Inflation The Right Start

Inflation: What is It? Inflation is a sustained rise in the average price level of all goods and services in an economy. Causes no direct harm to the economy’s resources or it’s ability to produce real goods and services. (see circular flow)

Inflation Causes Demand Pull—the money supply is increasing faster than the economy’s ability to produce goods and services. Cost Push—negative shocks to aggregate supply increase costs of production.

How is Inflation Measured? The Gross Domestic Production Deflator (GDP deflator) measures changes across all products included the GDP. The Consumer Price Index (CPI) measures the cost of a fixed basket of consumer goods and services and compares the basket cost to a base period.

Sample Calculation: GDP Deflator Year #1 Bikes x 100,000 x $100 = $10 million Oranges x 10M x $.10 = $1 million Airplanes x 10 x $1M = $10 million Total $21 million

Inflation Calculation Continued Year #2 Bikes x 100,000 x $120 = $12 million Oranges x 10M x $.20 = $2 million Airplanes x 10 x $1.1M = $11 million Total $25 million GDP Deflator = Nominal GDP year 2/Nominal GDP year 1 x 100. Year #1 is the base year.

Inflation Calculation Continued GDP Index number for year 2 is calculated as 25/21 x 100 = 119. The inflation rate is equal to the change in the index number from year 1 to year 2. The inflation rate is /100 =.19 or 19%. Inflation is always expressed as a percentage change.

A Real World Example 2000 GDP Deflator = GDP Deflator = /107.0 x 100 = 2.2%

Consequences of Inflation Income RedistributionCase #1 CPI = 100 Teacher (3 year contract) $50,000 Soccer Player (3 year contract$50,000 R.E. Agent (commission)$50,000 Retiree (With COLA)$50,000 Computer Consultant (fee)$50,000 Nominal GDP = $250,000

The Consumer Price Index: A Simplified Calculation

Consumer Price Index Categories Food and BeveragesRecreation HousingEducation ApparelOthers TransportationMedical Care Special Indexes Energy All Items Less Food and Energy

Consequences of Inflation Income RedistributionCase #2 Prices Double CPI = 200 Teacher (3 year contract) $50,000 Soccer Player (3 year contract $50,000 R.E. Agent (commission)$150,000 Retiree (With COLA)$100,000 Computer Consultant (fee)$150,000 Nominal GDP = $500,000

Consequences of Inflation Inflation causes unintended income redistribution from people with inflexible incomes to people with flexible incomes.

Consequences of Inflation Currency Devaluation Money is like other valuable economic things. If it is scarce each piece remains valuable. As money becomes more abundant each single piece becomes less valuable.

Consequences of Inflation An example Incomehamburger $10$5Spending = 50% food $20 $10Spending = 50% food At first $1 could buy 1/5 hamburger Now $1 can only buy 1/10 hamburger The value of the currency has declined. How many people still pick up pennies?

Conclusions Inflation does not harm an economy’s ability to produce goods and services. Inflation is caused by the money supply growing faster than output or from aggregate supply shocks. Inflation causes the value of currency to decline. Inflation causes unintended income redistribution.