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Inflation

Price of the Most Recent Market Basket in the Particular Year. This year’s CPI – Last year’s CPI. x. x. CPI. =. =. Inflation Rate. 100. 100. Price estimate of the Market Basket in 1982-1984. Last year’s CPI. Inflation. General rise in the price level

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Inflation

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  1. Price of the Most Recent Market Basket in the Particular Year This year’s CPI – Last year’s CPI x x CPI = = Inflation Rate 100 100 Price estimate of the Market Basket in 1982-1984 Last year’s CPI Inflation • General rise in the price level • Inflation reduces the “purchasing power” of money • Consumer Price Index (CPI) = 2.8% 26-1 LO2

  2. Inflation By the way, the rule of 70 apples to inflation as well as economic growth (or anything else). 26-2 LO2

  3. Types of Inflation • Demand-Pull inflation • Excess spending relative to output • Central bank issues too much money • Cost-Push inflation • Due to a rise in per-unit input costs • Supply shocks 26-3 LO3

  4. Inflation • Difficult to distinguish inflation types • Types differ in sustainability • Demand-pull continues as long as the excess spending continues • Cost-push ends in a recession • Without knowing what’s causing inflation, it can be difficult for the Federal Reserve to correct it. 26-4 LO3

  5. Redistribution Effects of Inflation • Nominal income • Unadjusted for inflation • Real income • Nominal income adjusted for inflation Real Income = Nominal Income Price Index ÷ 100 Percentage change in real income  Percentage change in nominal income Percentage change in price level = 26-5 LO3

  6. Unanticipated InflationHurts… • People on a fixed-income • Why? • Savers • Why? • Creditors • Why? 26-6 LO3

  7. Flexible-income receivers COLAs Social Security recipients Union members Debtors Why? Who is unaffected (or even helped) by unanticipated inflation? 26-7 LO3

  8. Anticipated Inflation • Real interest rate • Rates adjusted for inflation • Nominal interest rate • Rates not adjusted for inflation 26-8 LO3

  9. Anticipated Inflation 11% 6% = + 5% Inflation Premium Nominal Interest Rate Real Interest Rate Real interest rate = Nominal interest rate – inflation rate. 26-9 LO3

  10. Does Inflation Affect Output? • Cost-Push inflation • Reduces real output • Redistributes a decreased level of real income • Demand-Pull inflation • One view is that zero inflation is best • Another view is that mild inflation is best 26-10 LO3

  11. Costs of Inflation • Page 147 of your text, it doesn’t use these terms (but other AP sources do): • Menu costs: the cost of actually changing prices. Can be substantial if prices change rapidly. • Unit of Account costs: it’s difficult to know what the real value of money is (prices, wages, interest rates) • Shoe-leather costs: the cost of actually managing your finances to avoid getting hurt by inflation. 26-11 LO3

  12. Hyperinflation • Extraordinarily rapid inflation • Devastates an economy • Businesses don’t know what to charge • Consumers don’t know what to pay • Money becomes worthless 26-12 LO3

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