Download Economics for Today 2nd edition Irvin B. Tucker

Chapter 17
Inflation
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is inflation?
An increase in the
general (average) price
level of goods and
services in the economy
2
What is deflation?
A decrease in the general
(average) price level of
goods and services in
the economy
3
What is the most
widely reported
measure of inflation?
The Consumer Price Index
4
What is the
Consumer Price Index?
The CPI is an index that
measures changes in the
average prices of consumer
goods and services
5
Who reports the CPI?
The Bureau of Labor
Statistics (BLS) of the
Department of Labor
6
How is the CPI
calculated?
Price collectors contact retail
stores, homeowners, and
tenants in selected cities in
the U.S. monthly
7
Which goods and
services are included
in the CPI?
The BLS records average
prices for a “market
basket” of different items
purchased by the typical
urban family
8
Composition of the CPI
Food and Beverages
16.2%
Housing
40.0%
Apparel and Upkeep
4.4%
Transportation
17.6%
Medical Care
5.8%
Recreation
5.9%
Education & Communication
5.3%
All other goods & services
4.8%
9
Does the makeup of
the CPI change?
As people’s tastes and
preferences change,
some of the goods and
services that go into the
basket change
10
How is the CPI
computed?
Current year prices are
compared to prices of a
similar basket of goods and
services in a base year
11
What is a base year?
A year chosen as a
reference point for
comparison with some
earlier or later year
12
Why is the CPI always
100 in the base year?
The numerator and the
denominator of the
CPI formula are the
same in the base year
13
*CYP = cost of the market basket of
products at current-year prices
*BYP = cost of the market basket of
products at base-year prices
CPI =
CYP X 100
BYP
14
How is the
inflation rate computed?
The annual inflation rate is
computed as the
percentage change in
the official CPI from one
year to the next
15
*ARI = Annual rate of inflation
*CPIY = Consumer price index
in given year
*CPIPY = Consumer price
index in previous year
CPI
CPIPY
X 100
ARI =
CPIPY
16
20
16
12
8
The U.S. Inflation Rate 1929 - 2002
4
0
-4
-8
-12
1930 40
50
60
70
80
90
00
17
What is disinflation?
A reduction in the
rate of inflation
18
What are some
criticisms of the CPI?
• It can overstate or
understate the impact of
inflation for certain groups
• Does not measure quality
• Substitutes are ignored
19
What does inflation do
to people’s income?
A general rise in prices will
shrink people’s income
20
What is
nominal income?
The actual number of
dollars received over
a period of time
21
What is real income?
The actual number of
dollars received (nominal
income) adjusted for
changes in the CPI
22
*RI = Real income
*NI = Nominal income
*CPI = CPI as a decimal or CPI ÷ 100
NI
RI = CPI
23
%  in real
income
=
%  in
nominal
income
_
%  in
CPI
24
What is wealth?
The value of the stock
of assets owned at
some point in time
25
How is wealth
affected by inflation?
Inflation can benefit
holders of wealth
because the value of
their assets tends to
increase as prices rise
26
What will cause your
real income to decline?
The rate of inflation
is greater than your
rate of income
27
How does inflation
affect borrowers
and savers?
They can win or
lose depending on
the rate of inflation
28
What is the
interest rate?
Interest per year as a
percentage of the
amount loaned or lent
29
What is the
nominal interest rate?
The actual rate of
interest earned over a
period of time
30
What is the
real interest rate?
The nominal rate of interest
minus the inflation rate
31
What are the two basic
types of inflation?
Demand-pull
Cost-push
32
What is
demand-pull inflation?
A rise in the general
price level resulting
from an excess of total
spending (demand)
33
When does demandpull inflation occur?
When the economy is
operating at or near
full employment
34
What is
cost-push inflation?
A rise in the general
price level resulting
from an increase in
the cost of production
35
What can cause costpush inflation?
Cost increases for labor, raw
materials, construction,
equipment, borrowing etc.
36
Do people’s
expectations
affect inflation?
Yes, expectations can
influence both demandpull and cost-push
inflation
37
What is hyperinflation?
An extremely rapid rise in
the general price level
38
What is a
wage-price spiral?
A situation that occurs when
increases in nominal wage
rates are passed on in
higher prices, which, in turn,
result in even higher
nominal wages and prices
39
How does the U.S.
inflation rate
compare with other
countries?
It is lower than
some and higher
than others
40
Key Concepts
41
Key Concepts
• What is inflation?
• What is the Consumer Price Index?
• Which goods and services are included in
the CPI?
• How is the CPI computed?
• What is a base year?
• How is the inflation rate computed?
• What is disinflation?
42
Key Concepts cont.
•
•
•
•
•
•
What does inflation do to people’s income?
What is nominal income?
What is real income?
What is wealth?
How is wealth affected by inflation?
How does inflation affect borrowers and
savers?
• What are the two basic types of inflation?
43
Key Concepts cont.
•
•
•
•
•
What is demand-pull inflation?
What is cost-push inflation?
Do people’s expectations affect inflation?
What is hyperinflation?
How does the U.S. inflation rate compare
with other countries?
44
Summary
45
Inflation is an increase in the
general (average) price level of
goods and services in the
economy.
46
The consumer price index (CPI) is
the most widely known price-level
index. It measures the cost of
purchasing a market basket of
goods and services by a typical
household during a time period
relative to the cost of the same
bundle during a base year.
47
The annual rate of inflation is
computed using the following
formula:
48
*ARI = Annual rate of inflation
*CPIY = Consumer price index
in given year
*CPIPY = Consumer price
index in previous year
CPI
CPIPY
X 100
ARI =
CPIPY
49
Deflation is a decrease in the
general level of prices. During
the early years of the Great
Depression, there was deflation.
50
Disinflation is a reduction in the
inflation rate. Between 1980 and
1986, there was disinflation. This
does not mean that prices were
falling, but only that the inflation
rate fell.
51
The inflation rate is criticized
because (1) it is not
representative, (2) it incorrectly
adjusts for quality changes, and
(3) it ignores the relationship
between price changes and the
importance of items in the
market basket.
52
Nominal income is income
measured in actual money
amounts. Measuring your
purchasing power requires
converting nominal income into
real income, which is nominal
income adjusted for inflation.
53
The real interest rate is the
nominal interest rate adjusted for
inflation. If real interest rates are
negative, lenders incur losses.
54
%  in real
income
=
%  in
nominal
income
_
%  in
CPI
55
Demand-pull inflation is
caused by by pressure on
prices originating from the
buyers side of the market.
56
Cost-push inflation is caused
by pressure on prices
originating from the seller's
side of the market.
57
Hyperinflation can seriously
disrupt an economy by causing
inflation psychosis, credit
market collapses, a wage-price
spiral, and speculation.
58
Chapter 17 Quiz
©2002 South-Western College Publishing
59
1. Inflation is
a. an increase in the general price
level.
b. not a concern during war.
c. a result of high unemployment.
d. none of the above.
A. Inflation is always a concern and it is
not caused by a high unemployment
rate.
60
2. If the consumer price index in 1996 was
300 and the CPI in 1997 was 315, the
rate of inflation was
a. 5 per cent.
b. 15 per cent.
c. 25 per cent.
d. 315 per cent.
A. CPI = 315 - 300 / 300 x 100 =
5%
61
3. Consider an economy with only two
goods: bread and wine. In 1982, the the
typical family bought 4 loaves of bread
at 50 cents per loaf and two bottles of
wine for $9 per bottle. In 1996, bread
cost 75 cents per loaf, and wine cost
$10 per bottle. The CPI for 1996 (using
a 1982 base year) is
a. 100.
b. 115.
c. 126.
d. 130.
B.
62
*CYP = cost of the market basket of
products at current-year prices
*BYP = cost of the market basket of
products at base-year prices
CPI =
115 =
CYP
X 100
BYP
$23
X 100
$20
63
Exhibit 5
Year
CPI
1
2
3
4
5
100
110
115
120
125
64
4. As shown in Exhibit 5, the rate of
inflation for Year 2 is
a. 5 percent.
b. 10 percent.
c. 20 percent.
d. 25 percent.
B. A percent increase of decrease
between two numbers is the
difference divided by the original
number. In this case, it is 10 / 100 =
10%
65
5. As shown in Exhibit 5, the rate of
inflation for Year 5 is
a. 4.2 percent.
b. 5 percent.
c. 20 percent.
d. 25 percent.
A. A percent increase of decrease
between two numbers is the
difference divided by the original
number. In this case, it is 5 / 100 =
4.2%
66
6. Deflation is a (an):
a. increase in most prices.
b. decrease in the general price
level.
c. situation that has never occurred
in U.S. history.
d. none of the above.
B. Inflation is an increase in most
prices and deflation did occur in the
U.S. during the Great Depression of
the 1930’s.
67
7. Which of the following would
overstate the consumer price index?
a. Substitution bias.
b. Improving quality of products.
c. Neither (a) nor (b).
d. Both (a) and (b).
D. Substitution bias refers to the law
of demand in which people buy less
when the price rises. However, the
CPI is based on a fixed market
basket. Since quality is difficult to
measure, a decline in quality
understates inflation.
68
8. Suppose a typical automobile tire cost $50
in 1982 and had a useful life of 40,000
miles. In 1995, the typical automobile tire
cost $75 and had a useful life of 75,000
miles. If no adjustment is made for
mileage, the CPI would
a. underestimate inflation between the two
years.
b. overestimate inflation between the two
years.
c. accurately measure inflation between
the two years.
B. Quality changes are difficult to measure.
When the quality of items improves,
increases in the CPI overstate the change
in prices.
69
9. When the inflation rate falls, the
purchasing power of nominal income
a. remains unchanged.
b. decreases.
c. increases.
d. changes by the inflation rate minus
one.
nominal
income
C. Real income =
CPI ÷ 100
70
10. Last year the Harrison family earned $50,000.
This year their income is $52,000. In an
economy with an inflation rate of 5 per cent,
which of the following is correct?
a. The Harrison’s nominal income and real
income have both risen.
b. The Harrison’s nominal income and real
income have both fallen.
c. The Harrison’s nominal income has fallen,
and their real income has risen. .
d. The Harrison’s nominal income has risen,
and their real income has fallen.
D. % change real income 52,000 - 50,000- 5%,
50,000
4% - 5% = -1%
71
11. If the nominal rate of interest is less
than the inflation rate,
a. lenders win.
b. savers win.
c. the real interest rate is negative.
d. the economy is at full employment.
C. The real rate of interest is negative
because the lender is receiving less
money back, in real terms, then was
lent out.
72
12. Demand-pull inflation is
caused by
a. monopoly power.
b. energy cost increases.
c. tax increases.
d. none of the above.
D. Demand-pull inflation is caused by
an excess of total spending
(demand). Sellers regard by raising
prices.
73
13. Cost-push inflation is due to
a. excess total spending.
b. too much money chasing too few
goods.
c. resource cost increases.
d. the economy operating at full
employment.
C. Answers a, b, and d describe
demand-pull inflation.
74
END
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