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Inflation
Economics for Today by Irvin Tucker, 6th edition
©2009 South-Western College Publishing
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What will I study in
this chapter?
• How the government
measures the price level
• How it computes the rate
of inflation
• The consequences and
causes of inflation
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What puzzles will I
learn to solve?
 What is the inflation rate of your
college education?
 Can a person’s income fall even
though they received a raise?
 What would Babe Ruth’s salary
be worth today?
 Can an interest rate be negative?
3
What is inflation?
An increase in the
general (average) price
level of goods and
services in the economy
4
What is deflation?
A decrease in the general
(average) price level of
goods and services in
the economy
5
What is disinflation?
A reduction in the
rate of inflation
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What is the most
widely reported
measure of inflation?
The Consumer Price Index
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What is the
Consumer Price Index?
It measures changes in the
average prices of consumer
goods and services
8
Who reports the CPI?
The Bureau of Labor
Statistics (BLS) of the
Department of Labor
9
How is the CPI
calculated?
Price collectors contact retail
stores, homeowners, and
tenants in selected cities in
the U.S. monthly
10
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
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Composition of the CPI
Food
13%
Housing
33%
Apparel
4%
Transportation
18%
Health Care
6%
Entertainment
5%
Education
2%
All other goods
8%
Economic Report of the President, 2006
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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
13
How is the CPI
computed?
Current year prices are
compared to prices of a
similar basket of goods and
services in a base year
14
What is a base year?
A year chosen as a
reference point for
comparison with some
earlier or later year
15
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
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*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
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How is the
inflation rate computed?
By measuring the
percentage change in
the official CPI from
one year to the next
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*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
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Consumer Price Indexes and Inflation Rates
Year
CPI
Inflation Rate
1931
15.2
-
1932
13.7
-9.9%
1979
72.6
-
1980
82.4
13.5
2000
172.2
-
2001
177.1
2.8
2002
179.9
1.6
2005
195.3
-
2006
201.6
3.2
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The U.S. Inflation Rate 1929 - 2006
20
15
10
5
0
Inflation
Deflation
-5
-10
-15
30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05
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What are some
criticisms of the CPI?
• It can overstate or understate
for certain groups
• Does not measure quality
• Substitutes are ignored
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What does inflation do
to people’s income?
A general rise in prices will
shrink people’s income
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What is
nominal income?
The actual number of
dollars received over
a period of time
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What is real income?
The actual number of
dollars received (nominal
income) adjusted for
changes in the CPI
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*RI = Real income
*NI = Nominal income
*CPI = CPI as a decimal or CPI ÷ 100
NI
RI = CPI
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%  in real
income
=
%  in
nominal
income
_
%  in
CPI
27
What is wealth?
The value of the stock
of assets owned at
some point in time
28
How is wealth
affected by inflation?
Inflation can benefit
holders of wealth
because the value of
their assets tends to
increase as prices rise
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What will cause your
real income to decline?
The rate of inflation
is greater than your
rate of income
30
How does inflation
affect borrowers
and savers?
They can win or lose
depending on the rate of
inflation and interest
31
What is the
interest rate?
Interest per year as a
percentage of the
amount loaned or lent
32
What is the
nominal interest rate?
The actual rate of
interest earned over a
period of time
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What is the
real interest rate?
The nominal rate of interest
minus the inflation rate
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What are the two basic
types of inflation?
Demand-pull
Cost-push
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What is
demand-pull inflation?
A rise in the general
price level resulting
from an excess of total
spending (demand)
36
When does demandpull inflation occur?
When the economy is
operating at or near
full employment
37
What is
cost-push inflation?
A rise in the general
price level resulting
from an increase in
the cost of production
38
What can cause costpush inflation?
Cost increases for labor, raw
materials, construction,
equipment, borrowing etc.
39
Do people’s
expectations
affect inflation?
Yes, expectations can
influence both demand-pull
and cost-push inflation
40
What is hyperinflation?
An extremely rapid rise in
the general price level
41
What is a
wage-price spiral?
Increases in nominal wage
rates are passed on in
higher prices, which, in turn,
result in even higher nominal
wages and prices
42
How does the U.S.
inflation rate
compare with other
countries?
It is lower than some
and higher than others
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1,016.7%
14.6%
14.2%
13.6%
11.5%
9.7%
3.2%
1.8%
Zimbabwe Iran
Haiti Venezuela Costa
Rica
Russia
U.S. Germany
1.5%
China
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END
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