Chapter 7

Inflation

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 What Is This Chapter All About?

This chapter will introduction you to inflation, the second of the two
major macroeconomic problems we can face.
The core problems are:
• What kind of price increases are referred to as inflation?
• Who is hurt (or helped) by inflation?
• What is an appropriate goal for price stability?

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 Learning Objectives

After this chapter, you should know:

LO7-1 How inflation is measured.
LO7-2 Why inflation is a socioeconomic problem.
LO7-3 The meaning of “price stability.”
LO7-4 The broad causes of inflation.

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 What Is Inflation?

Inflation is an increase in the average level of prices, not a change

in any specific price of a good.
The prices of a specific market basket of goods are collected and computed
into an average price level for that basket in a year.
• A rise in that average price level is inflation.
• A decrease in that average price level is deflation.

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 Relative Prices vs. the Price Level

The market mechanism causes the prices of individual goods and

services to rise or fall – an essential market function.
Relative price is the price of one good compared to the price of
other goods.
• Buyers switch from one good to another when their relative prices change.
Inflation is a rise in the average price level of all goods.
• It is systematic, not a market function.

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 Table 7.1 Prices That Have Fallen
Item Early Price 2020 Price

Long-distance telephone call (per minute)

Table divided into 3 columns summarizes$prices6.90 (1915)
that $
have fallen. 0.02
The
Pocket electronic calculator 200.00 (1972) 1.99
column headers are marked from left to right as: Item, early price,
Digital watch 2,000.00 (1972) 1.99
and 2020 price.
Pantyhose 2.16 (1967) 1.29
Ballpoint pen 0.89 (1965) 0.29
DVD player 800.00 (1997) 19.99
Laptop computer 3,500.00 (1986) 149.99
Airfare (New York-Paris) 490.00 (1958) 277.00
Microwave oven 400.00 (1972) 35.00
Contact lenses 275.00 (1972) 15.79
Television (19-inch, color) 469.00 (1980) 59.99
Compact disk player 1,000.00 (1985) 14.99
Digital camera 748.00 (1994) 15.95
Digital music player (MP3) 399.00 (2001) 22.99
Cell phone 3,595.00 (1983) 9.99
Smartphone 400.00 (1999) 39.99
E-reader 398.00 (2007) 19.99

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 Redistributive Effects of Inflation 1

The distinction between relative and average prices determine

who’s hurt and who’s helped by inflation.
There are: price effects, income effects, and wealth effects.

Price effect: If prices rise, individuals can't buy as many goods and
services and are worse off.
• Might increase the buying of goods with a lower relative price instead.

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 Redistributive Effects of Inflation 2

Price Effects
• Those who buy products that are increasing in price the fastest end up worse
off.
• Those who sell products that are increasing in price the fastest end up better
off.
• Those who buy products that are increasing in price the slowest end up
better off.
• Those who sell products that are increasing in price the slowest end up
worse off.

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 Redistributive Effects of Inflation 3

Suppose you have $8,000 per year for schooling and housing and
books are $3,200.
• If tuition is $4,000, then you have $800 to spend on everything else.
• If tuition increases to $4,500, then you only have $300 to spend on
everything else.
• The $500 reduction to spend on everything else is a real income loss, even
though your nominal income is still $8,000.

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 Redistributive Effects of Inflation 4

The impact of inflation can be seen by the difference between

nominal income and real income.
Nominal income is the amount of income received in a given time
period, measured in current dollars.
Real income is the income in constant dollars; nominal income
adjusted for inflation.
• You may get a raise (nominal income increases) – but if it does not rise as
fast as inflation, your purchasing power decreases (real income falls).

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 Redistributive Effects of Inflation 5

Income Effect
There is a redistribution of income and wealth due to inflation.
Inflation makes some people worse off and others better off.
• Individuals with fixed incomes or fixed wages suffer real income losses when price levels
rise and are worse off.
• Some people's nominal income rises faster than average price levels and they are better
off.

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 Table 7.2 Price Changes in 2019

Access the text alternative for slide images.

Source: U.S. Bureau of Labor Statistics

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 Figure 7.1 Nominal Wages and Prices
If prices are rising, incomes must be rising too.

Access the text alternative for slide images.

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 Redistributive Effects of Inflation 6

Wealth Effect
• Those who own assets that are declining in real value end up worse off.
• Those who own assets that are increasing in real value end up better off.

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 Redistributive Effects of Inflation 7

Redistributions: The redistributive mechanics of inflation include:

• Price effects: People who buy products that are increasing in price the
fastest end up worse off.
• Income effects: People whose nominal incomes rise more slowly than the
rate of inflation end up worse off.
• Wealth effects: People who own assets that are declining in real value end
up worse off.
Inflation acts like a tax, taking income or wealth from one group
and giving it to another.

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 Redistributive Effects of Inflation 8

Social tensions are created as a result of the redistributive effects

of inflation.
• Tensions between labor and management.
• Tensions between government and the people.
There is a significant 'real cost' of inflation is what it does to
morale.

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 Redistributive Effects of Inflation 9

Individuals may have money illusion as the use nominal dollars

rather than real dollars to gauge changes in one’s income or wealth.
In the “good old days” a movie ticket was $5 and a textbook was $20.
• One must compare incomes to understand whether purchasing power has changed.

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 Exercise in Money Illusion

The inflation rate in 1980 was 13.5%.

In 1979 your income was $10,000.
In 1980 your income was $11,000.
Did your purchasing power increase? Decrease? Stay the same?
• Decrease!
• Your income went up 10% while prices went up 13.5%.

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 Macro Consequences
Inflation has macroeconomic effects as well.
• Uncertainty – not knowing the prices of goods in the future makes
purchasing and production decision making much more difficult.
• Speculation – decisions will shift from standard economic activity to betting
on the future prices of goods which can fuel hyperinflation (inflation rates in
excess of 200% lasting at least one year).
• Bracket creep – in a progressive tax system, when nominal incomes rise,
the taxpayer gets pushed into a higher tax bracket.
• Deflation dangers – this has redistribution effects that are the opposite of
those for inflation. Declining price levels deflate incomes and assets and
decrease consumer confidence.

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 Hyperinflation
When inflation is in excess of 200 percent per year, then the
economy may enter hyperinflation.
• Spending accelerates and production declines.

Tsvangirayi Mukwazhi/AP Images

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 Measuring Inflation

Measuring inflation serves two purposes:

• Gauges the average rate of inflation.
• Identifies its principal victims.

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 Consumer Price Index (CPI) 1

The most common measure of inflation is the Consumer Price

Index (CPI).
• A measure of the average price of consumer goods and services.
• Used to calculate the inflation rate.
• The inflation rate is an increase in the percentage rate of the average price
level.

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 Consumer Price Index (CPI) 2

Creating a Price Index

• The market basket of goods: a standardized list of goods and services a
typical consumer buys.
• Select a base year: the reference year whose dollar value will be used.
• Set the price index in the base year equal to 100.
• Measure the prices for the basket of goods in both the current year and in the
base year.

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 Figure 7.2 The Market Basket

This diagram shows

how the typical
urban consumer
spends each dollar.

Access the text alternative for slide images.

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 Computing a Price Index

The CPI can be computed using basket prices between the base
year and another year.
• Basket price in the base year = $12,000.
• Basket price in the current year = $13,200.
• Compute the price index (CPI) for the current year:

• A CPI of 110 indicates that prices in the current year are 10% higher than
prices in the base year.

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 Computing Inflation Rate from CPI

CPI in 2006 was 201.6.

CPI in 2005 was 195.3.
Compute the inflation rate for 2006:
• Inflation rate =

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 Other Measures of Inflation

• Core inflation rate: changes in CPI, excluding food and energy

prices, which are volatile.
• Producer price index (PPI): changes in the average prices at
intermediate steps of production.
• GDP deflator: changes in prices of all goods and services
included in GDP. Used to adjust nominal GDP to real GDP.

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 The Goal: Price Stability 1

Price stability is a major goal of economic policy.

• It is the absence of significant changes in the average price level.
• Officially defined as a rate of inflation less than 3 percent.
• There might be a trade-off between inflation and unemployment.
• A little inflation might be the “price” paid to keep unemployment rates from
rising.

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 The Goal: Price Stability 2

The second argument for setting our price stability goal above zero
inflation relates to our measurement capabilities.
From year to year, there are quality improvements in the basket of goods.
• CPI overstates inflation because quality improvements are undervalued.

New products change the content of the basket of goods we buy.

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 Figure 7.3 Annual Inflation Rates

The highest and lowest annual inflation in the past 60 years are
identified as A and B in the time series.
Access the text alternative for slide images.

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 Causes of Inflation

Changes in the price level are caused by changes in demand or

supply.
Demand-pull inflation results from excessive pressure to buy on the
demand side of the economy.
• A booming economy creates shortages.
• Too much money pumped into the economy by the Federal Reserve.

Cost-push inflation results from higher production costs putting pressure on

suppliers to push up prices.

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 Protective Mechanisms 1

There are some mechanisms to reduce the consequences of

inflation.
Cost of living adjustment (COLA) are automatic adjustments of nominal
income to the rate of inflation.
• COLA protects real income from inflation.

Adjustable-rate mortgage (ARM) is a mortgage (home loan) that adjusts

the nominal interest rate to changing rates of inflation.
• ARMs protect lenders so they do not lose money.

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 Decisions For Tomorrow
Is a Little Inflation a Good Thing?

A little inflation might be a good thing.

After the Great Recession, inflation fell to zero.
Individuals were still reluctant to borrow and spend.
Rising prices expectations can encourage spending.
The challenge for tomorrow is to find the optimal rate of inflation.
• High enough to encourage more spending.
• Low enough to not worry about inflationary flashpoint.
• Inflationary flashpoint: the rate of output at which inflationary pressures intensify.

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 Protective Mechanisms 2

Real interest rate: Using the inflation rate, borrowers and lenders
can estimate the real cost of borrowing. 
• Borrowers pay nominal interest to lenders.
• By subtracting inflation, the real interest rate is defined that is inflation-
adjusted.

Real interest rate = Nominal interest rate − Anticipated rate of inflation

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