Chapter 7 homework Numbers 2, 4, 10, 14, 16

Chapter 8 Inflation and Prices

Defining Inflation A general upward movement of prices.  Are we impacted by inflation? Yes…we all buy goods and services  Moderate inflation hurts everyone a little

The Relationship Between Inflation and Wages If level of prices rises faster than workers’ wages, workers need higher incomes to keep up with inflation. What happens if wages rise at the same rate as prices?  Workers are not affected by inflation.

The Costs of Inflation Extra time they have to work in order to buy the same quantities of goods and services at higher prices.  What about those with long-term contracts? Wages are fixed Worker hurt by inflation.

The Costs of Inflation (cont’d) Households, firms or financial institutions that receive a fixed return on savings or loans will be hurt by inflation.  The value of their returns decline as inflation rises.  BUT inflation benefits those who make fixed payments.

The Costs of Inflation (cont’d) Spend resources trying to predict which prices will rise and how quickly. Menu costs refer to the costs that firms encounter when they adjust to higher prices.  Changing the barcodes in the computer  Printing new menus with new prices  Printing new price signs

Causes of Inflation “Too much money chasing too few goods.” Results when:  The government prints too much money.  Producers cannot provide enough output.

Causes of Inflation (cont’d) Examples:  In the third century, Roman emperors debased their currency by adding base elements such as lead to gold coins.  In the mid-1980s, the Brazilian government printed additional money to cover a budget deficit.  In the fourteenth century, the Bubonic Plague devastated Europe, reducing production of goods such as food.

Real and Nominal Values Economists measure the effects of inflation by distinguishing between real and nominal values.  Nominal income is the actual dollar value of their pay.  Real income is the purchasing power of their nominal income.

Real and Nominal Income (cont’d) The relationship between real income, nominal income and inflation can be shown as: Example: Suppose a worker’s nominal wage increases by 5% and the inflation rate is 3%. The change in real income is:

Real and Nominal Interest Rates The nominal interest rate is the amount of interest a borrower pays for every $100 borrowed.

Real and Nominal Interest Rates (cont’d) The real interest rate is the purchasing power of the repayment the borrower makes for every $100 borrowed. Example: If the real interest rate is 3% and the inflation rate is 2%, what is the nominal interest rate?