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econ 105 > Chapter 12: Inflation & Money > Flashcards

Chapter 12: Inflation & Money Flashcards

1
Q

what is inflation

A
  • a generalized rise in the overall level of prices
  • a rise in the cost of living
  • a decline in the purchasing power of money
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2
Q

what is the Consumer Price Index (CPI)

A

it is a measure of the average prices people pay overt time for the goods and services they buy in their everyday lives

this index tracks the average prices consumers pay over time for a representative basket

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3
Q

what is inflation rate

A

it is how much the CPI changes on average.

It is the percent change in the price of a fixed basket of goods

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4
Q

how do you calculate inflation rate

A

inflation rate = (price level this year - price level last year) / price level last year * 100

or

inflation rate = 100 * (change in price level CPI/ starting price level CPI)

you can calculate inflation rate using any price index, including the GDP deflator

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5
Q

say inflation was 2%,

it can be interpreted 3 ways. what are they

A
  • prices are 2% higher on avg
  • the cost of living is 2% higher
  • a dollar buys 2% less
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6
Q

what are the 4 steps in constructing the consumer price index and measuring inflation

A
  1. find out what people buy (via surveys and construct a basket)
  2. collect prices from the stores where people do their shopping
  3. Tally up the prices of the basket
    4.calculate inflation rate as the percentage change in the price of the basket
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7
Q

true or false: the CPI puts equal weights on the products, regardless of how much of one you purchase

A

false: CPI puts more weight on products you buy more of.

ex. if you buy 5x as much coffee as tea then the basket included 5x as much coffee than tea

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8
Q

define deflation

A

generalized decrease in the overall price level

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9
Q

what problem comes from deflation

A

people will stop buying

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10
Q

what is substitution bias and how does it affect CPI measures

A

it is the overstating of inflation due to people substituting their basket of goods for goods whose price rise by less.

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11
Q

The CPI has sub-indices

such as
- all items
- all items except food and energy (“core” CPI / “core” inflation)
- Median price change (rather than average)

define them

A

all items: it is a broad measure which best captures how inflation is experienced by Canadian households.

core CPI: when you set aside temporary fluctuations and reveal the underlying inflation trend. food and energy markets are volatile, leaving them out may give a clearer picture into trends

Median price change: it tracks the 50th percentile of price changes withing the CPI basket. Median is less sensitive to outliers, leaving them out may reduce the effects of the substitution bias.

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12
Q

what is indexation

A

it automatically adjusts policies/wages/taxes etc to keep up with rising cost of living

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13
Q

what is the producer price index (PPI)

A

measures the price of inputs in the production process

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14
Q

what is the GDP deflator

A

an alternative price index that represents changes in the market price of a country’s output

like CPI is is always 100 in the base year

can be used to convert nominal GDP into Real GDP

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15
Q

how do you calculate the GDP deflator

A

GDP deflator = nominal GDP / Real GDP * 100

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16
Q

how do you use the CPI to convert dollar amounts in year s to its equivalent in year t

A

value in year t = value in year s * CPI(t) / CPI(s)

17
Q

what is a nominal variable

A

it is measured in dollars whose values may fluctuate, either due to changing quantities or inflation

18
Q

what is a real variable

A

a variable that has been adjusted for the influence of inflation

19
Q

what is nominal interest rate

A

interest rate without a correction for the effects of inflation

20
Q

what is real interest rate

A

measures interest rate in terms of changes in purchasing power

21
Q

what is money illusion

A

the mistaken tendency to focus on nominal dollar amounts (leads you to be fooled by inflation)

22
Q

what are the 3 consequences of money illusion

A
  1. can distort decision
  2. can lead to mis pricing
  3. creates nominal wage rigidity
23
Q

what are the 3 functions of money

A
  1. is a medium of exchange
  2. is a unit of account
  3. money is a store of value
24
Q

how does inflation affect the functions of money

A

high, unstable, unpredictable inflation undermines the benefits of money

25
Q

what is hyperinflation

A

extremely high rates of inflation. it erodes the 3 functions of money

26
Q

what is the costs of expected inflation

A
  1. menu costs for sellers (costs of adjusting prices)
  2. shoe-leather costs for buyers (people hold less money, and tend to keep money in assets that maintain value better), it is the costs taken to avoid holding money
27
Q

what is the costs of unexpected inflations

A
  1. confuses the signals prices send
  2. inflation redistributes (inflation higher than normal is good for borrowers and bad for lenders, and vice versa) (increased risk)
28
Q

what is the inflation fallacy

A

the mistaken belief that inflation destroys purchasing power, wages rise too

29
Q

how do you calculate real interest rate

A

real interest rate = nominal interest rate - inflation rate

30
Q

what are 3 reasons inflation overstates the cost of living

A
  • unmeasures quality improvments
  • new products
  • substitution bias
31
Q

how do you calculate CPI

A

CPI = 100 * (cost of basket in other year / cost of basket in base year)

note: CPI is unitless, not a percent or anything else

32
Q

what are the 3 steps to calculate the CPI

A
  1. choose a market basket and base year
  2. calculate the cost of the basket each year
  3. apply the CPI formula on each year against the base year
33
Q

true or false: the CPI is always 100 in the base year

A

true

34
Q

you can convert nominal variables into real variables by applying the inflation adjustment formulas

you can find
1. Today’s dollars
2. Percent change in real value
3. real interest rate

what are the formulas for the above 3

A
  1. Today’s Dollar = Another time’s dollar * (price level today / price level in another time)
  2. Percent change in real value = percent change in nominal value - percent change in prices
  3. Real interest rate = nominal interest rate - inflation rate
35
Q

true or false: inflation rate does not depend on our choice of base year

A

true, inflation is the same since it is measuring the difference

36
Q

define the quantity theory of money as a theory of the cause of inflation

A

the theory states that: inflation is caused by the supply of money is growing faster than the supply of things to buy

inflation rate = money growth rate - GDP growth rate

this theory is useful for predicting inflation over long time periods, not useful for predicting short time periods

econ 105 (7 decks)

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