5.

Inflation and Money

1. Measuring Inflation

a) Price Indexes

Year 1 Year 2
Price of apple $0.20 $0.40
Price of grapes 0.60 1.00
Price of peach 0.25 0.45
Cost of market basket (200 × $0.20) + (200 × $0.40) +
(200 apples, 50 bunches of (50 × $0.60) + (50 × $1.00) +
grapes, 100 peaches) (100 × $0.25) = (100 × $0.45) =
$95.00 $175.00

typical purchase: 200 apples, 50 grape bunches, 100 peaches

⇒ "basket"

□ Price index always defined relative to base year

□ The price index in the base year is normalized to 100

𝐶𝑜𝑠𝑡
𝑃 = ⎯⎯⎯⎯⎯⎯⎯⎯∗ 100
𝐶𝑜𝑠𝑡

95
𝑃 = ⎯⎯⎯∗ 100 = 100
95
175
𝑃 = ⎯⎯⎯ ∗ 100 = 184.2
95

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b) The Inflation Rate

► The inflation rate (𝜋) is the percentage growth rate in

the price index

𝑃 −𝑃
𝜋 = ⎯⎯⎯⎯⎯⎯⎯⎯
𝑃

184.2 − 100
π = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯= 0.842 = 84.2%
100

c) The Consumer Price Index

The CPI basket:

□ Used to calculate official CPI inflation rate

□ reflects purchases of typical Canadian household

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□ The cost of this basked has steadily been rising
 Inflation

𝐶𝑃𝐼 − 𝐶𝑃𝐼
π = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯
𝐶𝑃𝐼

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 Inflation: An increase in the price level (𝜋 > 0)

Deflation: A decrease in the price level (𝜋 < 0)

Disinflation: A slowdown in inflation (Δ𝜋 < 0)

Problems with CPI:

 Substitution Bias
 New Goods Bias
 Changes in Quality Bias

 CPI might be too high by about 0.5%

2. Other Measures of Inflation

a) Core Inflation

CPI - trim

CPI - median

https://www.bankofcanada.ca/rates/indicators/key-variables/key-inflation-indicators-and-the-target-range/

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 b) Producer Price Index (PPI)

https://www150.statcan.gc.ca/n1/daily-quotidien/240117/dq240117b-eng.htm?indid=3556-1&indgeo=0

industrial product price index

industrial product price index excluding energy and petroleum

c) GDP Deflator

𝑛𝑜𝑚. 𝐺𝐷𝑃 $𝑌
𝒫 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯∗ 100 = ⎯⎯⎯∗ 100
𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑌

► GDP deflator is the weighted price of all

domestically produced goods
► CPI includes foreign goods
► CPI does not include capital goods
► GDP deflator has flexible weights

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3. Real and Nominal Variables

a) Real GDP

$𝑌
𝑌 = ⎯⎯⎯
𝒫
. /

b) Real Wages

𝑊
𝒲 = ⎯⎯
𝑃
. /

- downward nominal wage rigidity -

US data

► Reduction of labour input happens at the extensive

margin (unemployment!)

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 c) Real Interest Rate

- Fisher Equation -

𝑖 = 𝑟 + 𝜋

d) Real Money Balances

How much does a certain amount of money buy?

 The purchasing power or money

𝑀
ℳ = ⎯⎯
𝑃
/

 Economic decisions are based on real variables

► No money illusion

Note: □ Inflation has generally no impact on macroeconomic

variables in the long run
□ Inflation impacts macroeconomic variables in the short
run while sluggish wages slowly catch up

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 4. The Cost of Inflation

(1) Menu Cost

□ cost of printing a new menu at restaurant
► Real cost of changing prices

(2) Shoe-Leather Cost

□ running to the bank to get cash
► Increased transaction cost (TAC)

(3) Distortion of Price Signals

□ identification problem if increase in nominal
price is due to increase in real price or
inflation
► Distorted production decisions

(4) Unintended Redistribution

□ inflation deflates debt
► Redistribution from lender to borrower

(5) Hyperinflation
□ very high inflation rates are self-reinforcing
► Brake-down of financial system

Note: Deflation can be even worse!

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 5. Money

What is money?

Def.: Money
Money is anything (stock of financial assets) that is widely
accepted in exchange for goods and services

a) Functions of Money

(1) Story of Value

 eliminate necessity for "double-coincidence of wants
(2) Unit of Account
 preserve purchasing power over time
(3) Medium of Exchange
 eliminate need for multiple prices

b) Types of Money

a) Commodity Money
► Intrinsic Value

□ Barley
□ Shells
□ Gold/Silver

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b) Commodity Backed Money
► Value backed up by commodity

□ Gold Coins
□ Paper Money (backed by gold)
□ Cheques

Italy:
► Money changers (banco)
England:
► Gold smiths develop into
banks

c) Fiat Money
► Value backed by central authority

□ Currency (Notes and coins)

□ Chequing and demand deposits
□ Debit Cards
□ eBanking

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d) Cryptocurrency?

□ Could it be money?
 widely used
□ Is it "good" money?
(1) Unit of Account
(2) Medium of Exchange
(3) Store of Value

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