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The Monetary System,
Prices, and Inflation
© 2003 South-Western/Thomson Learning
The Monetary System
•History of the Dollar
•Why Paper Currency Is Accepted
as a Means of Payment
The Monetary System
Unit of Value
A common unit for measuring how much
something is worth
Means of Payment
Anything acceptable as payment for
goods and services
History of the Dollar
In 1790, Congress created a new
unit of value called the dollar.
Before then, every colony had a
different currency and each had
different purchasing power.
The Federal Reserve System
Federal Reserve System
The central bank and national
monetary authority of the United
States.
The Monetary System
The earliest means of payment were
precious metals and other valuable
commodities such as furs or jewels,
called commodity money.
The Monetary System
Fiat Money
Anything that serves as a means of
payment by government declaration
The Monetary System
Money is no longer backed by gold or
any other physical commodity.
The real force behind the dollar is that it
is considered “legal tender,” as well as
its long-standing acceptability by others.
Measuring the Price
Level and Inflation
•Index Numbers
•The Consumer Price Index
•How the CPI Has Behaved
•From Price Index to Inflation Rate
•How the CPI Is Used
•Real Variables and Adjustment for Inflation
•Inflation and the Measurement of Real GDP
Measuring the Price
Level and Inflation
Price Level
The average level of dollar prices in
the economy
Index Numbers
Index
A series of numbers used to track a variable’s
rise or fall over time
Value of measure in current period
100
Value of measure in base period
Consumer Price Index
Consumer Price Index (CPI)
An index of the cost, through time,
of a fixed market basket of goods
purchased by a typical household in
some base period
Consumer Price Index
CPI
Cost of market basket in current year
100
Cost of market basket in 1983
Consumer Price Index, December,
Selected Years, 1960-2001
Year
CPI
1960
29.8
1965
1970
1975
1980
1985
1990
1995
2000
2001
31.8
39.8
55.5
86.3
109.3
133.8
153.5
174.0
176.7
From Price
Index to Inflation Rate
Inflation Rate
The percent change in the price level
from one period to the next
Deflation
A decrease in the price level from one
period to the next
How the CPI Is Used
The CPI is used in three major ways:
•As a Policy Target
•To Index Payments
•To Translate from Nominal
Real Values
to
How the CPI Is Used
Indexation
Adjusting the value of some nominal
payment in proportion to a price
index, in order to keep the real
payment unchanged
How the CPI Is Used
Nominal Variable
A variable measured in current
dollars
Real Variable
A variable measured in terms of
purchasing power
How the CPI Is Used
Annual
Inflation
Rate 14
(% )
12
10
8
6
4
2
0
–2
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
2001
Year
Real Variables and Adjustment
for Inflation
To find what happens to our purchasing
power, we must:
•focus on real wages,
•not on nominal wages - the number of dollars we
earn
Nominal wage in that year
Real wage in any year 
100
CPI in that year
Real Variables and
Adjustment for Inflation
In measuring changes in the
macroeconomy, we usually don’t care
about the number of dollars we’re
counting, but the purchasing power those
dollars represent.
We translate nominal values into real
values.
Inflation and Measurement
of Real GDP
GDP Price Index
An index of the price level for all
final goods and services included
in GDP
Inflation and Measurement
of Real GDP
•GDP price index measures the prices
of all goods and services that are
included in U.S. GDP
•CPI measures the prices of all goods
and services bought by U.S.
households
The Costs of Inflation
•The Inflation Myth
•The Redistributive Cost of Inflation
•The Resource Cost of Inflation
The Inflation Myth
Myth: Inflation robs the average citizen
of real income.
Fact: Inflation can redistribute
purchasing power from one group to
another, but it cannot - by itself decrease the average real income in the
economy.
The Redistributive Cost of
Inflation
Inflation can shift purchasing power
away from those who are awaiting future
payments specified in dollars and toward
those who are obligated to make such
payments.
The Redistributive Costs of
Inflation
Over any period, the percentage change in a
real value is approximately equal to the
percentage change in the associated nominal
value minus the rate of inflation.
%Real  %Nominal  Rate of Inflation
The Redistributive Costs of
Inflation
If inflation is fully anticipated, and if
both parties take it into account, then
inflation will not redistribute
purchasing power.
The Redistributive Costs of
Inflation
Nominal Interest Rate
The annual percent increase in a lender’s
dollars from making a loan
Real Interest Rate
The annual percentage increase in a
lender’s purchasing power from making a
loan
The Redistributive Costs of
Inflation
% in Lender's purchasing power
 % in Lender's dollars  Rate of Inflation
or
Real interest rate =
Nominal interest rate – Rate of inflation
Unexpected Inflation Shifts
Purchasing Power
When inflationary expectations are
inaccurate, purchasing power is shifted
between those obliged to make future
payments and those waiting to be paid.
Unexpected Inflation Shifts
Purchasing Power
An inflation rate higher than expected
harms those awaiting payment and
benefits the payers.
An inflation rate lower than expected
harms the payers and benefits those
awaiting payment.
The Resource Cost of
Inflation
When people must spend time and other
resources coping with inflation, they pay
an opportunity cost - they sacrifice the
goods and services those resources could
have produced instead.