Inflation. Inflation. Measurement of Inflation. Inflation Since Inflation is a continual rise in the price level. Chapter 6

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1 Inflation Inflation Chapter 6 Inflation is a continual rise in the price level. From 1800 until World War II, the U.S. inflation rate and price level fluctuated. Since World War II, the rate fluctuated, but the movement of the price level has been consistently upward. Inflation Since 1900 Measurement of Inflation Inflation is measured with changes in price indexes. Price index a number that summarizes what happens to a weighted composite of prices of a selection of goods over time McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1

2 Creating a Price Index A price index is calculated by dividing the current price of a basket of goods by the price of the basket in a base year then multiplying by 100. Price of basket in current year Price index = Price of basket in base year X 100 A Simple Year-to-Year Market Basket Comparison Basket of Goods Prices Expenditures pairs of jeans $20.00/pr. $25.00/pr. $200 $ flannel shirts 15.00/ea /ea lbs. Apples 0.80/lb. 1.05/lb lbs. Oranges 1.00/lb. 1.00/lb Total Expenditures $540 $675 $675 Price indexin 2003 = X 100 = 125 $540 Real-World Price Indexes Real-world price indexes include the PPI, the CPI, and the GDP deflator. The GDP Deflator The GDP deflator (gross domestic product deflator) is an index of the price level of aggregate output or the average price of the components in GDP relative to a base year. 2

3 The GDP Deflator Another price index is the chain-type price index for GDP which uses a GDP deflator with a constantly moving base year. The GDP Deflator The GDP deflator is the measure of inflation most economists favor since it includes the widest number of goods. The Consumer Price Index (CPI) The consumer price index (CPI) measures the prices of a fixed "basket" of consumer goods. It is weighed according to each component's share of an average consumer's expenditures. The Consumer Price Index (CPI) Many economists believe that the CPI as currently constituted, overstates inflation by one percentage point. To avoid some of the problems of the CPI, some policymakers have been focusing on the personal consumption expenditure (PCE) deflator. 3

4 The Consumer Price Index (CPI) Composition of CPI Personal consumption expenditure (PCE) deflator a measure of prices of goods that consumers buy that allows yearly changes in the basket of goods that reflect actual consumer purchasing habits. Housing (40.5%) Other (5.0%) Education and Communication (5.4%) Food and beverage (16.4%) Apparel (4.2%) Transportation (16.6%) Medical care (6.0%) Recreation (5.9%) The Producer Price Index (PPI) The producer price index (PPI) is an index of prices that measures average change in selling prices received by domestic producers of goods and services over time. It gives an early indication as to where inflation is headed. Real and Nominal Concepts Nominal output is the total amount of goods and services measured at current prices. Real output is the total amount of goods and services produced, adjusted for price level changes. 4

5 Real and Nominal Concepts The real amount is the nominal amount divided by the price index. It is the nominal amount adjusted for inflation. real output = nominal output price index X 100 Expected and Unexpected Inflation Expected and unexpected inflation affects behavior differently. Expected inflation is inflation people expect to occur. Unexpected inflation is inflation that surprises people. Expected and Unexpected Inflation Expectations of inflation play an important role in the inflation process. Inflationary expectations can accelerate large inflation. Costs of Inflation Inflation may not make a nation poorer. It can redistribute income from those who do not raise their prices to those who do. It can reduce the amount of information that prices are supposed to convey. 5

6 Costs of Inflation Inflation is usually accepted by governments as long as it stays at a low level. What worries policymakers is hyperinflation. Costs of Inflation Hyperinflation exceptionally high levels of inflation of, say, 100 percent or more a year. The U.S. has not experienced hyperinflation since the Civil War ( ). 6