$ Inflation = an increase in the average price level

$ When there is a lot of money in the economy, each dollar buys you less

$ Your purchasing power is reduced – value of money decreased$ Problem: Prices rise faster than income and

standard of living declines

$ Deflation = a decrease in the average price level

$ Associated with recession

$ Your purchasing power has increased – value of money increased

$ Hyperinflation = extremely high rate of inflation (100%+ per year)

$ Consumers and producers do not know the value of prices

$ Historical Example…

1918 = 0.63 marks

1922 = 163 marks

1/1923 = 250 marks

7/1923 = 3465 marks

9/1923 = 1,512,000 marks

11/1923 = 201,000,000,000 marks

Inflation = 5,470%

(Left) Public domain photograph accessed at <http://www.nationmaster.com/encyclopedia/Hyperinflation> (3 April 2006).(Above Left) Public domain photograph from "Notgeld" entry on www.wikipedia.com.

(Above) Facing History and Ourselves, "Inflated Weimar Currency, 1923," The Weimar Republic: The Fragility of Democracy, accessed at <http://www.facinghistorycampus.org/campus/weimar.nsf> (3 April 2006).

• How do we measure the price level?–By index numbers

• Series of numbers, each one representing a different period–A relative measure: one period’s index number can be

compared with another’s at a glance.

$ Measure how much prices have risen over time

$ Find a market basket of goods and services

$ Price Index:

Price of Market Basket in the Current Year x 100

Price of Market Basket in the Base Year

*Base Year Index will be equal to 100*

$ Number used to measure change

$ Compare the price of a basket of goods in the current year versus the base year$ Market Basket contains

400 goods and services

$ What a typical urban family purchases

$ Every month the BLS surveys prices around the country for a basket of products

$ By itself that does not tell us what the current Inflation rate is$ We must do some

calculations using that index to tell us the Percentage of increase or decrease in the level of prices.

• In order to calculate the percent of inflation or deflation we have to use the Consumer Price Index as a  starting point.

• So assuming You wanted to calculate the inflation rate from July 2000 until July 2008.– You need to know the CPI for the starting and

ending dates.  So the CPI index in July 2000 is 172.8 and the CPI index is 219.964 in July 2008. (Note a three decimal place accuracy in between).

Current Year’s CPI – Base Year’s CPI

Base Year’s CPI

* % change in price level from one year to the next*

x 100

• The formula is: (current-base)/base• (219.964-172.8)/172.8 =

47.164/172.8= .2729• Now that has to be converted to a percent so we

multiply it by 100 to get 27.29% inflation.• Normally, the inflation rate is calculated on an

annual basis for example from July 2007 until July 2008.  That will give you the amount of inflation in one year.  Which is typically called "The Inflation Rate".

$ Index that measures average change in the selling prices received by domestic producers of goods and services overtime$ If the prices of these goods rise, the cost to

firms of producing final goods and services will rise, which may lead firms to increase the prices of goods and services purchased by consumers

$ Real vs. Nominal GDP

$ Nominal GDP – values output using current prices. It is not corrected for inflation.

$ Real GDP – values output using the prices of a base year. It is corrected for inflation.

• Deflator is an adjustment so that we know how much total output would have risen if there were no inflation (if price level remained constant)

GDP Deflator = Nominal GDP x 100

Real GDP

1. Substitution bias– Change in prices affect spending habits– It ignores substitution from a relative price change

2. Quality improvement bias– Price change (increase) is a payment for improved quality not

inflation

3. New product bias– Difficult to figure how much of a price change (increase) is a sign of

an increase in quality – new product on the market

4. Outlet substitution bias– People respond to a price change (increase) by shopping at

discount stores and on-line

• Congressional Advisory Commission on the Price Index

• Boskin Report– CPI overstates inflation by 1.1% per year

(best estimate)

Who does this help?

Income receiver may be

able to avoid or lessen

the adverse effects of

inflation• Debtors• People with flexible

incomes• COLAs • Social Security

Who does this hurt?

Income receiver may

not be able to avoid or

lessen the adverse

effects of inflation• Creditors• People with fixed

incomes• Savers• Pensions