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Inflation
- A rise in the general level of prices.
- Price index numbers(as described in
previous lessons) measure inflation.
- The price index measures the general
level of prices in a given year relative
to prices in a base year.
EXAMPLE
• In the year 2000 the CPI was 172,
which means that the price level was
72% higher in 2000 than in the base
period of 1982-1984, when the CPI
was 100.
Inflation
• The rate of inflation for any given
year is found by subtracting the
preceding year’s price index from
that year’s index, dividing by the
preceding year’s index, and
multiplying by 100 to express the
result as a percentage.
Example
• The CPI was 166.6 in 2003 and 172.2
in 2004. Rate of inflation for 2004 is
calculated as follows:
172.2-166.6/ 166.6 x 100 = 3.4%
inflation rate
Inflation
• Types:
–1. demand-pull: changes in the price
level are caused by an excess of total
spending beyond the economy’s
capacity to produce. “too much
spending chasing too few goods”
Inflation
• Types: Demand-pull
-There are three ranges of changes in
price level and real output.
Inflation
• Types: Demand-pull
Range 1: Output is very low
relative to the economy’s fullemployment output. This implies
a low level of total spending and a
GDP gap. Unemployment rates
are high.
Inflation
• Types: Demand-pull
Range 1: Assume now that total spending
increases. As it does, real GDP will
increase, and the unemployment rate fall.
There will little or no increase in price
level. Large amounts of idle human and
property resources will be put back to
work at their existing prices.
Inflation
• Types: Demand-pull
Range 2 = As output continues to
expand in response to further
increases in total spending, the
economy enters range 2. It
approaches and surpasses its fullemployment output.
Inflation
• Types: Demand-pull
Range 2= Price levels begin to rise.
More workers are employed, and each
added worker contributes less to
output. Labor costs therefore begin to
rise, forcing up product prices.
Inflation
• Types: Demand-pull
Range 2= As production expands, supplies
of idle resources disappear at different
rates in various industries. Some input
supplying industries are able to reach
their full-production capacity before
others and thus cannot respond to
further increases in total spending for
their products.
Inflation
• Types: Demand-pull
Range 2 = Shortages of inputs cause
resource prices to rise, boosting the
production costs and product prices of
industries that still have excess
capacity.
Inflation
• Types: Demand-pull
Range 2 = As total spending in range 2
increases beyond full-employment
level of output.
Inflation
• Types: Demand-pull
Range 2 = Firms may employ additional
work shifts and use overtime to achieve
greater output. Households may supply
additional workers such as teenagers and
spouses. The rate of unemployment falls
below the natural rate and the actual GDP
exceeds potential GDP, the pace of
inflation quickens.
Inflation
• Types: Demand-pull
Range 3 = As total spending increases into range
3, the economy simply cannot supply more
resources.
Inflation
Demand-pull Inflation: Range 3
-Firms cannot respond to increases in demand
by increasing output. So, in effect, further
increases in demand raise the price level. The
rate of inflation may be high and still rising
because total demand greatly exceeds society’s
capacity to produce. There is no increase in real
output to asorb some of the increased spending.
Inflation
Cost-Push Inflation:
Inflation may also arise on the
supply, or cost, side of the economy.
These are times when output and
employment both decline while the
general price level rises.
Inflation
Cost-Push Inflation: explains rising
prices in terms of factors that raise
per-unit production costs at each level
of spending.
Inflation
• Cost-Push Inflation:
-A per-unit production cost is the
average cost of a particular level of
output. This is found by dividing the
total cost of all resource inputs by
the amount of output produced.
Inflation
• Cost-Push Inflation:
Per-unit production cost =
total input cost/ units of output
Rising per-unit production costs squeeze profits
and reduce the amount of output firms are
willing to supply at the existing price level. As a
result,____________________
Inflation
• Cost-Push Inflation:
As a result, the economy’s supply
of goods and services declines and the
price level rises. In this scenario, costs
are pushing the price level upward,
whereas in demand-pull inflation
demand is pulling prices upward.
Inflation
• Cost-Push Inflation:
The major source of cost-push
inflation has been supply shocks.
Inflation
• Cost-Push Inflation:
Abrupt increases in the costs of raw
materials or energy inputs have driven up
per-unit production costs and thus product
prices. Ex= imported oil in 1973-1974 and
again in 1979-1980.
Inflation
• Cost-Push Inflation:
As energy prices surged upward
during these periods, the costs of
producing and transporting virtually every
product in the economy rose. Rapid costpush inflation ensued.
Inflation
• Effects of Inflation: Inflation redistributes
real income from some people to others.
• There is a difference between money
(nominal) income and real income.
Inflation
• Nominal income is the number of
dollars received as wages, rent,
interest, or profits.
• Real income is a measure of the
amount of goods and services
nominal can buy; it is the purchasing
power of nominal income, or income
adjusted for inflation.
Inflation
• Real Income = nominal income/ price
index (in hundredths)
• Inflation need not alter an
economy’s overall real income – it’s
purchasing power. (Explain)
Inflation
-Real income will remain the same
when nominal income rises at the
same percentage rate as does the
price index.
-But when inflation occurs, not
everyone’s nominal income rises at the
same pace as the price level.
Inflation
• If the change in the price level differs
from the change in a person’s
nominal income, his or her real
income will be affected.
Inflation
• Effects of inflation: Example
-The price level rises by 6%
-If Bob’s nominal income rises by 6%,
his ________________________.
-If his nominal income rises by 10%,
his _________________________.
-If his nominal income rises by 2%,
his__________________________.
Inflation
• Who is hurt by Inflation?
– Fixed-Income Receivers
–Savers
–Creditors
Inflation
• Who is Unaffected or Helped by
Inflation?
–Flexible Income Receivers
–Debtors
Inflation
• Real Interest Rate = is the
percentage increase in purchasing
power that the borrower pays the
lender.
• The nominal interest rate = is the
percentage increase in money that
the borrower pays the lender,
including that resulting from the
built-in expectation of inflation.
Inflation
• Effects of Inflation on Output
• Cost Push Inflation and Output:
Explain
• Demand Pull Inflation and Output:
Explain
Inflation
• Hyperinflation: an extremely rapid
inflation whose impact on real
output and employment usually is
devastating.
• Explain how it happens.