Inflation and the Price Level

Inflation and the Price Level

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Inflation

● Definitions:• Inflation

is a rise in the price level.• Pure inflation

where the prices of goods (output) andinputs rise at the same rate.

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Measuring the Price Level(Consumer Price Index)

● Definition: The consumer price index (CPI) for any

period measures the cost in that period of a standardset, or basket, of goods and services relative to thecost of the same basket of goods and services in afixed year, called the base year (Frank& Bernake,2009, 454). This index represents the basic tool formeasuring inflation. CPI is a measure of the cost ofliving during a particular period.

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● Question: How can the Consumer Price Index

(CPI) be constructed?

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● The CPI is not itself the price of a specificgood or service as it has no units ofmeasurement at all.

● It is a measure of the average price of a givenclass of goods or services relative to the priceof the same goods and services in a base year.

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Inflation

● While the CPI provides a measure of the average level of prices relative to prices in the base year, inflation is a measure of how fast the average price level is changing over time.

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Inflation

● Definition: The rate of inflation (inflation rate) is

defined as the annual percentage rate of changein the price level.

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Inflation Rate

● Inflation rate = nominal money growth-real

money demand growth

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Inflation

● The negative inflation rate: It is called deflation

where the prices of most goods and servicesare falling over time.

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Inflation

● Definitions:1- Nominal quantity: a quantity that is measured in

terms of its current dollar value.2- Real quantity: a quantity that is measured in

physical terms (in terms of quantities of goodsand services).

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Inflation

● Adjusting for Inflation: the deflating process is

used by dividing a nominal quantity by a priceindex to express the quantity in real terms.

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Inflation

● Definition: real wage is the wage paid to

workers measured in terms of purchasingpower.

Real wage = nominal wage/CPI

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Inflation

● The True Costs of Inflation:● Definitions:

1- Price level is a measure of the overall level of prices at

a particular point in time as measured by a priceindex such as the CPI.

2- Relative price is the price of a specific good or service in

comparison to the prices of other goods and services.0


Inflation● Note that the changes in the price level and changes

in relative prices of specific goods are two quitedifferent issues.

● The true costs of inflation include “noise” in the pricesystem; distortions of the tax system; “shoe-leather”costs, which are the real resources that are wasted aspeople try to economise on cash holdings; unexpectedredistribution of wealth; and interference with long-run planning.

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Inflation

● Definition Hyperinflation is a situation in which

the inflation rate is extremely high.For example: inflation was 102,000,000 percent

in Germany in 1923. “Imagine the situation”

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Inflation

Economic theory suggests that high

inflation rates, especially those associated withhyperinflation, reduce economic efficiency andgrowth.

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Inflation● Inflation and the Interest Rates

Definitions:1- Real interest rate is the annual percentage increase in the purchasing power of

a financial asset. r = i – π Where,r = the real interest rate,i = the nominal, or market, interest rate,π= the inflation rate.Note that the real interest rate is not equal to the nominal interest rate divided

by the price level as the nominal rate is a rate of return which is measuredin percent, not a nominal quantity measured in dollars.

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Inflation

2- Nominal interest rate (or market interest rate) is the annual percentage increase in the

nominal value of a financial asset.3- inflation-protected bonds are bonds that pay a

nominal interest rate each year equal to a fixedreal rate plus the actual rate of inflation duringthat year. They pay a fixed real interest rate.

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Inflation

4- Fisher effect is the tendency for nominal

interest rates to be high when inflation is highand vice versa.

i.e. higher inflation leads to similarly highernominal interest rates.

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Inflation and the Price Level

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