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Chapter 8
Inflation
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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Basics of inflation
Average price level
Inflation rate
Globalization and inflation
Quality improvements
Adjusting for inflation
Money illusion and expectations
8-2
Basics of Inflation
• Inflation is the rise and fall in the overall
level of prices in the economy as a whole.
– The overall price level is an average of
millions of prices of different goods and
services.
• Inflation is one of the key measures of the
health of the economy.
– The economy is in trouble if prices are rising
or falling too fast.
8-3
Basics of Inflation
• The goal of economic policymakers is to keep
inflation under control.
• Inflation is a problem since it reduces
consumers’ purchasing power.
– If inflation increases, your money buys less and less.
• The situation where prices are falling is known
as deflation.
8-4
Average Price Level
• At any time in the economy, the price of some
goods and services will be rising, while others
will be falling.
• So when we measure inflation, we are
concerned with the extent that overall prices
(prices across the economy) are rising or falling,
not with the rise or fall of any particular good or
service.
8-5
Average Price Level
• The average price level in the economy
measures how much it costs to buy a market
basket of common goods and services.
• The US Bureau of Labor Statistics (BLS) selects
the contents of the market basket which
represents the goods and services the typical
US household will buy.
• The BLS gives each item in the market basket a
certain weight to represent its relative
importance in the typical budget.
8-6
Market Basket
• The two largest items in the market basket:
– The cost of housing measured by the owners’
equivalent rent of primary residence. This is the single
biggest part of the market basket.
– Food consumed at home. This is the second largest
part of the market basket, and is followed by medical
care.
• The market basket, while not perfect, is a
reasonable representation of the spending
pattern of an average US household.
8-7
Consumer Price Index (CPI)
• The consumer price index (CPI) is a measure
that tracks the average price level in the US.
• CPI is based on a market basket of goods.
• BLS selected the average 1982-84 price level as
the base year.
– The base year is assigned a value of 100.
• The CPI measures all other years relative to this
base period.
8-8
Consumer Price Index, 1982-84 = 100
Consumer Price Index (CPI)
250
200
2007
207.3
150
1984
103.9
100
50
1960
29.6
0
8-9
Inflation Rate
• Inflation is defined as a sustained upward
movement in the average level of prices.
• The inflation rate is the annual
percentage change in the average price
level.
– Since the CPI tracks the average price level,
the inflation rate is also the annual percentage
change in the CPI.
• CPI is published each month by the BLS.
8-10
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1968
1965
1962
1959
1956
1953
1950
Annual increase in consumer price index
(percent)
Inflation Rate
16%
14%
12%
10%
8%
6%
4%
2%
0%
8-11
Calculating Percentage Change
• Economists are concerned with the speed
of change over time.
• The inflation rate measures how fast
prices are rising.
• Measure the rate of change as an annual
percentage change, which is calculated
as follows:
– Percentage change = [(original number – new
number)/original number] x 100
8-12
Relative Price Shifts
• BLS reports not only overall inflation rate, but
also the inflation for subcategories of goods and
services.
• A relative price shift happens when the inflation
rate of a good or service is significantly higher or
lower than the overall inflation rate.
– If it’s higher, then that good or service is getting more
expensive over time, relative to other possible
purchases.
– If it’s lower than the overall inflation rate, then it’s
getting relatively cheaper.
8-13
Globalization and Inflation
• The inflation rate has been higher for
services compared to goods.
• The main reason goods have become
cheaper is globalization.
• Production of goods has shifted from the
US to lower-cost countries such as China.
• It is much harder to shift the production of
services overseas.
8-14
Quality Improvements and Inflation
• A difficulty involved in measuring inflation
is that the quality and features of a product
change over time.
• When the price of a good or service goes
up because of an improvement in
quality, the BLS does not count that price
increase as part of the inflation rate.
– Rapid technological change makes the job of
measuring inflation especially difficult, since
the product changes are rapid and it’s hard to
compare them to the original.
8-15
Adjusting for Inflation
• To compare household income over time,
we must adjust the income for the impact
of inflation.
• Otherwise, we run the risk of suffering
from money illusion.
• Money illusion happens when we compare
dollar amounts in different time periods
without adjusting for inflation.
8-16
Real versus Nominal Dollars
• To avoid money illusion, we should use the
real or inflation-adjusted increase.
– This is calculated as the percentage increase
in dollars minus the inflation rate.
• The increase without the adjustment for
inflation is called the nominal increase.
• The real or inflation-adjusted increase is
the nominal percentage change minus the
inflation rate.
8-17
Expectations and Inflation
• Expected inflation is the inflation rate that
consumers and businesses expect will hold for
some future period.
• Expected inflation forms the basis for pricing and
wage decisions that businesses make.
• If people expect that the higher rate of inflation
will continue, a wage-price spiral may occur.
– Business now boosts prices and wages faster and
faster to stay ahead of expected inflation.
– The worst possible case of a wage–price spiral is
hyperinflation.
8-18
Harm from Inflation
• The harm from inflation depends on two
cases.
– First is the case of unanticipated inflation,
which occurs when the actual inflation rate is
above the expected inflation rate.
• In this case, lenders are harmed since they’re
being paid back with less valuable dollars.
• Borrowers benefit from unanticipated inflation.
8-19
Harm from Inflation
– Second is the case of anticipated inflation,
where the actual rate of inflation is equal to
the expected rate of inflation.
• The problem with anticipated inflation is that it
leads to cost-of-living adjustments (COLA) in union
contracts and certain government programs.
• High levels of inflation increase the cost of
transactions - the time and effort that goes into
managing your spending.
8-20
Deflation
• Deflation is an actual fall in the average
price level.
• In contrast, disinflation is a reduction in
the inflation rate.
• Deflation is a problem for two reasons:
– First, deflation usually means demand is so
weak that businesses cannot raise their
prices.
– Second, deflation hurts borrowers, because
they are paying back their loans with more
expensive dollars.
8-21