Price level

Petr Wawrosz

What is price level

• Theoretical concept expressing all prices in economics

• Aggregate indicators of all prices in economy• We are not able to measure (to identify) all

prices in economy (prices of all goods, final and capital goods)

• However we need to know what happens with prices on the aggregate level.

CPI

• Price level is expressed (measured) by CPI• Consumer price index• Basket of selected goods – mostly consumed by

household• Weight mean of the price• Weight = the share of spending for one good (in

the basket) on the total amount of the spending• The indicator without unit of measurement.

Equation of CPI:

• Explanation of the symbol:• p = price, q = quantity• 1 =symbol for the current period, 0 = symbol for the basic period• i = symbol for specific good (first good e.g. sandwich, second one

e.g. beer, third one e.g. sending sms)• = change of the price of i good between current and basic period

• = sum of the weights of all goods

The problems with CPI

• Stable weight • No new goods• No change of quality of the good

Inflation

• = growth of the price level• = the value of the price level in the next (further)

period is higher than the value of the price level in former period.

• If we expect that price level is expressed by CPI:

• Inflation is usually measured in percentage (the equation is multiplied by 100)

Change of inflation

• If price level change about 5 % between period 1 and 2 and also between period 2 and 3, the value of the inflation become same = stable inflation.

• If price level change about 5 % between period 1 and 2 and e.g. A bout 8 % between period 2 and 3 we speak about acceleration of inflation.

• If price level change about 5 % between period 1 and 2 and e.g. about 2 % between period 2 and 3 we speak about deceleration of inflation or about disinflation.

• Negative change of price level calls deflation.

Nominal and real interest rate

• i = nominal interest rate (including inflation)• r = real interest rate (without inflation)

• (1 + i) = (1 + r) * (1 + π)

• For small value of i, r, π it is valid:r ≈ i – π, ≈ symbol for approximate equity

The main reason of inflation

• The growth of the amount of the money in economy.

• The amount of money grows quickly (higher) than amount of produced goods.

• If amount of goods and amount of money growth in same rate -> usually no inflation.

• Attention! V = velocity of money: how often the unit of money is used in defined period of timeIf V changes (increases) than situation of same growth rate of money and goods leads to inflation.

The consequences of inflation

The loss of purchasing power of money

• Money loses its value. • The purchasing power of money is the volume

of things that we can buy for a unit of money.• Purchasing power of money is the inverse

function of the price level.

• or

Menu cost

• = cost connecting with necessity of changing price• = prices do not fulfill their role (inflations distorts the

information delivered by prices) to inform about relative scarcity and utility of each good or factor of production in comparison with other good or factor of production

• Inefficient allocation• Confusion and inconvenience• People bears (takes) higher risk. • Shoelaether costs

Redistribution of wealth

• In favor of people who anticipate the right level of inflation and not in favor of people who do not anticipate the right level.

• Anticipated and anticipated inflation• Adaptive and rational expectations

Tax distortion

• Taxes on nominal measurement.• Examples:

- progressive taxes on income- taxes on nominal income

Deflation

• Credit-freeze• In deflation people are not willing to borrow money

– they face high real interest rate and the are not able to pay the interests. -> reduction of investments, shrink of capital goods, negative impact on production.

• People postpone their purchases – they are waiting for another fall of prices -> firms reduce their production.

The best solution?

• Small positive inflation (about 2 % p.a.)• People are forced to care about their money.• If one firms is in trouble it does not increase

wages of its employee.• No-increase of wages in the situation of small

inflation is more acceptable than shrink of wages.