer's purchasing power ($954.55) to keep up with inflation,
the income would have to increase by the same percentage as the increase
in prices by 10% or $100.00 (= $1000 x 0.10) to $1100 (= $1000 + $100)
The purchasing power of a current dollar is inversely related to the
consumer price index
The lower the CPI , the higher purchasing power of nominal income
The higher the CPI, the lower purchasing power of nominal income
Therefore, those whose incomes increase at a higher rate than the rise in
prices have a higher standard of living, visa versa
Limitations of CPI
1. ______________________
2. ______________________
3. ______________________
The GDP Deflator



The GDP deflator is an indicator of _________ ___________ for all goods and
services produced in the economy
More accurate then CPI due to frequent updates, although the values of
the index are not as quickly available compared to CPI
To calculate the value of the GDP deflator in each subsequent year,
multiply the output of each year by the current price, divided by the
same output in reference year prices. Then multiplies by 100
Nominal versus Real GDP


Nominal GDP is GDP in ________ dollars
Real GDP gives an indication of the purchasing power of an entire
economy
Real GDP = Nominal GDP / GDP Deflator (in hundredths)
Inflation’s Effects


Inflation redistributes purchasing power among different groups in ways
that can be both economically harmful and unjust, in other words it
widens the gap between the rich and the poor
To see the effects of inflation, you can look at its effects on household
incomes and on borrowing and lending.
Incomes
 If household’s income increases steadily every year, but inflation rises at a
higher rate, the household loses purchasing power, therefore lowers
standard of living
 If income increases at around the same rate as inflation, the household
keeps its purchasing power
 Cost of Living Adjustment Clauses are provisions for income adjustments to
accommodate changes in price levels, which are included in wage
contracts
 Fully Indexed Incomes are nominal incomes that automatically increase
by the rate of inflation
 Partially Indexed Income are nominal incomes that increase by less than
the rate of inflation
 Fixed Incomes are nominal incomes that remain fixed at some dollar
amount regardless of the rate of inflation
Borrowing and Lending


Nominal Interest Rate is the interest rate expressed in money terms
Real Interest Rate is the nominal interest rate minus the rate of inflation
Real Interest Rate = Nominal Interest Rate – Inflation Rate

Inflation Premium is a percentage built into a nominal interest rate to
anticipate the rate of inflation for the loan period
Nominal Interest Rate = Desired real Interest Rate + Inflation premium