inflation Flashcards
what is economics?
economics is the study of the optimal use of limited resources in production and consumption
what is inflation?
inflation is a generalized rise in the overall level of prices
also the decline in the purchasing power of money
what is CPI?
the consumer price index (CPI) is an index that tracks the average price consumers pay over time for a representative basket of goods and services
what is the formula for inflation rate?
inflation rate = ( (price this year - price last year)/ price last year ) x 100
how is CPI constructed?
step one: find out what people typically buy
step two: collect prices from the stores where people do their shopping
step three: tally up the price of the basket of goods and services
step four: calculate the inflation rate based off the weighting
what are some challenges with measurement of CPI?
- basket doesn’t apply to everyone
- government may not accurately collect price data
- quality improvements can hide price decreases (better products last longer)
- new products can make you better off, reducing your cost of living ( CPI only tracks the changing prices of existing goods - doesn’t account for the reduction in the cost of living due to the introduction of new products )
- you can save yourself money without sacrificing much (substitution bias)
what is substitution bias?
the overstating of inflation occurs because people substitute towards goods whose prices rise by less
what are the inflation measures (consumer) ?
1) CPI
2) personal consumption expenditure deflator
3) core inflation
what is CPI used to measure?
measure the change in the cost of living
automatically adjusting wages, benefits, tax brackets, and the like to compensate for inflation is called indexation
what is the personal consumption expenditure deflator used for?
used for monetary policy
the federal reserve sets its inflation target using the personal consumption expenditure (PCE) deflator
uses a slightly different basket of goods and services compared to the CPI
what core inflation used for?
for forecasters who look for underlying trends in inflation
what is core CPI?
everything except food and energy
what is the formula for calculating CPI?
CPI (t) = (ptq0)/ (p0q0) x 100
quantity always stays the same
what is the CPI for a base year?
always equal to 100
what are the inflation measures for businesses?
1) Producer price index (PPI): a price index that tracks the price of inputs into the production process
2) GDP deflator: a price index that tracks the price of all goods and services produced domestically
what is the formula for GDP deflator?
GDP deflator = nominal GDP/ real GDP x 100
what is the inflation adjustment formula?
another time’s nominal dollars x (price level today / price level over time)
what is a nominal variable?
a variable measured in dollars
what is a real variable?
a variable that has been adjusted to account for inflation
what is the nominal interest rate?
the stated interest rate without a correction for the effects of inflation
what is the real interest rate?
the interest rate in terms of changes in your purchasing power
how do you calculate real interest rate?
real rate = nominal rate - inflation rate
what is money illusion?
the (mistaken) tendency to focus on nominal dollar amounts instead of inflation-adjusted amounts
what are some issues that arise from money illusion?
1) distorting prices
2) leads to mispricing
3) creates nominal wage rigidity
what is nominal wage rigidity?
the reluctance to cut nominal wages
what is money?
any asset regularly used in transactions
what are the three functions of money?
1) medium of exchange
2) unit of account
3) store of value
what is hyperinflation?
hyperinflation is an extremely high rate of inflation
makes most aspects of life harder and erodes all the functions and value of money
what are the costs of expected inflation?
1) Menu costs: (businesses have to change prices regularly, which is costly)
2) shoe leather costs: the costs incurred trying to avoid holding cash.
Arise because inflation undermines money’s function as a store of value
what are costs of unexpected inflation?
1) confusing signals that the prices send
2) redistributing income - refers to loans
what is the inflation fallacy?
the mistaken belief that inflation destroys purchasing power
The purchasing power stays the same because the wage also increases. Therefore, the opportunity cost of buying each item doesn’t change.
There is no change in the real variables
