______________________’ S THEORY OF INFLATION

• What is inflation (CD)?

• What do you think causes inflation (CM)?

• Who does it benefit( CM)?

• Who does it hurt (CM)?

• What types of societal problems could it cause (CM)?

• Can you think of any examples where rising prices created a climate of political or social unrest (CD/CM)?

INFL

ATIO

N

PRICES

JUST

KEEP O

N RISIN

G

HOW MUCH DOES IT COST???????

HOW MUCH DOES IT COST??????

HOW MUCH DOES IT COST???????

HOW MUCH DOES IT COST?????

WHAT IS IT?????????????

Inflation is when prices increase over time

Deflation is when prices decrease over time

1-2% is acceptable

Creeping, Galloping, Hyper are unacceptable

Inflation is measured by Price Indexes

PRICE INDEXES

CPI- The consumer price index. Measures the change in prices of consumer goods in various categories.

PPI- The producer price index. Measures the change in prices of capital goods.

GDP Deflator- The most comprehensive price index a combination of the CPI and the PPI. Measures the change in the price of over 40,000 products.

PRICE INDEXES

Measure the price change in a market basket of goods.

What is in the CPI?FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals,

snacks)

HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

APPAREL (men's shirts and sweaters, women's dresses, jewelry)

TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);

EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

INFLATION SUMMARY VID

http://www.youtube.com/watch?v=SmOMp8gycMA&feature=related

EXAMPLEMarket Basket of Products

Product Base Year Current Year Milk 1.00 3.00 Eggs .75 1.50 Chicken 1.50 2.00 Tooth Paste .75 1.00 Coke .50 1.25 Gas .75 2.50 Bread .50 1.50 Total $ 5.75 12.75 Value 100 (CY / BY)100 =(x)= 221.7 % Inflation 0% x-100= 121.7%

CPI FOR FOOD

CPI FOR MEDICAL CARE

CPI FOR HOUSING

WHAT CAUSES INFLATION?

?

WHAT CAUSES INFLATION??Demand-Pull Inflation

WHAT CAUSES INFLATION??Cost-Push Inflation

HOW WOULD UNEMPLOYMENT AFFECT INFLATION?

DEFICIT SPENDING

-Increases in government debts drives down the value of the dollar (purchasing power)

- If the value of decreases it takes more $’s to purchase the item.

- Monetizing the Debt, aka printing more $’s

- Inflating your way out of debt.

HOW DOES THE MONEY SUPPLY AFFECT PRICE LEVELS?

Excessive Monetary Growth causes Inflation.

- When Money Supply grows faster than GDP

High

Low

INFLATION….GOOD???? BAD????

HELPED BY INFLATION

-Borrowers with fixed payments

-Banks with fixed rate savings accounts

-Government in debt

-Fixed rate contracts

HURT BY INFLATION

-Banks with fixed rate loans

-Borrowers with adjustable rate loans

-People with fixed rate savings accounts

- People living on fixed incomes

PROBLEMS AND APPLICATION

P 544; Problems… #1,#6

WAS BABE RUTH’S SALARY GOOD COMPARED TO TODAY’S PLAYERS?Babe’s 1931 salary - $81,000

CPI 1931 – 15.2

CPI 2005 – 195

Amount in today’s $’s = (P level today/P level in year T) * 81,000

GRAPHING PRACTICE

Show the following on an aggregate demand (AD) aggregate supply (AS)

• What is the effect on price levels and GDP if personal income taxes are increased? • Same for a decrease?• Could the government use tax rates to influence the economy?• What is the effect on price levels and GDP if energy costs increase?

Show the following on a money market graph:What does an increase in the money supply do to nominal interest rate and price levels? What is the likely affect on the economy?