L6&L7 Money, Price level, and

Inflation
Sub-topics

• Definition of Money
• Function of Money
• Consumer Price Index
• Definition of Inflation
• Causes of Inflation
• Effects from Inflation
Definition of Money
What is money?

• Economist said that “Money is the set of assets in the

economy that people regularly use and at the same
time it is accepted by sellers in exchange to goods and
services received”
Function of Money
Function of Money
• Medium of exchange
• An item that buyers give to sellers when they want to
purchase goods and services
• Unit of account
• The yardstick people use to post prices and record debts
• Store of value
• An item that people can use to transfer purchasing
power from the present to the future
• Liquidity
• The ease with which an asset can be converted into the
economy’s medium of exchange
Consumer Price Index/Price
level (Indeks Harga
Konsumen)
Consumer price index/ Price level and the
value of money
• Consumer Price Index (CPI):
An index which calculates average price changes of a
commodity package consisting of goods and services
that people consumes in a certain period of time.
• Example: The CPI rose by 3 percent in February, led by a
20 percent rise in the price of oil and gas, and 30
percent rise in electricity.
• The CPI/Price level is not only indicate that the price is
rising, but it also indicates that the value of money is
decreasing.
Price Level, Inflation, and Deflation
•The Consumer Price Index
•The Consumer Price Index, or CPI, measures the average of the prices
paid by urban consumers for a “fixed” basket of consumer goods and
services.
Price Level, Inflation, and Deflation
•Reading the CPI Numbers
•The CPI is defined to equal 100 for the reference base period.
•Currently, the reference base period is 19821984.
•That is, for the average of the 36 months from January 1982 through
December 1984, the CPI equals 100.
•In June 2010, the CPI was 218.
•This number tells us that the average of the prices paid by urban
consumers for a fixed basket of goods was 118 percent higher in June 2010
than it was during 19821984.
Price Level, Inflation, and Deflation
•Constructing the CPI
•Constructing the CPI involves three stages:
 Selecting the CPI basket
 Conducting a monthly price survey
 Calculating the CPI
Price Level, Inflation, and Deflation
•The CPI Basket
•The CPI basket is based on a Consumer Expenditure Survey, which is
undertaken infrequently.
•The CPI basket today is based on data collected in the Consumer
Expenditure Survey of 2008.
Price Level, Inflation, and Deflation
•Figure 5.6 illustrates the CPI
basket.
•Housing is the largest
component.
•Transportation and food and
beverages are the next largest
components.
•The remaining components
account for 26 percent of the
basket.
Price Level, Inflation, and Deflation
•The Monthly Price Survey
•Every month, BLS employees check the prices of the 80,000 goods in the
CPI basket in 30 metropolitan areas.
•Calculating the CPI
•1. Find the cost of the CPI basket at base-period prices.
•2. Find the cost of the CPI basket at current-period prices.
•3. Calculate the CPI for the current period.
Price Level, Inflation, and Deflation
•Let’s work an example of the CPI
calculation.
•In a simple economy, people
consume only oranges and
haircuts.
•The CPI basket is 10 oranges and
5 haircuts.
•The table also shows the prices
in the base period.
•The cost of the CPI basket in the
base period was $50.
Price Level, Inflation, and Deflation

•Table 5.1(b) shows the fixed CPI

basket of goods.
•It also shows the prices in the
current period.
•The cost of the CPI basket at
current-period prices is $70.
Price Level, Inflation, and Deflation
•The CPI is calculated using the formula:
•CPI = (Cost of basket at current-period prices ÷ Cost of basket at base-period
prices)  100.
•Using the numbers for the simple example,
•CPI = ($70 ÷ $50)  100 = 140.
•The CPI is 40 percent higher in the current period than it was in the base
period.
QUIZ TIME
Definition of Inflation
Price Level, Inflation, and Deflation
•The price level is the average level of prices and the value of money.
•A persistently rising price level is called inflation.
•A persistently falling price level is called deflation.
•We are interested in the price level because we want to
•1. Measure the inflation rate or the deflation rate
•2. Distinguish between money values and real values of economic
variables.
Price Level, Inflation, and Deflation
•Measuring the Inflation Rate
•The major purpose of the CPI is to measure inflation.
•The inflation rate is the percentage change in the price level from one
year to the next.
•The inflation formula is:
•Inflation rate = [(CPI this year – CPI last year) ÷ CPI last year]  100.
Price Level, Inflation, and Deflation
•Figure 5.7 shows the relationship between the price level and the
inflation rate.
•Figure 5.7(a) shows the CPI from 1970 to 2010.
Price Level, Inflation, and Deflation
•Figure 5.7(b) shows that the inflation rate is
 High when the price level is rising rapidly and
 Low when the price level is rising slowly.
Causes of Inflation
Is CPI the only variables that determine
the inflation?
• The rise in CPI indicates the decrease in value of money.
• What determines the value of money?
• The value of money is determined by supply and demand.
• How to increase supply and demand of money?
• The monetary policy

• The supply demand in the commodities

Causes of Inflation
• Demand Pull
Causes of Inflation
• Cost Push
Monetary policy: an evidence from
Indonesia (Perry Warjiyo & Solikin M.
Juhro, 2019)
• BI officially introduce the ITF in July, 2005
• Interest rate as operational target
• Monetary policy (ITF): open market operations, the
discount rate, reserve requirement and bank lending
regulations.
• But somehow the policy does not work very well due to
some reasons
External and Internal Factors

• The reasons are: “stemmed from the GFC along with

short-term capital flow mobility, which had a strong
impact on exchange rate developments.
• changing behavior in the financial system, which was
linked to the growing role of risk perception and
procyclicality
• structural rigidity on the supply side, which
fundamentally disrupted the policy transmission
mechanism and placed additional pressures on
monetary stability.
The Global Financial Crisis and Inflation
Target in Indonesia
• No one could have predicted the rapidity and depth at
which the financial crisis struck
• 2008, the IMF still projected global economic growth at
around 3.9% but ubiquitous uncertainty and risk
compelled the international institution to revise down
its projection again and again.
• Currently, global economic growth is around 3% and
expected to track a decelerating trend, primarily due to
the deep contractions experienced in advanced
countries.
Recommendation
• overriding goal of monetary policy must remain focused on
achieving price stability or low inflation
• the substance of stability could be interpreted into a broader
rationale, demonstrating that (flexible) ITF implementation was
necessary but not sufficient
• successes of ITF implementation must be supported by a
macroprudential policy regulatory framework
• central bank must strengthen financial system stability to ensure
a stable economy and financial system in terms of the
macroeconomy and financial sector
• the need for a new paradigm and a central bank policy mix
(15Departing from the existing format and governance of
monetary policy that was widely understood in terms of ITF
implementation, the new format began development and
implementation at central banks in the wake of the GFC in
2008/2009 )
Effects on Inflation
Price Level, Inflation, and Deflation
•Why Inflation and Deflation Are Problems
•Low, steady, and anticipated inflation or deflation is not a problem.
•Unpredictable inflation or deflation is a problem because it
 Redistributes income and wealth
 Lowers real GDP and employment
 Diverts resources from production
Price Level, Inflation, and Deflation
•Unpredictable changes in the inflation rate redistribute income in
arbitrary ways between employers and workers and between borrowers
and lenders.
•A high inflation rate is a problem because it diverts resources from
productive activities to inflation forecasting.
•From a social perspective, this waste of resources is a cost of inflation.
•At its worse, inflation becomes hyperinflation—an inflation rate that is
so rapid that workers are paid twice a day because money loses its value
so quickly.
Hyperinflation in Zimbabwe
Hyperinflation in Venezuela
DISCUSSION
Does Islamic Economics and Finance matter?
Tazkia Strategic Values

T TAUHID

A AMANAH

Z ZERO DEFECT AND QUALITY ORIENTED

K KNOWLEDGE AND COMPETENCE

I INNOVATIVE, ISTIQAMAH

A ACHIEVMENT THROUGH TEAM WORK