Inflation

An increase in the general (average) price level of goods and services in the economy Deflation A decrease in the general (average) price level of goods and services in the economy Disinflation A reduction in the rate of inflation Consumer Price Index The most widely reported measure of inflation It measures changes in the average prices of consumer goods and services

Reporting and Calculation The Bureau of Labor Statistics (BLS) reports CPI Price collectors contact retail stores, homeowners, and tenants in selected cities in the U.S. monthly Goods and Services are Included in the CPI The BLS records average prices for a “market basket” of different items purchased by the typical urban family Food Housing Apparel Transportation Health Care Entertainment Education All other goods 13% 33% 4% 18% 6% 5% 2% 8% Composition of the CPI

The makeup of the CPI changes as people’s tastes and preferences change, some of the goods and services that go into the basket change Reporting and Calculation Computing CPI Current year prices are compared to prices of a similar basket of goods and services in a base year A year chosen as a reference point for comparison with some earlier or later year base year CPI is always 100 in the base year CPI = cost of the market basket of products at current-year prices cost of the market basket of products at base-year prices X 100

Computing Inflation Rate The percentage change in the official CPI from one year to the next CPIY is the Consumer price index in given year CPIPY is the Consumer price index in previous year Inflation Rate CPI - CPIPY CPIPY X 100 = Inflation Rate CPI 2006 – CPI 2005 CPI 2005 X 100 = Inflation Rate – X 100 = = 3.2%

Consumer Price Indexes and Inflation Rates YearCPI Inflation Rate % Where to find the current inflation rate? YearCPIInflation Rate %

The U.S. Inflation Rate Deflation Inflation Year Inflation Rate (percentage change in CPI from previous year) `30 `35 `40 `45 `50 `55 `60 `65 `70 `75 `80 `85 `90 `95 `00 `05 `10

Criticisms of the CPI It can overstate or understate for certain groups Does not measure quality Substitutes are ignored A general rise in prices will shrink people’s income Inflation Impacts Income Nominal Income The actual number of dollars received over a period of time Real Income The actual number of dollars received (nominal income) adjusted for changes in the CPI

Real Income = Nominal Income CPI Calculating Real Income The “Real Income” is now in 1982 dollars While “Nominal Income” is going up over the years this person can not purchase the same level of goods and services in 2006 compared to 1980 X 100 YearCPI Base=1982 Nominal Income Real Income Real Income Calculation $30,000$36,408 ($30,000 / 82.2) * $40,000$23,229 ($40,000 / 172.2) * $45,000$22,321 ($45,000 / 201.6) * 100

%  in real income %  in nominal income %  in CPI _ = Percentage Change in Real Income 5% 2% _ 3% = Real income increases when the rate of inflation is greater than a percentage increase in nominal income 2% 3% _ -1% = Real income declines when the rate of inflation is greater than a percentage increase in nominal income

Wealth The value of the stock of assets owned at some point in time Wealth and Inflation Inflation can benefit holders of wealth because the value of their assets tends to increase as prices rise

Inflation Affects Borrowers and Savers Nominal Interest Rate The actual rate of interest earned over a period of time The nominal rate of interest minus the inflation rate Real Interest Rate Nominal Rate Real Rate - Inflation Rate 7% 4% 3% - 7% -2% 9% - In the above example savers receive a nominal interest rate of 7% with inflation of 9% during the loan term causing saver purchasing power to decline by 2% Borrowers receive 2% increase in purchasing power Bankers have a great fair of inflation, it devalues a loan contract

Two basic types of inflation Demand-pull Cost-push Demand-pull Inflation is a rise in the general price level resulting from an excess of total spending (demand) When the economy is operating at or near full employment Cost-push inflation is a rise in the general price level resulting from an increase in the cost of production Cost increases for labor, raw materials, construction, equipment, borrowing etc. Expectations can influence both demand-pull and cost-push inflation Hyperinflation: An extremely rapid rise in the general price level Wage-price spiral: Increases in nominal wage rates are passed on in higher prices, which, in turn, result in even higher nominal wages and prices