Chapter 13, Section 2

 Instability is not limited to fluctuations in GDP or GNP.  Changes in prices also can be disruptive to the economy.  When the general level of prices increases, inflation is occurring.  A decline in the general level of prices is called deflation.  Both inflation and deflation are harmful to the economy and thus it should be avoided if possible.

 Price index –a statistical series used to measure changes in the level of prices over time.  Consumer price index (CPI) –a series used to measure price changes for a representative sample of frequently used consumer items.  The Market Basket ◦ First step is to select a market basket – the representative selection of goods and services used to compile a price index. ◦ The index uses about 364 goods and services. ◦ Example in Figure 13.3

 The Market Basket ◦ Number of items are scientifically selected to represent the types of purchases most consumers make. ◦ The next step is to find the average price of each item in the market basket. ◦ U.S. Census Bureau employees sample prices on about 80,000 items in stores across the country. ◦ They then add up the prices to find the total cost of the market basket. ◦ A base year is then selected. The base year being the year that serves as the point of comparison for all other years.

 The Price Index ◦ The last step in the process is to make the numbers in the table easier to interpret. ◦ This is done by converting the dollar cost of a market basket to a index value. ◦ The index number represents the level of prices in comparison to the base-period prices. ◦ All conversions are understood to be a percentage of the base-period cost even though it is not explicit. ◦ A different base year would give a different index number, which is why the base year is not changed often.

 Measuring Inflation ◦ We find the percentage change in the monthly price level, which is how inflation is measured. ◦ Figure 13.4 ◦ The rate of inflation tends to change over long periods of time. ◦ Last 20 years – creeping inflation has occurred, which is a relatively low rate of inflation, usually between one and three percent annually. ◦ Hyperinflation – inflation in the range of 500 percent or above. It does not happen very often, but when it does it is the last stage before a monetary collapse.

 Measuring Inflation ◦ The record for hyperinflation was set in Hungary during World War II. ◦ At the end of the war it was claimed that 828 octillion pengo = 1 prewar pengo. ◦ Economies may also experience stagflation, which is a period of stagnant economic growth coupled with inflation. ◦ Stagflation was a concern in the 1970s, which was a time of rising prices coupled with high unemployment.

 Other Price Indexes ◦ A price index can be constructed for any segment of the economy, for instance the agricultural sector. ◦ Producer Price Index (PPI) – a monthly series that reports prices received by domestic producers. ◦ Prices in this series are recorded when a producer sells its output to the very first buyer. ◦ 100,000 commodities make up the sample for this index. ◦ Implicit GDP price deflator – index used to measure price changes in GDP. Is not frequently used.

 Demand-Pull ◦ Demand-pull inflation is the explanation that prices rise because all sectors of the economy try to buy more goods and services than the economy can provide. ◦ Shortages drive up prices, thus prices are pulled up by excessive demand. ◦ A similar explanation blames inflation on excessive spending by the federal government. ◦ Only the federal government’s deficit spending is responsible.

 Cost-Push ◦ Cost-push inflation is the explanation that rising input costs, especially energy and organized labor is what drives up prices. ◦ Examples:  National union wins a large wage contract.  Sudden rise in the international price of oil.  Wage-Price Spiral ◦ A more neutral explanation that does not place blame on any entity. ◦ The blame is on a self-perpetuating spiral of wages and prices that is difficult to stop.

 Excessive Monetary Growth ◦ Most popular explanation for inflation. ◦ This occurs when the money supply grows faster than real GDP. ◦ Any extra money or additional credit created by the Federal Reserve System will increase someone’s purchasing power, which can create a demand-pull effect. ◦ Advocates state that inflation cannot be maintained without a growing money supply.

 Reduced Purchasing Power ◦ Most obvious effect is that the dollar buys less as prices rise. ◦ Figure 13.5 ◦ Retired people and people on fixed incomes are the ones that hurt the most when inflation occurs.  Distorted Spending Power ◦ People change their spending habits due to inflation. ◦ Example: early 1980s prices.

 Encouraged Speculation ◦ Inflation tempts some people to speculate in an attempt to take advantage of rising prices. ◦ Example: Housing market & Recession ◦ Some people make money, but even speculators lose money from time to time.  Distorted Distribution of Income ◦ Creditors, or people who lend money, are usually worse off than debtors, or people who borrow money. ◦ Earlier loans are repaid with dollars that buy less.