CHAPTER 13

Inflation

© 2019 Cengage. All rights reserved.

 What will I learn
in this chapter?

• What inflation is
• How the government measures
changes in the price level and
computes the rate of inflation
• The consequences and root causes of
inflation
© 2019 Cengage. All rights reserved.
 What is inflation?

An increase in the general (average)

price level of goods and services in the
economy

© 2019 Cengage. All rights reserved.

 What is deflation?

A decrease in the general (average)

price level of goods and services in the
economy

© 2019 Cengage. All rights reserved.

What conclusion can we
make regarding inflation?

Inflation is an increase in the overall

average level of prices and not an
increase in the price of any specific
product.

© 2019 Cengage. All rights reserved.

 What is the most
widely reported
measure of inflation?
The consumer price index (CPI)

© 2019 Cengage. All rights reserved.

 What is the consumer
price index (CPI)?

An index that measures changes in the

average prices of consumer goods and
services

© 2019 Cengage. All rights reserved.

 How is the consumer
price index different from
the GDP chain price index?
The consumer price index includes only
consumer goods and services in order to
determine how rising prices affect the
purchasing power of consumers’ incomes; it
does not consider items purchased by
businesses and government.

© 2019 Cengage. All rights reserved.

 How is the CPI prepared?

Each month, “price collectors” from the Bureau of

Labor Statistics (BLS) of the Department of Labor
contact retail stores, homeowners, and tenants in
selected U.S. cities. Based on these monthly inquiries,
the BLS records average prices for a “market basket”
of different items in a number of categories purchased
by the typical urban family.

© 2019 Cengage. All rights reserved.

EXHIBIT 1 Composition of the Consumer Price Index

© 2019 Cengage. All rights reserved.

 How is the CPI calculated?

cost of market basket of products at current-year prices

CPI =  100
cost of same market basket of products at base-year prices

© 2019 Cengage. All rights reserved.

 What is a base year?

A year chosen as a reference point for

comparison with some earlier or later
year

© 2019 Cengage. All rights reserved.

 EXHIBIT 2 A Hypothetical Consumer
Price Index for a Simple Economy
(1) (2) (3) (4) (5)
Products in
consumers’ 1982 Market basket Market basket
market quantity 1982 cost in 1982 2000 cost in 2000
basket purchased price [(1) × (2)] price [(1) × (4)]
Hamburgers 50 $ 0.80 $ 40 $ 1.00 $ 50
Gallons of 250 0.70 175 0.90 225
gasoline
Jeans 2 15.00 30 30.00 60
Total $245 Total $335
1982 2000
cost = cost =

2000 market basket cost

2000 CPI =  100
1982 market basket cost
$335
2000 CPI =  100 = 136.7
$245
© 2019 Cengage. All rights reserved.
 Why is the value of
the CPI in the base
year always 100?
Because the numerator and the
denominator of the CPI formula are the
same in the base year

© 2019 Cengage. All rights reserved.

What is the inflation rate?

The percentage change in the official

consumer price index from one year to
the next

© 2019 Cengage. All rights reserved.

 How is the annual
inflation rate calculated?
CPI in given year  CPI in previous year
Annual rate of inflation =  100
CPI in previous year

© 2019 Cengage. All rights reserved.

 EXHIBIT 3 Consumer Price Indexes and
Percentage Changes, Selected Years
Year CPI Inflation rate
1931 15.2 –9.0%
1932 13.7 –9.9
1979 72.6 11.3
1980 82.4 13.5
2000 172.2 3.4
2001 177.1 2.8
2002 179.9 1.6
2008 215.3 3.8
2009 214.5 –0.4
2013 233.0 1.5
2014 236.7 1.6
2015 237.0 0.1
2016 240.0 1.3

© 2019 Cengage. All rights reserved.

 What is disinflation?

A reduction in the rate of inflation

© 2019 Cengage. All rights reserved.

EXHIBIT 4 The U.S. Inflation Rate, 1929–2016

© 2019 Cengage. All rights reserved.

 What are some
criticisms of the CPI?
• Because the market basket may not be
representative, it can overstate or
understate inflation for certain groups.
• It has difficulty adjusting for quality changes.
• It ignores the relationship between price
changes and the importance of items in the
market basket.
© 2019 Cengage. All rights reserved.
 How does inflation affect
standard of living?
Inflation tends to reduce your standard of living
through declines in the purchasing power of
money. The greater the rate of inflation, the
greater the decline in the quantity of goods we
can purchase with a given nominal income, or
money income.

© 2019 Cengage. All rights reserved.

What is nominal income?

The actual number of dollars received

over a period of time

© 2019 Cengage. All rights reserved.

How is purchasing power
measured?

By converting nominal income to real

income

© 2019 Cengage. All rights reserved.

 What is real income?

The actual number of dollars received

(nominal income) adjusted for changes in
the CPI

© 2019 Cengage. All rights reserved.

 What is the formula
for real income?
nominal income
Real income =
CPI (as decimal, or CPI/100)

© 2019 Cengage. All rights reserved.

 How do we compute the
percentage change in real
income between years?

Percentage
Percentage Percentage
change in
change in change in
nominal
real income CPI
income

© 2019 Cengage. All rights reserved.

 What conclusion can we
make regarding purchasing
power and inflation?
People whose nominal incomes rise
faster than the rate of inflation gain
purchasing power, while people whose
nominal incomes do not keep pace with
inflation lose purchasing power.

© 2019 Cengage. All rights reserved.

 What is wealth?

The value of the stock of assets owned

at some point in time

© 2019 Cengage. All rights reserved.

 How is wealth
affected by inflation?

Inflation can benefit holders of wealth

because the value of assets tends to
increase as prices rise. On the other
hand, the impact of inflation on wealth
penalizes people without it as it becomes
more difficult for them to acquire assets.

© 2019 Cengage. All rights reserved.

 What is the
nominal interest rate?

The actual rate of interest without

adjustment for the inflation rate

© 2019 Cengage. All rights reserved.

 What is the
real interest rate?

The nominal rate of interest minus the

inflation rate
Real interest rate  Nominal interest rate  Inflation rate

© 2019 Cengage. All rights reserved.

 What conclusion can we
make regarding the real
interest rate and inflation?
When the real rate of interest is negative,
lenders and savers lose because interest
earned does not keep up with the
inflation rate.

© 2019 Cengage. All rights reserved.

 EXAMPLE

Suppose you receive a one-year loan from your parents to start a

business. Both you and your parents anticipate the inflation rate
to be 2 percent in the coming year. You agree to repay the
principal plus the 2 percent to offset inflation. However, the
inflation rate is actually 5 percent during the year of the loan.
Because your parents are paid the principal and only 2 percent
interest, their purchasing power still falls by 3 percent because
the actual inflation rate is 5 percent. Thus, they incur a loss.

© 2019 Cengage. All rights reserved.

What is an adjustable-rate
mortgage (ARM)?

A home loan that adjusts the nominal

interest rate to changes in an index rate,
such as rates on Treasury securities

© 2019 Cengage. All rights reserved.

EXHIBIT 5 Annual Inflation Rates
in Selected Countries, 2016

© 2019 Cengage. All rights reserved.

 What is hyperinflation?

An extremely rapid rise in the general

price level

© 2019 Cengage. All rights reserved.

 What are the
economic outcomes
of hyperinflation?
• Inflation psychosis
• Credit market collapses
• A wage-price spiral
• Speculation

© 2019 Cengage. All rights reserved.

 What is inflation
psychosis?

A situation in which people spend their

earnings immediately in order to avoid
paying even more tomorrow

© 2019 Cengage. All rights reserved.

 What is a
wage-price spiral?

A situation that occurs when increases in

nominal wage rates are passed on in
higher prices, which, in turn, result in
even higher nominal wage rates and
prices

© 2019 Cengage. All rights reserved.

 What are the two
basic types of inflation?

1. Demand-pull inflation
2. Cost-push inflation

© 2019 Cengage. All rights reserved.

 What is
demand-pull inflation?

A rise in the general price level resulting

from an excess of total spending
(demand)

© 2019 Cengage. All rights reserved.

 When does demand-pull
inflation occur?

At or close to full employment, when the

economy is operating at or near full
capacity

© 2019 Cengage. All rights reserved.

 What is
cost-push inflation?

An increase in the general price level

resulting from an increase in the cost of
production

© 2019 Cengage. All rights reserved.

 How do expectations
influence both demand-pull
and cost-push inflation?
• If buyers expect prices to rise, they might believe
they should purchase the items before they cost
much more tomorrow. At or near full employment,
the result is demand-pull inflation.
• If firms expect their production costs to rise in the
future, they raise prices in anticipation of the higher
costs. The result is cost-push inflation.

© 2019 Cengage. All rights reserved.