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ECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
CHAPTER 7
“Inflation”
1
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Learning Objectives
1. Describe inflation rates in the U.S. and
other countries.
2. Discuss the cost of inflation that cause
low inflation to be a macroeconomic
goal.
3. Compute, interpret, and use a price
index to compute a real value.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Learning Objectives
4. Identify problems with price indexes and
efforts to improve them.
5. (E&A) Explain how people respond to
inflation, and how that affects its
measurement.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
7.1
THE GOAL OF LOW INFLATION
Along with economic growth and high
employment, low inflation is the third
fundamental goal of the economy.
Inflation is a persistent increase in the
price level.
The price level refers to the prices of
goods and services, when considered in
the aggregate.
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The Goal of Low Inflation
• The inflation rate is the annual
percentage increase in the price level.
• In the U.S., as long as the inflation rate
from year to year stays at around 3% per
year, Americans are satisfied that the goal
of low inflation has been accomplished.
• If the inflation rate is above 3%, people
expect the government to take action to
“fight” inflation.
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Ayers/Collinge, 1/e
The U.S. Inflation Rate
Selected Years
Year
Inflation Rate
1945
2.3
1946
8.3
1947
14.4
1948
8.1
1949
-1.2
1950
1.3
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The U.S. Inflation Rate
Selected Years
Year
Inflation Rate
1955
-.4
1960
1.7
1965
1.6
1970
5.7
1975
9.1
1980
13.5
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Ayers/Collinge, 1/e
The U.S. Inflation Rate
Selected Years
Year
Inflation Rate
1985
3.6
1990
5.4
1991
4.2
1992
3.0
1993
3.0
1994
2.6
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Inflation – A World-Wide
Phenomenon
The CIA estimates that the average inflation in
the world in 2000 was 25%.
Most of these severely high rates occurred in
developing countries.
The developing countries inflation rates ranged
between 5% and 60% as compared to the range in
developed countries which was between 1% and
3%.
Political instability can result from severe
inflation
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Inflation Rates in Selected
Countries
Country - Year 2000
Inflation Rate
Ecuador
96
Zimbabwe
60
Yugoslavia
42
Ukraine
25.8
Russia
20.6
Venezuela
13
Mexico
9
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Inflation Rates in Selected
Countries
Country - Year 2000
Inflation Rate
Brazil
6
Bolivia
4.4
U.S.
3.4
U.K.
2.4
Germany
2.0
China
0.4
Japan
-0.7
Argentina
-0.9
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Ayers/Collinge, 1/e
Deflation and Disinflation
 When the inflation rate is negative, deflation is
said to occur.
 This would happen if the price level declined from
one year to the next.
 Deflation is not an economic goal.
 Historically, widespread falling prices and poor
economic performance seem to go hand in hand.
 Disinflation means that the rate of inflation
declines, and is different than both inflation,
and deflation.
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7.2
THE HARM FROM INFLATION
o Energy and food prices are subject to
wide fluctuations caused by temporary
shifts in their supply.
o Excluding food and energy prices from
the computation of the inflation rate
reveals what is termed core inflation.
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The Harm from Inflation
Inflation hurts those
on fixed incomes.
Inflation hurts
lenders.
Inflation increases
the opportunity cost
of search time for
cheaper substitute
goods.
Inflation motivates
businesses to offer
new products.
Inflation might
motivate business to
trim the amount of
product rather than
raise its price.
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Ayers/Collinge, 1/e
Anticipated and Unanticipated
Inflation
Anticipated inflation is expected by the
public.
In theory, everyone is able to defend
themselves against losses imposed by
anticipated inflation.
Unanticipated inflation is inflation that
catches the public by surprise.
Borrower’s gain by unanticipated inflation,
while lenders lose.
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Indexing to Offset Inflation’s
Effects
Indexing is a solution to offset the
problems created by unanticipated
inflation.
Automatically adjusting the terms of an
agreement to account for inflation is
referred to as indexing.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
7.3
MEASURING INFLATION
A price index measures the average level
of prices in the economy.
There are several price indexes.
The consumer price index.
The producer price index.
The GDP chain-type price index
 The GDP deflator.
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Ayers/Collinge, 1/e
Measuring Inflation –
The Consumer Price Index
The CPI measures prices of typical
purchases made by consumers living in
urban areas.
The base period used in the CPI is an
arbitrary selected initial time period
against which other time periods are
compared.
The base period index number always
equals 100.
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Ayers/Collinge, 1/e
Measuring Inflation –
The Consumer Price Index
The Inflation rate is calculated by taking
the percentage change in the CPI as follows:
Inflation Rate =
[change in price index / initial price index]
multiplied by 100
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Measuring Inflation –
The Consumer Price Index
The collection of goods and services used in the
calculation of the CPI is called the market
basket.
The market basket represents a sampling of the
items that consumers buy that make up a
significant portion of their budget.
There are 200 specific items that make up the
CPI.
Each item is assigned a weight that reflects its
importance in the consumers’ budgets.
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CPI Market Basket
Expenditure Categories
Expenditure Category
Food and beverages
Housing
Apparel
Transportation
Medical care
Recreation
Education and communication
Other goods and services
Total
Weight (in %)
15.7
40.9
4.4
17.1
5.8
6.0
5.8
4.3
100.0
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Computing a Price Index
The CPI measure the increase in the price of the
market basket between the current year and the
base period.
The simplified formula for the CPI is:
Cost of market basket at current prices
Cost at market basket at base period prices
X 100
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Ayers/Collinge, 1/e
Nominal Versus Real Values
o A nominal interest rate is the payment
from a borrower to a lender, expressed in
percentage terms.
o A real interest rate measure the percentage
payment in terms of purchasing power.
Real interest rate = nominal interest rate – inflation rate
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Ayers/Collinge, 1/e
Price Indexes for Other Purposes
• The Producer Price Index (PPI) focuses
on the prices received by U.S. producers,
as measured by the revenue they receive.
• The prices in the PPI are those received
by producers no matter who makes the
initial purchase, whether it be another
firm or consumer.
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Ayers/Collinge, 1/e
Price Indexes for Other Purposes
• The GDP chain-type price index is
computed in a manner similar to the GDP
deflator.
• The difference is that the real chained
GDP is used in the calculation.
GDP chain-type = nominal GDP/real chained GDP
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Price Indexes for Other Purposes
• The term chain weight comes about
because the GDP chain-type price index
links quantities (weights) in two successive
years.
• It then moves forward a year and does
that link again, and so forth.
• This continuous linking , for two years at
a time forms a chain, hence the name.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Price Indexes for Other Purposes
The GDP deflator is a type of price index
called an implicit price deflator.
An implicit price deflator takes current
quantities and calculates what they would
have cost at prices prevailing during the
base period.
GDP deflator =
Value of current quantities at current period prices
Value of current quantities at base period prices
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Recent Changes to the CPI
 Prior to 1999, the CPI was calculated
using fixed-weights throughout the
market basket.
 Fixed-weights do not take into account
that people change their consumption
patterns when prices rise.
 When the price level rises people substitute
relatively cheaper goods for goods that have
become relatively more expensive.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Recent Changes to the CPI
 The inaccuracy in the CPI cause by using
fixed weights is termed the substitution
bias.
 The substitution bias causes inflation to
be overstated.
 A new CPI was established in 2002 called
the Chained weight CPI (C-CPI).
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
7.4 EXPLORE & APPLY
Living the Life of Inflation
The CPI is used in three ways.
As an economic indicator.
To convert nominal values to real
values.
To adjust selected monetary payments
upward as prices increase.
Hyperinflation is inflation that is out of
control.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Living the Life of Inflation
The rule of 72 is used to compute the
approximate time it takes for a rate to
double.
To compute how long it would take for an
inflation rate to double the equation
would be…
72/the inflation rate
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Living the Life of Inflation
Annual Inflation Rate
1%
Estimated # of Years for
Price Level to double
72
2%
36
4%
18
8%
9
10%
7.2
16%
4.5
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Key Terms
inflation
inflation rate
indexing
Consumer Price
Index
Producer Price Index
GDP chain-type
index
GDP deflator
nominal value
real value
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Test Yourself
1. Which of the following best fits the
definition of inflation?
a. A one-time increase in a few prices.
b. A one-time increase in many prices.
c. A sustained increase in a few prices.
d. A sustained increase in many prices.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Test Yourself
2. The core inflation rate excludes
a.
b.
c.
d.
energy prices.
the price of medical care.
food prices.
both food and energy prices.
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Ayers/Collinge, 1/e
Test Yourself
3. The goods and services included in the
computation of the CPI are referred to
as the _____________________ .
a. base year.
b. fixed weights.
c. market basket.
d. price level.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Test Yourself
4. How is inflation computed?
a. The inflation rate equals the value of a price
index.
b. The inflation rate equals the value of a price
index.
c. By the following computation:
(change in price index/initial value of price
index multiplied by 100).
d. By the following computation:
change in price index multiplied by the initial
value of price index.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Test Yourself
5. When the real value of GDP is computed by
the government
a. the CPI is used.
b. the PPI is used.
c. The GDP deflator or the chained-type price
index is used.
d. no price index is necessary because the real
and nominal values of GDP are always
identical.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
Test Yourself
6.
a.
b.
c.
The substitution bias causes the CPI to?
overstate the effects of inflation.
understate the effects of inflation.
more accurately reflect the effects of
inflation.
d. be nearly useless as a measure of
inflation.
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
The End!
Next Chapter 8
“A Framework for
Macroeconomic
Analysis"
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©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e