Module Inflation: An Overview KRUGMAN'S MACROECONOMICS for AP* 14 Margaret Ray and David Anderson.

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Presentation transcript:

Module Inflation: An Overview KRUGMAN'S MACROECONOMICS for AP* 14 Margaret Ray and David Anderson

What you will learn in this Module : The economic costs of inflation How inflation creates winners and losers Why policy makers try to maintain a stable rate of inflation The difference between real and nominal values of income, wages, and interest rates The problems of deflation and disinflation

The Level of Prices Doesn’t Matter... It’s all relative-if wages increases keep up with price increases, purchasing power stays same $20 income/week Gas =$2/gal or Latte=$4/cup $40 income/week Gas=$4gal or Latte = $8 cup If $20 income, but $4/gal or Latte $8 cup Real Wage= wage rate/price level Real Income=income/price level Could buy 10 gal gasCould buy 5 lattes Could buy 10 gal gasCould buy 5 lattes Could buy 5 gal gasCould buy 2.5 lattes

...But the Rate of Change of Prices Does Price level in year 2 - Price level in year 1 Price level in year 1 X 100 Inflation Rate Inflation rate = Shoe-Leather Costs- effort required to consider alternatives for your money as it loses value if you hold it Menu Costs- cost incurred to “reprice” constantly Unit-of-Account Costs- less efficient decisions resulting from uncertainty-unreliability of value of dollar

Winners and Losers from Inflation Winners Anyone paying back debt (borrowers) If inflation is actually higher than 5%, say 7%, you are better off You will pay $108 You should have to pay $110 Losers Anyone lending out money (Lenders) or living on fixed income Ex: You loan your friend $100You charge interest to compensate yourself for not having that money to enjoy. Plus enough to cover any purchasing power you lost with inflation= NOMINAL INTEREST 8%= REAL INTEREST(3%) + INFLATION (5%) You receive $108 at end of year

Inflation is Easy; Disinflation is Hard Disinflation- process of reducing prices when too much money being spent driving up prices and wages The cost of disinflation is painful-usually means higher unemployment Policy response to inflation-prefer low and predictable amt’s of inflation