Chapter 8: The Price Level and Inflation
- high inflation can cause the destruction of wealth across an entire economy
How is inflation measured?
- deflation – occurs when overall prices fall; negative inflation
- goals of the Bureau of Labor Statistics (BLS) determines the prices of all the
goods/services a typical consumer buys and identifies how much of a typical consumer’s
budget is spent on these particular items
The Consumer Price Index (CPI)
- consumer price index (CPI) – the measure of the price level based on the consumption
patterns of a typical consumer
- process is to define the basket and assign appropriate weights, determine prices of
goods across periods, and convert to the index number for each period
Measuring Inflation Rates
Using the CPI to Compare Dollar Values over Time
The Accuracy of the CPI
- employers use the CPI to adjust wages for inflation
- concern that the CPI overstates true inflation
1. substitution – less expensive goods that alter weight of goods/services in basket
2. changes in quality – new technologies
3. new goods, services, and locations
- chained CPI – measure of the CPI in which the typical consumer’s basket of
goods/services is updated monthly
What problems does inflation bring?
Shoe-Leather Costs
- shoe-leather costs – the resources that are wasted when people change their behavior to
avoid holding money, e.g. fuel costs and time for multiple trips to the bank
Money Illusion
- money illusion – occurs when people interpret nominal changes in wages or prices as
real changes e.g. going to less movies when they go up (wage also goes up), realistically
nothing changes
- nominal wage – wage expressed in current dollars
- real wage – nominal wage adjusted for changes in the price level, what a worker earns in
terms of purchasing power
Menu Costs
- menu costs – costs of changing prices
Future Price Level Uncertainty
- output – the product the firm creates
- inflation can cripple loan markets because future price levels are hard to know; future
production is limited when firms can’t borrow money or hire long-term workers
Wealth Redistribution
- when inflation is unpredictable, it’s hard to make loans and wealth is redistributed from
the lenders to the borrowers (unexpected inflation) → unexpected deflation does the
opposite
- steady deflation discourages borrowing and consumption, damaging the economy
Price Confusion
- typically rising prices signal firms to increase output and vise versa but with inflation it
can be hard to tell which price changes are only due to inflation and resources are
misdirected in the economy
- firms shouldn’t increase output if price increases are due to inflation, only if it’s a real
increase in demand
Tax Distortions
- capital gains taxes – taxes on the gains realized by selling an asset for more than its
purchase price
- sometime you can look at CPI and see that without inflation there would have
been no tax → less incentive to make these purchases
What is the cause of inflation?
- when a nation’s money supply grows relative to the quantity of real goods/services in the
economy
- inflation and money growth are tied together
The Equation of Exchange
- equation of exchange – specifies the long-run relationship between the money supply,
the price level, real GDP, and velocity of money → M x V = P x Y
- quantity of money in economy (M) x velocity of money (V) = nominal GDP =
real GDP (Y) x price level (P)
- velocity of money – the number of times a unit of money exchanges hands in a given
year
- money is more than paper currency and coins, it can be whatever we use in exchange for
goods/services e.g. flying miles, discount coupons, reward points, cryptocurrency
- also sub growth rates for the equation
Other Causes of Inflation
- Cost-push inflation
- arises as a result of a supply shock
- occurs when these is a rise in the costs of production
- Demand-pull inflation
- caused by an increase in the aggregate for goods and services
The Reasons Why Governments Inflate the Money Supply
- large government debts
- short-term gains – surprise increases in the money supply can temporarily stimulate an
economy toward more rapid growth rates
