AP Economics Mr. Bernstein Module 14: Inflation: An Overview February 2, 2015

AP Economics Mr. Bernstein Inflation: An Overview Objectives - Understand each of the following: 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 2

AP Economics Mr. Bernstein Price Levels don’t matter, Relative Prices do If the price of gas doubles, one can only drive half as much…unless income also doubles!...in this case real income was flat The rate of change is therefore important, not the absolute value of price changes 3

AP Economics Mr. Bernstein Price Levels don’t matter, Relative Prices do Inflation rate = (Price level, year 2 – Price level, year 1) / (Price level, year 1) x 100 Costs of inflation Shoe leather costs – Effort spent by consumers seeking lower prices or substitutes Menu costs – Effort spent by businesses realigning pricing strategies Unit of Account costs – Tax increases based on inflating asset values may not be matched by income increases 4

AP Economics Mr. Bernstein Winners and Losers from Inflation Borrowers pay back loans in dollars with reduced purchasing power Nominal Interest Rates = Real Interest Rates + Expected Inflation So when inflation exceeds expectations, the borrower benefits; when inflation is below expectations, the lender benefits Inflation can redistribute income from those that are hurt by rising prices to those who gain from rising prices 5

AP Economics Mr. Bernstein Inflation is Easy; Disinflation is hard Inflation is a rise in overall price levels Deflation is a decline in overall price levels Disinflation is the reduction in inflation rates Most obvious policy to bring about disinflation is Monetary Policy (reduce money supply) Can be painful because it causes a reduction in the demand for goods and services, which in turn causes a reduction in demand for labor 6