Inflation

Inflation: A rise in the general level of prices 

• reduces the purchasing power of money (each dollar gets you less)
• Does not indicate that all prices are rising

Measuring inflation

via.

Consumer Price Index (CPI)

• compiled by the Bureau of Labor Statistics (BLS)
• reports inflation rates by month and year
• used to adjust gov. policies (social security, tax brackets, etc.)

How does it work?

• "market basket" of 300 goods and services consumed by the average urban citizen in the US 
• Measured against a standard (1982-1984) 
• Index = 100

CPI = most recent market basket / market basket index x 100

Rate of inflation = % growth of CPI from year to year. 

RI = later year CPI - earlier year CPI / earlier year CPI x 100

Types of Inflation

Demand-Pull Inflation

• Too many consumers chasing too few goods (can be normal)
• Excessive spending out of fear of future inflation
• Too few unemployed and wage inflation due to competition

step-by-step scenario

1. Producer's resources are fully employed 
2. Can't meet excess demand by producing more
3. Excess demand then bids-up prices of limited goods 

Demand is "pulling-up" inflation. 

Cost-Push Inflation

• Natural disasters cut supply (supply shocks)
• Political actions like boycotts cut the supply (OPEC 1973, 1979)
• Natural reduction of resources with no new discoveries

step-by-step scenario

1. Rise in per-unit production costs
2. Squeeze profits
3. Firms less willing and able to supply at given prices 
4. goods and services decline 
5. prices rise

costs are "pushing up" inflation

Political Inflation

• Governments printing too much currency to cover debts…
• Central Bank interventions in the economy 

Examples:

• Continental Dollars of the 1770’s and 1780’s
• Germany of the early 1920’s
• Zimbabwe Civil War 2008 to 2011

Effects of Inflation
Redistribution of real income 

Nominal v. Real income 

• Nominal income: number of dollars received (wages, etc.) 
• Real income: measure of the amount of goods and services that can be purchased with nominal income. (purchasing power) 

Real income = nominal income / price index

inflation affects different people's real income differently.

Inflation “Helps”:

• Those who pay back loans at a fixed interest rate

Inflation “Hurts”:

• Those who lend money at a fixed interest rate (banks)
• Those saving money at fixed rate interest rate returns (consumers)
• Those on any long term fixed level of income (retired, disabled)
• Those trying to hire workers and keep costs under control (business, workers)
• Those trying to plan future business projects and project costs (business)

Economic Norms:

• Unemployment = 4 to 5 % (post 1980 in the USA) 
• Inflation = 2 to 3 % per year (“Anticipated Inflation”)

Misery Index = Unemployment and Inflation Rates Together:

• Acceptable Misery: 6 to 8
• Excessive Misery: Any double digit number

Why is Unemployment Bad?

• Not enough Consumption (GDP) 
• Too much poverty...
• Too much government assistance needed.

Why is Unemployment Good?

• More workers available for future expansions. 
• Less pressure to raise wages.

Why is Inflation Bad?

• Loss of real wages 
• Loss of real wealth
• Loss of the value of savings
• Loss of the value of fixed income
• Panic buying
• Loss of the value of currencies
• Loss of the incentive to take financial risks
• Loss of the incentive to hire

Why is Inflation Good?

• If you owe money, you pay back cheaper money

BECAUSE Unemployment hurts the unemployed, but Inflation hurts everyone, always assume that government policies should focus on controlling inflation FIRST.