1 Chapter 17 Inflation Key Concepts Key Concepts Summary Summary Practice Quiz Internet Exercises Internet Exercises ©2002 South-Western College Publishing

2 What is inflation? An increase in the general (average) price level of goods and services in the economy

3 What is deflation? A decrease in the general (average) price level of goods and services in the economy

4 What is the most widely reported measure of inflation? The Consumer Price Index

5 What is the Consumer Price Index? The CPI is an index that measures changes in the average prices of consumer goods and services

6 Who reports the CPI? The Bureau of Labor Statistics (BLS) of the Department of Labor

7 How is the CPI calculated? Price collectors contact retail stores, homeowners, and tenants in selected cities in the U.S. monthly

8 Which 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

9 Composition of the CPI Food and Beverages Housing Apparel and Upkeep Transportation Medical Care Recreation Education & Communication All other goods & services 16.2% 40.0% 4.4% 17.6% 5.8% 5.9% 5.3% 4.8%

10 Does the makeup of the CPI change? As people’s tastes and preferences change, some of the goods and services that go into the basket change

11 How is the CPI computed? Current year prices are compared to prices of a similar basket of goods and services in a base year

12 What is a base year? A year chosen as a reference point for comparison with some earlier or later year

13 Why is the CPI always 100 in the base year? The numerator and the denominator of the CPI formula are the same in the base year

14 CPI = CYP BYP *CYP = cost of the market basket of products at current-year prices *BYP = cost of the market basket of products at base-year prices X 100

15 How is the inflation rate computed? The annual inflation rate is computed as the percentage change in the official CPI from one year to the next

16 ARI = CPI - CPIPY CPIPY *ARI = Annual rate of inflation *CPIY = Consumer price index in given year *CPIPY = Consumer price index in previous year X 100

The U.S. Inflation Rate

18 What is disinflation? A reduction in the rate of inflation

19 What are some criticisms of the CPI? It can overstate or understate the impact of inflation for certain groups Does not measure quality Substitutes are ignored

20 What does inflation do to people’s income? A general rise in prices will shrink people’s income

21 What is nominal income? The actual number of dollars received over a period of time

22 What is real income? The actual number of dollars received (nominal income) adjusted for changes in the CPI

23 RI = NI CPI *RI = Real income *NI = Nominal income *CPI = CPI as a decimal or CPI ÷ 100

24 %  in real income %  in nominal income %  in CPI = _

25 What is wealth? The value of the stock of assets owned at some point in time

26 How is wealth affected by inflation? Inflation can benefit holders of wealth because the value of their assets tends to increase as prices rise

27 What will cause your real income to decline? The rate of inflation is greater than your rate of income

28 How does inflation affect borrowers and savers? They can win or lose depending on the rate of inflation

29 What is the interest rate? Interest per year as a percentage of the amount loaned or lent

30 What is the nominal interest rate? The actual rate of interest earned over a period of time

31 What is the real interest rate? The nominal rate of interest minus the inflation rate

32 What are the two basic types of inflation? Demand-pull Cost-push

33 What is demand-pull inflation? A rise in the general price level resulting from an excess of total spending (demand)

34 When does demand- pull inflation occur? When the economy is operating at or near full employment

35 What is cost-push inflation? A rise in the general price level resulting from an increase in the cost of production

36 What can cause cost- push inflation? Cost increases for labor, raw materials, construction, equipment, borrowing etc.

37 Do people’s expectations affect inflation? Yes, expectations can influence both demand- pull and cost-push inflation

38 What is hyperinflation? An extremely rapid rise in the general price level

39 What is a wage-price spiral? A situation that occurs when increases in nominal wage rates are passed on in higher prices, which, in turn, result in even higher nominal wages and prices

40 How does the U.S. inflation rate compare with other countries? It is lower than some and higher than others

41 Key Concepts

42 Key Concepts What is inflation? What is the Consumer Price Index? Which goods and services are included in the CPI?Which goods and services are included in the CPI? How is the CPI computed? What is a base year? How is the inflation rate computed? What is disinflation?

43 Key Concepts cont. What does inflation do to people’s income? What is nominal income? What is real income? What is wealth? How is wealth affected by inflation? How does inflation affect borrowers and savers?How does inflation affect borrowers and savers? What are the two basic types of inflation?

44 Key Concepts cont. What is demand-pull inflation? What is cost-push inflation? Do people’s expectations affect inflation? What is hyperinflation? How does the U.S. inflation rate compare with other countries?How does the U.S. inflation rate compare with other countries?

45 Summary

46 Inflation is an increase in the general (average) price level of goods and services in the economy.

47 The consumer price index (CPI) is the most widely known price-level index. It measures the cost of purchasing a market basket of goods and services by a typical household during a time period relative to the cost of the same bundle during a base year.

48 The annual rate of inflation is computed using the following formula:

49 ARI = CPI - CPIPY CPIPY *ARI = Annual rate of inflation *CPIY = Consumer price index in given year *CPIPY = Consumer price index in previous year X 100

50 Deflation is a decrease in the general level of prices. During the early years of the Great Depression, there was deflation.

51 Disinflation is a reduction in the inflation rate. Between 1980 and 1986, there was disinflation. This does not mean that prices were falling, but only that the inflation rate fell.

52 The inflation rate is criticized because (1) it is not representative, (2) it incorrectly adjusts for quality changes, and (3) it ignores the relationship between price changes and the importance of items in the market basket.

53 Nominal income is income measured in actual money amounts. Measuring your purchasing power requires converting nominal income into real income, which is nominal income adjusted for inflation.

54 The real interest rate is the nominal interest rate adjusted for inflation. If real interest rates are negative, lenders incur losses.

55 %  in real income %  in nominal income %  in CPI = _

56 Demand-pull inflation is caused by by pressure on prices originating from the buyers side of the market.

57 Cost-push inflation is caused by pressure on prices originating from the seller's side of the market.

58 Hyperinflation can seriously disrupt an economy by causing inflation psychosis, credit market collapses, a wage-price spiral, and speculation.

59 END