Inflation

Inflation - An increase in the overall price level. It

results in a decrease in the purchasing
power of money.
Purchasing - The volume of goods and services that a
Power given sum of money will buy.
Deflation - A decrease in the overall price level.

Core Inflation or - The level of inflation that exists when

"Underlying Inflation" actual output is equal to potential
output.

- Inflation will be above its core level

when actual output is greater than
potential output.

- Inflation will be below its core level

when actual output is less than
potential output.

Measuring Inflation

Index - A number that expresses the values of a statistic in

Number terms relative to a specified base.

Price Indexes - Index numbers that are used as a measure of

aggregate price levels.

Consumer - A price index that is used as a measure of the

Price overall (i.e. average) price of consumer goods and
Index (CPI) services. This is done by expressing the cost of a
"market basket" of goods relative to its cost in the
base period. The "market basket" consists of a
bundle of goods that is representative of the
monthly purchases of the typical urban consumer.

CPI in a given = Cost of Market Basket in given year x 100

year
 Cost of Market Basket in base year

Inflation Rate
in a given = CPI2006 - CPI2005 x 100
year E.g. CPI2005
2006

Is Inflation Really All That Bad?

Not - In looking at the costs of inflation we must be careful
Necessarily to look not only at the increases in prices of the good
and services we buy, but also at the increase in our
nominal income. In the case of workers, we need to
remember that wages are prices too! During inflation,
most prices tend to rise together (however, there may
be a time lag, see the caveat below). The pertinent
question is "Has my purchasing power from a
month's income really decreased?"

- Caveat: Money wages in the real world do not

change immediately. The bargaining process for wage
increases occurs at intervals. IF inflation is HIGHER
during the contract period than was expected, then
the agreed increase in wages would not be high
enough to compensate fully for inflation.

Anticipated vs. Unanticipated Inflation

Anticipated - Inflation which has been accurately
Inflation forecasted and can be prepared for.
Unanticipated - Inflation which has not been
Inflation accurately forecasted and therefore is
not expected, and cannot be prepared
for.
Costs of Inflation
Unexpected - The elderly (who received fixed income) and
Redistribution of poor/uneducated workers (who do not have much
Wealth bargaining power over their income) are victimized by
inflation, whether anticipated or unanticipated.

- Debtors gain at the expense of creditors when

inflation is unanticipated given that: Nominal
Interest Rate = Real Rate of Interest +
Expected Inflation Rate
 The nominal rate of interest is the percentage
by which the money a borrower pays back
exceeds the money that he borrowed.

 The real rate of interest is the percentage

increase in purchasing power that
borrowers pay to lenders for the privilege of
borrowing. It indicates the amount by which
lenders' ability to purchase goods and services
will increase when the loan is repaid.

Increased - More frequent banking transactions may be required

Transaction Costs as people tend to hold less cash. This uses up
resources including time and effort that could be
dedicated to other activities.

Interference with - When the inflation rate is high and erratic, there is
Long-term increased uncertainty about the future. This makes
Planning long-term planning difficult and gives people a short-
term focus, leading to a reduction in investment and a
slowing of the growth rate.

Noise in the Price - It becomes more difficult for firms to ascertain

Systems correctly whether the demand for their goods and
services has increased.

Distortions of the - If taxes are not indexed to inflation, then when

Tax System people's nominal incomes increase, they will have to
pay a larger amount in taxes although their real
income has not increased.