Inflation: An Overview How to Calculate Inflation

Price level in year 1 Inflation Inflation Rate = Price level in year 2 – Price level in year 1 X 100 Question: Does the level of prices matter? Why/why not? Question: When it comes to inflation, what does matter?

Price Level Doesn’t Matter… The most gas she could buyThe most lattes she could buyTo buy one more latte, she must give up: Laura has $20 per week to spend on gasoline ($2/gallon) or venti mochaccino lattes ($4/cup). What proportion of her income does one gallon of gas consume? What proportion of her income does one cup of latte consume? What would happen if the price of gas and coffee DOUBLED… and so did her income?

…But the RATE of Price Changes DOES! The most gas she could buyThe most lattes she could buyTo buy one more latte, she must give up: Laura has $20 per week to spend on gasoline ($4/gallon) or venti mochaccino lattes ($8/cup). What would happen if the price of gas and coffee DOUBLED… but her income stayed the same? What proportion of her income does one gallon of gas consume? What proportion of her income does one cup of latte consume?

The Costs of Inflation What are the varieties of the “costs of inflation”, and who bears them?

Inflation: Winners and Losers Who wins from high inflation? Who loses? Borrowing and lending scenarios: Your buddy borrows $100 and agrees to pay you back in one year. Why do you charge interest? For 1) your inconvenience, and 2) to offset inflation. You agree to the following: Real interest rate + Expected inflation = Nominal Interest Rate 3% + 5% = 8% (How much do you both agree that your friend will pay you next year?) 1.What happens if inflation is exactly 5% this year? 2.What happens if inflation is only 1% this year? Who “wins”? 3.What happens if inflation is 17% this year? Who “wins”? When actual inflation is above expected inflation, the lender loses and the borrower gains.

Inflation, Deflation, and Disinflation Huh?

Questions to ponder In each of the following scenarios, has inflation created: a) winners/losers (if so, identify the costs), or b) is there no net effect to the economy? 1.During a period of rapid unexpected inflation, Sam’s Meat Market must change the price of his products on a weekly basis. 2.The First Bank of Reffville has made many long-term loans with fixed interest rates assuming a stable inflation of 3% every year. For the last two years inflation has been even lower at 1.5% 3.Sonya is retired and collecting her Social Security checks every month. Every year Social Security payments are adjusted to reflect any increase in the cost of living. 4.Dwight is renting a storage locker from Jim and signed a two-year lease that said his monthly payment would be $20 over the course of the lease. Since signing the lease, the inflation rate has been higher than expected, at about 5.5% 5.When inflation is expected to be high, workers get paid more frequently and make more trips to the bank. 6.Lanwei is reimbursed by her company for her work-related travel expenses. Sometimes, however, the company takes a long time to reimburse her. She is less willing to travel during times of high inflation. 7.Hector Homeowner has a mortgage loan that he took out five years ago with a fixed 6% nominal interest rate. Over the years, the inflation rate has crept up unexpectedly to its present level of 7%. 8.In response to unexpectedly high inflation, the manager of Cozy Cottages of Cape Cod must reprint and resend expensive color brochures correcting the price of rentals this season.