Inflation

A general increase in prices caused by too much money in the circular flow

Imagine you have a job that pays $50 a day. You are pretty happy with your job and your ability to pay your bills with your income. At the end of the work day you receive your $50 and stop at the grocery store to buy dinner. When you get to the grocery store, you find out that your can of beeferoni is not $1.09 like it was yesterday, it is now $49. What happened?

Types of inflation

Demand-Pull Inflation– Too much spending

chasing too few goods

Cost-Push Inflation– Supply shocks –

abrupt increases in the cost or raw materials or energy sources

Hyperinflation

Radical inflation – money becomes worthless and is no longer used as a median of exchange economic collapse and political chaos– Examples: Germany after the war, after

break up of Soviet Union

CPI – consumer price index

Indication of inflation calculated by sampling households and monitoring expenditures on specific goods and services

Core CPI takes out food and energy CPI not perfect – consumption patterns

change, doesn’t account for quality and hard to account for new products

Downfalls of CPI Quality bias

– What happens when quality changes year to year?

New product bias – What happens when new products aren’t

considered in CPI right away? (also price changes)

Discounting and substitution – What happens when we shop in new

places?

Fixed CPI calculation

YearTheatre tickets

(quantity)

Cinema tickets

(quantity)

Theatre ticket (price)

Cinema ticket (price)

2005 25 12 $40 $15

2006 15 18 $45 $10

(25 Theatre tickets x $45) + (12 Cinema tickets x $10) x 100(25 Theatre tickets x $40) + (12 Cinema tickets x $15)

= 105.5 or 5.5% inflation rate

An alternative – chain weighted CPI

It implements weight shifting, which means the shift from one product to another due to the changed needs of the consumer.

Suggested as a way for the government to save money

Chain weighted CPI calculation

YearTheatre tickets

(quantity)

Cinema tickets

(quantity)

Theatre ticket (price)

Cinema ticket (price)

2005 25 12 $40 $15

2006 15 18 $45 $10

(15 Theatre tickets x $45) + (18 Cinema tickets x $10) x 100(25 Theatre tickets x $40) + (12 Cinema tickets x $15)

= 72.5 or 27.5% deflation

Unexpected Inflation

Unexpected inflation imposes costs on many people and benefits others because it arbitrarily redistributes purchasing power

Inflation can reduce the rate of growth of national living standards because individuals and organizations use resources to protect themselves against the uncertainty of future price changes

Redistribution Effects Nominal income – the number of $

received as wages, rent, interest or profits

Real income- measure of the amounts of goods and services nominal income can buy

Real= nominal income / price index COLA – cost of living adjustment

How are different people affected? Hurts savers and

people on fixed incomes

Helps people who borrowed money at a fixed rate

MV = PQ Equation of Exchange

M – Quantity of Money in the Economy V – Velocity of Money P – Price Level Q – Total Final Output Produced