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Inflation
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A general and progressive increase in prices
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Hyperinflation
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A very rapid rise in the price level; an extremely high rate of inflation.
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Deflation
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A situation in which prices are declining
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Consumer Price Index (CPI)
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a measure of the overall cost of the goods and services bought by a typical consumer
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Production Price Index (PPI)
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an average of the prices received by producers of goods and services at all stages of the production process
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price index
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a measurement that shows how the average price of a standard group of goods changes over time
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Price Index Formula
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(Cost of Basket this Year/Cost of Basket in Base Year) x 100
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Inflation formula
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(Price index in year 2 - price index in year 1)/(Price index in year 1) x 100
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price in today's dollars equation
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price in earlier time x (price level today/price level in earlier time)
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CPI overstates inflation for 3 possible reasons:
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1. substitution bias
2. changes in quantity
3. new products and locations
2. changes in quantity
3. new products and locations
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Costs of Inflation
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1. Shoe-leather costs
2. Money illusion
3. Menu costs
4. Uncertainty about future price levels
5. Wealth redistribution
6. Price confusion
7. Tax distortions
2. Money illusion
3. Menu costs
4. Uncertainty about future price levels
5. Wealth redistribution
6. Price confusion
7. Tax distortions
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shoe leather costs
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the resources wasted when inflation encourages people to reduce their money holdings
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money illusion
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when people mistake changes in nominal prices for changes in real prices
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menu costs
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the costs of changing prices
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Future price uncertainty
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long-term agreements may not be signed if lenders, firms, and workers are unsure about future price levels
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interest rate
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the proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding.
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nominal interest rate formula
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risk premium + inflation premium
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wealth redistribution
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inflation can redistribute wealth between borrowers and lenders
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price confusion
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Prices act as signals for producers
-higher prices signal producers to produce more, but what if that is caused by inflation?
-if prices go up because of inflation but producers misinterpret this, their businesses can fail.
-higher prices signal producers to produce more, but what if that is caused by inflation?
-if prices go up because of inflation but producers misinterpret this, their businesses can fail.
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tax distortions
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inflation makes nominal income grow faster than real income
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capital gains tax
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a tax levied on the returns that people earn from capital investments, like the profits from the sale of stocks or a home
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cause of inflation
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expansions in the nation's money supply
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Equation of Exchange
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M x V = P x Q
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equation of exchange in growth rates
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%ΔM + %ΔV ≈ %ΔP + %ΔY
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real salary
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the purchasing power of the dollars
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Real salary equation
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nominal salary x adjustment factor
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