Inflation – sustained increase in the general price level.

Deflation – sustained decrease in the general price level.

Disinflation – a decrease in the inflation rate.

Consumer price index (CPI) – a measure of the cost of living or of goods

and services purchased by the typical household in an economy; it does
so by constructing a hypothetical basket containing many goods and
services typically consumed over a year.

Weighted price index – a price index that considers the relative

importance (quantities) of various goods and services in consumer
spending.

nomicalincome
Real income = CPI
× 100
Problems with CPI:
- Different rates of inflation for different income earners (different
consumers have different consumptions pattern spending, so
results in different price increases)
- Different rates of inflation depending on regional or cultural factors
(same as above, since different consumption patterns are affected
by tastes varying due to those factors)
- Changes in consumption patterns due to consumer substitutions
when relative prices change (increase or decrease in prices affects
weights, but since they’re fixed, the changes of consumption
patterns aren’t accounted in CPI)
- Changes in consumption patterns due to increasing use of discount
stores and sales (CPI can overstate inflation by reason of some
consumers buying goods and service at lower prices than those
used in the CPI calculations)
- Changes in consumption patterns due to introduction of new
products (typical households haven’t had time yet to consume this
product regularly for it to be counted in CPI)
- Changes in product quality
- International comparisons (CPIs of different countries contain
baskets of different goods and services, thus limiting comparability)
- Comparability over time (base year is being changed every 10 years,
while weights of goods and services change every year, so
comparability over long periods is lessened because of changes in
baskets)

The core rate of inflation

Energy and food prices tend to be quite volatile over time (due to wide
swings in supply and demand), so economists measure a core rate of
inflation that doesn’t include food and energy products.
Causes of inflation
Demand-pull inflation – inflation caused by increases in AD (which creates
an inflationary gap).

Cost-push inflation – inflation caused by increases in costs of production

or supply-side shocks (changes in SRAS).

The relationship between inflation, purchasing power, and nominal and

real income
Real income (purchasing power) increases when prices fall and decreases
as prices rise, although nominal income doesn’t change (initial money
stay with a person) or changes slower.

%change in real income (purchasing power) = %change in nominal income

- %change in price level

Costs of inflation
- Redistribution effects (inflation redistributes income away from
certain groups in an economy towards other groups)
Groups that lose from inflation:
 People who receive fixed incomes or wages
 People who receive incomes or wages that increase slower
than the inflation rate
 Holders of cash
 Savers
 Lenders (creditors)
Groups that benefit from inflation:
 Borrowers (debtors)
 Payers of fixed incomes or wages (firms, government)
 Payers of incomes or wages that increase slower than the
inflation rate
- Uncertainty (inability to predict the future inflation can cause
uncertainty among economic decision-makers and firms who, in
particular, will be more cautious by making fewer investments and
leading to lower economic growth)
- Effects on saving (inflation lowers the incentive to save)
 - International competitiveness (increasing prices lead to more
expensive exports for foreign buyers and cheaper imports to
domestic buyers, thereby decreasing exports and increasing
imports)
- Effects on resource allocation (increasing prices lead to less
effective incentive functions since they don’t rise the same for all
products, so signals become more distorted, resulting in increased
allocative inefficiency)
- Social and personal costs unequally distributed (low-income people
are less likely to place their savings in assets that don’t lose value
with inflation, like real estate or stocks, and rising prices of
necessities can cut the incomes of those people even more)

Consequences of hyperinflation
Hyperinflation results from very significant increases in money supply
(like government printing money).
It has serious negative consequences, such as:
- Inflationary spiral (consumers increase spending to benefit from
current prices => demand-pull inflation, and workers start
demanding higher nominal wages => cost-push inflation)
- Massive disruption of economic activity ()