Week 15 - Inflation Flashcards
Price index
Measures the average price of a given quantity of goods or services relative to the price of the same goods in a base year.
Consumer price index (CPI)
A measure of the cost of living over a specified time period.
It measures the cost of a standard basket of goods in a given year relative to the cost of the same basket of goods and services in the base year.
Calculating CPI
Find CPI by finding the ratio of the cost of the current year’s standard basket of goods to the cost of the base year.
CPI = currentYear/baseYear * 100
Consumer expenditure survey
The method of data collection for the data used to calculate CPI.
Meanings of CPI values
If CPI = 100, prices have remained the same as in the base year.
If CPI > 100, prices have increased (inflation).
If CPI < 100, prices have decreased (deflation).
Inflation
Measures how fast average price levels are changing over time.
A normal level of inflation is around 2-3%.
Rate of inflation
The annual percentage rate of change in the price level.
Deflation
A situation in which most goods or services are falling over time - inflation is negative.
Nominal and real quantities
Nominal quantity: measured in terms of its current dollar value.
Real quantity: measured in physical terms quantities of goods and services.
Real quantities are used to compare values over time as they hold price constant meaning the quantity is not affected by inflation.
Real quantity is found by dividing a nominal quantity by its price index.
Real wage
The wage paid to the worker measured in terms of purchasing power.
The real wage for a time period is found by diving nominal wage by CPI for that time period.
Indexing
Increasing a nominal quantity each period by the percentage increase in a specified price index.
This allows for some values to be automatically adjusted by the amount of inflation. E.g., social security payments or labour contracts.
Indexing prevents the purchasing power of the nominal quantity being eroded by inflation.
Minimum wage
The minimum amount workers are legally allowed to be paid.
This is set by congress in nominal terms however it is argued that changing minimum wage by indexing could be simpler and less controversial.
It is agreed that increasing minimum wage can lead to inflation however some argue that small increases does not cause inflation while others argue any increase in minimum wage leads to inflation.
Tight labour markets
A situation where there are low levels of unemployment and also high levels of job vacancies.
Tight labour market is a sign of a strong economy but, if left unchecked, it can lead to higher inflation and potential wage-inflationary spirals.
How can tight labour markets lead to inflation
In tight labour markets, employers must compete for workers, often through higher salaries.
Higher salaries in tight labour markets increases disposable income which increases demand, putting upward pressure on prices, leading to inflation.
CPI limitations
- Hard to add new items - new items do not exist in the base year so cannot be compared.
- CPI may overstate cost of living because it is based on a fixed basket of goods and services.
- Quality bias: It is hard to measure changes in the quality of products with CPI as there are many goods and quality change can be subjective.
- Substitution bias: When prices go up, people can substitute on good for another. Failing to account for substitution in CPI calculations can cause inflation to be overstated.
GDP price deflator
Measures the changes in prices for all of the goods and services produced in an economy.
More comprehensive than CPI as it represents total output of goods and services, not just a fixed basket of goods.
Allows changes in consumption patterns or the introduction of new goods and services to be automatically included.
GDP price inflator captures how much of nominal GDP increase is due to price changes and how much is increases of quantity of goods/services produced.
GDP price deflator formula
GDP price deflator = Nominal GDP/ Real GDP * 100
Price level
A measure of the overall level of prices at a particular point in time as measured by a price index such as the CPI.
Relative price
The price of a specific good or service in comparison to the prices of other goods and services.
E.g., if inflation rate is 2% but light bulbs increase by 1%, there has been a 1% relative decrease in relative price of light bulbs.
Increasing relative price encourages consumers to save money on expensive products and search for their substitutes.
Increasing relative price encourages companies try to bring more products to the market to gain profit.
Bracket creep
Bracket creep: non indexed taxes create distortions in tax incentives because as inflation rises, taxpayers may end up paying higher taxes from increased nominal income even if their real income has not increased. This can reduce incentives for people to work, save, and invest.
Lower savings and investment from bracket creep decreases economic growth.
Effect of inflation on cost of cash
When inflation is high, cash loses its value over time. This means people are likely to make more frequent, smaller transactions to get cash at the highest value.
The more frequent trips cost consumers on time and travel and costs banks on increased transaction costs.
Effect of inflation on wealth distribution
Unexpected inflation and un-indexed salaries cause salaries to lose purchasing power and employers to gain at the expense of workers.
Unexpected inflation can benefit borrowers at the expense of lenders as borrowers repay with money that is worth less than when it was borrowed.
Effect of inflation on long term planning
Erratic inflation can make long term planning risky.
E.g., retirement requires long term planning as by saving too much you live less well now but by saving too little now, you live less well in the future.
Menu costs
Costs of adjusting prices.
Need to update prices lists and other prices during inflationary times however this is resource and time consuming.
Prices adjust with a delay and don’t always move in line with changing economic conditions
Real and nominal interest rate
The annual percentage increase in the purchasing power of financial assets.
Fisher equation: r = i - π
Real interest rate = nominal interest rate - inflation
The annual percentage increase in the dollar value of an asset
Higher interest rates means households and firms spend more on interest debt payments, leaving them with less money to spend on anything else
Demand pull inflation
When government increases spending, causing increased demand for goods and services, which can lead to higher prices.
If supply cannot keep up with the increased demand, prices rise leading to inflation.
Monetary inflation
Governments can finance its spending through borrowing or printing money however this increase in the money supply can lead to a decline in the value of money, which can also result in inflation
Transfer payments
Spending on transfer payments can increase demand without increasing supply which can lead to higher inflation.
Spending on infrastructure
Government spending on infrastructure and other productive investments can increase the supply of goods and services, which can help to counteract inflationary pressures.
Effects of inflation on the government
Increased inflation causes increased cost of borrowing for the government as lenders demand higher interest rates to compensate for decline in moneys value. This can limit the ability to finance spending through borrowing as this increases the budget deficit.
Inflation can affect governments revenue as it reduces real tax values and other income sources. This means the government can have to cut spending or increase borrowing.
Increased transfer payments and welfare benefits indexed to cost of living places upward pressure on budget deficit unless taxes are adjusted accordingly.
Stagflation
A phenomenon in which an economy experiences both high inflation and stagnant economic growth at the same time.
Typically occurs when there are supply-side shocks to the economy, such as an increase in the price of oil or other important inputs, which push up prices while also reducing economic growth and increasing unemployment.
Addressing stagflation
Can be difficult to address because monetary policy, which would usually be used, is less effective when prices are rising.
Fiscal policy, such as increasing government spending, can be less effective as well because it can lead to higher inflation which adds to the problem.
Reversing high consumer prices requires government to balance slowing the economy just enough to ease consumer demand but without falling into a recession or triggering stagflation.
