Inflation

Inflation
Defined as:

– A SUSTAINED RISE IN THE AVERAGE

PRICE LEVEL OVER A PERIOD OF
YEARS.
 Inflation
Measured by:

– CONSUMER PRICE INDEX = CPI

 Inflation
Measured by:

CPI = price of the most recent market basket

in a particular year
price estimate of same market basket
in 1982-1984
 Inflation
Percent increase in CPI =

[(CPI in current year – CPI in previous year)]

[CPI in previous year]

all*100
 Inflation
From 1972 to 1982, the consumer price index
rose from 125.3 to 289.1

By what percentage did the cost of living rise?

 Inflation
Percent increase in CPI =

[(289.1 – 125.3]
[125.3]
*100
=130.7%
 Inflation
The CPI rose from 114.3 in 2013 to 126.1 in
2020.

By what percent did the CPI rise?

 Inflation
Percent increase in CPI =

[(126.1 – 114.3]
[114.3]
*100
=10.3%
 Inflation
The CPI rose from 200 in 1991 to 240 in
1997.

By what percent did the CPI rise?

 Inflation
The CPI rose from 129.6 in 2029 to 158.3 in
2045.

By what percent did the CPI rise?

 Inflation
Percent increase in CPI =

[(240 – 200]
[200]
*100
=20%
 Inflation
Percent increase in CPI =

[(158.3 – 129.6]
[129.6]
*100
=22.1%
 Deflation
Defined as:

– A SUSTAINED FALL IN THE AVERAGE

PRICE LEVEL OVER A PERIOD OF
YEARS.
 Deflation
• Around the world from 1929-1933
• In Japan from 1998-2005
• Fear that it would happen again 2008-?
 Deflation
• Fall in stock prices
• Fall in real estate and housing prices
• Fall in consumer prices
• Business profits down since their prices are down,
but their debts and costs don’t fall
• Wage cuts to lower costs
• Rising unemployment
 Types of Inflation
A. DEMAND PULL

B. COST PUSH
- WAGE-PRICE SPIRAL
- PROFIT PUSH
- EXTERNAL SHOCK
 Types of Inflation
A. DEMAND PULL

Defined as:
- Excess demand pulls up prices

• Often caused by increases in government

spending, such as wars
 Types of Inflation
B. COST-PUSH

Defined as:
- Rising costs drive up prices
 Types of Inflation
B. COST-PUSH
Three types:
- Wage-price spiral
- Profit-push inflation
- Supply-side shocks
 Types of Inflation
B. Wage-price spiral

Rising wages force companies to increase

prices.
Blamed on labor unions or shortage of
workers.
Not a problem since early 1980’s.
 Types of Inflation
B. Profit-push inflation

In many industries, there are only a small

number of companies.
Easy for them to raise prices to protect their
profit margins.
 Types of Inflation
B. Supply-side shocks

Dramatic and unexpected increases in the

prices of key materials, such as oil or
energy in general.
 Inflation
Who is hurt by inflation?
 Who is Hurt by Inflation
• PEOPLE ON FIXED INCOMES

• LENDERS/CREDITORS
 Who is Hurt by Inflation:
People on Fixed Incomes
• Nominal Income

• Real Income
 Who is Hurt by Inflation:
Nominal vs. Real Income

NOMINAL INCOME = face value of your

income

REAL INCOME = nominal income adjusted for

inflation with price indexes
 Who is Hurt by Inflation:
Nominal vs. Real Income
% CHANGE IN REAL INCOME =

% Change Nominal Income - % Change Price Level

 Who is Hurt by Inflation:
Nominal vs. Real Income
• Fixed income receivers

Anyone who income is fixed over time finds

that their real income falls at the same rate
that inflation rises.
 Who is Hurt by Inflation:
Lenders/creditors

Lenders, such as banks and credit card

companies, lend money to earn a profit.

– To earn a profit, the interest they charge must

cover all costs, and be higher than the rate of
inflation.
 Who is Hurt by Inflation:
Lenders/creditors

When lenders lend money, they have an expected

rate of inflation at the time of the loan.

– This expected rate of inflation is based on

current rate of inflation, plus a guess about
the future.
 Who is Hurt by Inflation:
Lenders/creditors

– If lenders guess right about inflation, they

earn a profit.

– If lenders guess wrong, they lose money.

 Who is Hurt by Inflation:
Lenders/creditors

Nominal interest rate = the observed

interest rate

Real interest rate = nominal interest rate –

rate of inflation
 Who is Hurt by Inflation:
Lenders/creditors

If inflation is less than the nominal interest

rate, lenders earn a profit.

If inflation is greater than the nominal interest

rate, lenders suffer a loss.
 Inflation: Any Winners?
Not everyone loses with low and moderate
rates of inflation.
- People whose income is flexible.
- Borrowers (debtors).
 Inflation: Any Winners?
Borrowers win because the real value of their
loan repayments decreases at the same
rate as inflation rises.

If their incomes rise as well, they are double

winners.
 Inflation Problems
Suppose your income rose by 4.6%, and
inflation rose by 1.6%.
Suppose your income rose by 4.0%, and
inflation rose by 3.0%.
Suppose your income rose by 4.0%, and
inflation rose by 5.0%.
 Inflation Problems
Suppose a lender made a loan with 7.0%
interest, and inflation was 3.1%.
Suppose a lender made a loan with 6.0%
interest, and inflation was 4.2%.
Suppose a lender made a loan with 4.75%
interest, and inflation was 5.1%.
 Inflation Problems
Suppose you invested in a bank CD that paid
4.75% interest, and inflation was 3.1%.
Suppose you invested in a bank CD that paid
4.75% interest, and inflation was 4.6%.
Suppose you invested in a bank CD that paid
4.75% interest, and inflation was 5.1%.
 Problems with Inflation
Much of the United States Federal
government’s monetary policy, and the
focus of most introductory econ textbooks,
is on the evils of inflation.

In the dispute between lenders and

borrowers, which side are they on?