Inflation: it is a rise in the price level.

Pure inflation: where the prices of goods (output) and inputs rise at the same rate.
Consumer Price Index (CPI): it measures the cost in that period of a standard set, or basket, of
goods and services relative to the cost of the same basket of goods and services in a fixed year,
called base year. This index represents the basic tool for measuring inflation. CPI is a measure of the
cost of living during a particular period.

The CPI is not itself the price of a specific good or service as it has no units of measurement at all.

It is a measure of the average price of a given class of goods and services relative to the price of
the same goods and services in a base year.

While the CPI provides a measure of the average level of prices relative to prices in the base year,
inflation is a measure of how fast the average price level is changing over time.

The rate of inflation (inflation rate): the annual percentage rate of change in the price level.
Inflation rate = nominal money growth – money demand growth

The negative inflation rate: it is called deflation where the prices of most goods and services are
falling over time.

Nominal quantity: a quantity that is measured in terms of its current dollar value.
Real quantity: a quantity that is measured in physical terms (in terms of quantities of goods and
services).

Adjusting for inflation: the deflating process is used by dividing a nominal quantity by a price index
to express the quantity in real terms.

Real wage: it is the wage paid to workers measured in terms of purchasing power.
Real wage = nominal wage/CPI

Price level: it is a measure of the overall level of prices at a particular point in time as measured by a
price index such as the CPI.

Relative price: it is the price of a specific good or service in comparison to the prices of other goods
and services.

Note that: the changes in the price level and changes in relative prices of specific goods are two
quite different issues.

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The true costs of inflation include “noise” in the price system; distortions of the tax system; “shoe
leather” costs, which are the real resources that are wasted as people try to economize on cash
holdings; unexpected redistribution of wealth; and interference with long-run planning.

Hyperinflation: it is a situation in which the inflation rate is extremely high.

Economic theory suggests that high inflation rates, especially those associated with hyperinflation,
reduce economic efficiency and growth.

Real interest rate: it is the annual percentage increase in the purchasing power of a financial asset.
r = i – π

Note that: the real interest rate is not equal to the nominal interest rate divided by the price level
as the nominal rate is a rate of return which is measured in percent, or a nominal quantity measured
in dollars.

Nominal interest rate (market interest rate): it is the annual percentage increase in the nominal
value of a financial asset.

Inflation protected bonds: are bonds that pay a nominal interest rate each year equal to a fixed real
rate plus the actual rate of inflation during that year. They pay a fixed real interest rate.

Fisher effect: it is the tendency for nominal interest rates to be high when inflation is high and vice
versa.