Overview of Inflation Lesson 25 Sections 14, 15

Inflation and Deflation (14) Inflation: General rise in prices over time Disinflation: Lowering the inflation rate Deflation: General drop in prices over time The level of Prices doesn’t matter Real wages, Real income The rate of change of Prices does matter Inflation Rate Shoe-leather costs Increased costs of transactions because of inflation Menu Costs Costs of changing prices Unit of Account Costs As the value of money is changing so fast, it’s value is uncertain

Winners and Losers of Inflation Borrowers win in high inflation The value of money goes down over time, making the loan easier to repay Savers Loose in High Inflation Value of savings decline Nominal Interest Rate Interest Rate unadjusted for inflation Real Interest Rate Interest Rate adjusted for inflation Disinflation Lowering the rate of inflation, austerity

Measurement and Calculation of Inflation (15) Prince Indexes and Aggregate Price level Market Basket and Price Indexes Market Basket: typical consumption of a family Price Index: Measure of the overall price level Price Index = [Cost of basket(year)/Cost of basket (base year)] x 100 Inflation Rate = [(Price Index in year 2 – Price Index in year 1)/Price index in year 1] x 100

FYI: What Is in the CPI’s Basket? 17% Transportation 42% Housing 15% Food and beverages 6% Education and communication Medical care 6% Recreation 6% Apparel 4% Other goods and services 4%

Price Indexes CPI Consumer Price Index PPI Producer Price Index GDP Deflator Real GDP = Nominal GDP/GDP Deflator x 100

Two Measures of Inflation Percent per Year 15 CPI 10 GDP deflator 5 1965 1970 1975 1980 1985 1990 1995 2000 2005