 Inflation: a general increase in the prices of goods and services in an entire economy over time.  *Note* If for instance Canada’s has an annual inflation rate of 3%, this doesn’t mean that all prices are rising. Some prices are rising, others remain constant, while still others may be falling  The overall rise in prices is 3%  Deflation: a general decrease in the level of prices and income  Hyperinflation: a situation in which prices increase rapidly and inflation is out of control (e.g. prices doubling/tripling within a month) 9.1 Inflation

 Consumer Price Index: A measure of price changes for a typical basket of consumer products  Stats Canada surveys typical Canadian households’ buying habits every few years so that it can determine what they buy The Consumer Price Index

Consumer Price Index (CPI)

 Item Weights: the proportions of each good in the total cost of the basket of consumer goods used to calculate CPI  Base Year: the survey year used as a point of comparison in subsequent years Consumer Price Index (CPI)

Consumer Price Index Weights

Nominal versus Real Income

 Consumer Differences  One consumer might buy a lot of books, while another doesn’t, so CPI takes the average of every person, making it appear like every person likes to read a bit  Changes in Spending Patterns  When an object’s price falls (e.g. cell phones in the 2000’s) consumers will likely choose to buy more  Product Quality & New Products  Index cannot reflect changes in quality or introduction of new products Limitations of the CPI

 GDP Deflator – another indicator of price changes, but measures changes in all goods and services  CPI simply looks at a small number of consumer items The GDP Deflator

Nominal vs Real GDP

 High inflation rates is a serious problem – it redistributes purchasing power among different groups that can be:  Economically harmful  Unjust  Households also increase nominal income when inflation occurs  If percentage of inflation is greater than that of nominal income, then that household’s purchasing power declines  If nominal income rises faster than inflation, then a household can actually benefit from inflation Inflation’s Effects

The Inflation Rate Deflation

 Cost-of-living-adjustment clauses: provisions for income adjustments to accommodate change in price levels, which are included in wage contracts  Fully Indexed Incomes: nominal incomes that automatically increase by the rate of inflation  Partially Indexed Incomes: these people lose the most from inflation, as only a portion of their income rises  Fixed Incomes: nominal incomes that remain fixed at some dollar amount regardless of the rate of inflation Incomes

 If a lender lends funds at an interest rate that is not adjusted for inflation, the lender may lose out  Interest rate is “prime plus 1%” – prime can always change – right now, “prime” = 3%  This is the inflation premium  Nominal Interest Rate: interest rate expressed in money terms  Real Interest Rate: the nominal interest rate minus the rate of inflation Borrowing & Lending