Inflation: a general increase in the prices of goods and services in an entire economy over time.

*Note* If for instance Canada’s has an annual inflation rate of 3%, this doesn’t mean that all prices are rising. Some prices are rising, others remain constant, while still others may be falling The overall rise in prices is 3%

Deflation: a general decrease in the level of prices and income

Hyperinflation: a situation in which prices increase rapidly and inflation is out of control (e.g. prices doubling/tripling within a month)

9.1 Inflation

Consumer Price Index: A measure of price changes for a typical basket of consumer products

Stats Canada surveys typical Canadian households’ buying habits every few years so that it can determine what they buy

The Consumer Price Index

Consumer Price Index (CPI)

Item Weights: the proportions of each good in the total cost of the basket of consumer goods used to calculate CPI

Base Year: the survey year used as a point of comparison in subsequent years

Consumer Price Index (CPI)

Consumer Price Index Weights

CPI helps consumers determine the cost of living CPI also help people judge how much better/worse off

they are as a result of inflation – need nominal and real income amounts

Nominal Income: income expressed in current dollars Real Income: income expressed in constant base-year

dollars

For a consumer’s purchasing power to keep up with inflation, their income has to increase by the same percentage as the increase in price.

Nominal versus Real Income

Consumer Differences One consumer might buy a lot of books, while another

doesn’t, so CPI takes the average of every person, making it appear like every person likes to read a bit

Changes in Spending Patterns When an object’s price falls (e.g. cell phones in the

2000’s) consumers will likely choose to buy more

Product Quality & New Products Index cannot reflect changes in

quality or introduction of new products

Limitations of the CPI

GDP Deflator – another indicator of price changes, but measures changes in all goods and services

CPI simply looks at a small number of consumer items

The GDP Deflator

Nominal GDP: Gross Domestic Product expressed in current dollars

Nominal vs Real GDP

High inflation rates is a serious problem – it redistributes purchasing power among different groups that can be: Economically harmful Unjust

Households also increase nominal income when inflation occurs If percentage of inflation is greater than that of nominal

income, then that household’s purchasing power declines

If nominal income rises faster than inflation, then a household can actually benefit from inflation

Inflation’s Effects

The Inflation Rate

Deflation

Cost-of-living-adjustment clauses: provisions for income adjustments to accommodate change in price levels, which are included in wage contracts

Fully Indexed Incomes: nominal incomes that automatically increase by the rate of inflation

Partially Indexed Incomes: these people lose the most from inflation, as only a portion of their income rises

Fixed Incomes: nominal incomes that remain fixed at some dollar amount regardless of the rate of inflation

Incomes

If a lender lends funds at an interest rate that is not adjusted for inflation, the lender may lose out Interest rate is “prime plus 1%” – prime can always

change – right now, “prime” = 3% This is the inflation premium

Nominal Interest Rate: interest rate expressed in money terms

Real Interest Rate: the nominal interest rate minus the rate of inflation

Borrowing & Lending