Chapter 9 - Inflation Flashcards
Basket of goods and services
Things people buy
Percentage change equation
(Level in new year - level in previous year) / level in previous year
Base year
Starting point from which we measure inflation. Always equal to 100
Index numbers
Have values around 100, are easier for estimating, unit free numbers
Inflation
Overall and ongoing rise in prices in an economy. Not related to change in relative prices or supply and demand changes
Rate of inflation
Percentage change of price levels over time
Consumer price index (CPI)
Prices in a fixed basket of goods and services that represents the purchases of the average family of four
Cost of living
Cost for a person to feel that their consumption provides an equal level of satisfaction or utility
Substitution bias
Inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise by a lot
Two problems with measuring cost of living
Substitution bias and quality/new goods bias
Quality/new goods bias
Inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not take into account improvements in the quality of existing goods or the invention of new goods
8 components of CPI
Food, housing, apparel, transportation, medical care, recreation, education, and others.
Core inflation index
Calculated by taking the CPI and excluding volatile economic variables. Useful for the government, shows underlying trends
Difference between CPI and core inflation index
CPI helps households understand cost of living. Core inflation index helps government make important policy changes
Producer price index (PPI)
Prices paid for supplies and materials by producers of goods and services
International price index
Prices of merchandise that is exported or imported
Employment cost index
Wage inflation in the labor market
GDP deflator
Includes all the components of GDP
Deflation
Negative inflation
Hyperinflation
Extremely high rates of inflation
Typical rate of inflation
2-4%
Three problems with inflation
Unintended redistributions of purchasing power, blurred price signals, and difficulties in long-term planning
Unintended redistributions of purchasing power
Decreases value of cash, investments with nominal returns suffer, wages sometimes don’t keep up, pensions don’t account for inflation
Blurred price signals
Prices are messengers about demand and supply, inflation blurs those signals, can create more of a chance for surpluses or shortages
Problems in long term planning
Have to consider what money can buy in the future when the rate of inflation cannot be known with certainty, businesses can suffer or gain from inflation, hard for businesses to plan further in advance
Indexing
Price, wage, or interest rate is adjusted automatically with inflation
Cost of living adjustments (COLAs)
Guaranteed wages would keep up with inflation in unions
Adjustable rate mortgage (ARM)
Interest rate on loan varies with the rate of inflation
Indexing in government
Moving into higher tax bracket, Social Security payments
