Chapter 17 Inflation Key Concepts Summary

Chapter 17 Inflation • Key Concepts • Summary • Practice Quiz • Internet Exercises © 2002 South-Western College Publishing 1

What is inflation? An increase in the general (average) price level of goods and services in the economy 2

What is deflation? A decrease in the general (average) price level of goods and services in the economy 3

What is the most widely reported measure of inflation? The Consumer Price Index 4

What is the Consumer Price Index? The CPI is an index that measures changes in the average prices of consumer goods and services 5

Who reports the CPI? The Bureau of Labor Statistics (BLS) of the Department of Labor 6

How is the CPI calculated? Price collectors contact retail stores, homeowners, and tenants in selected cities in the U. S. monthly 7

Which goods and services are included in the CPI? The BLS records average prices for a “market basket” of different items purchased by the typical urban family 8

Composition of the CPI Food and Beverages 16. 2% Housing 40. 0% Apparel and Upkeep 4. 4% Transportation 17. 6% Medical Care 5. 8% Recreation 5. 9% Education & Communication 5. 3% All other goods & services 4. 8% 9

Does the makeup of the CPI change? As people’s tastes and preferences change, some of the goods and services that go into the basket change 10

How is the CPI computed? Current year prices are compared to prices of a similar basket of goods and services in a base year 11

What is a base year? A year chosen as a reference point for comparison with some earlier or later year 12

Why is the CPI always 100 in the base year? The numerator and the denominator of the CPI formula are the same in the base year 13

*CYP = cost of the market basket of products at current-year prices *BYP = cost of the market basket of products at base-year prices CPI = CYP X 100 BYP 14

How is the inflation rate computed? The annual inflation rate is computed as the percentage change in the official CPI from one year to the next 15

*ARI = Annual rate of inflation *CPIY = Consumer price index in given year *CPIPY = Consumer price index in previous year CPI - CPIPYX 100 ARI = CPIPY 16

20 16 12 8 The U. S. Inflation Rate 1929 - 2002 4 0 -4 -8 -12 1930 40 50 60 70 80 90 00 17

What is disinflation? A reduction in the rate of inflation 18

What are some criticisms of the CPI? • It can overstate or understate the impact of inflation for certain groups • Does not measure quality • Substitutes are ignored 19

What does inflation do to people’s income? A general rise in prices will shrink people’s income 20

What is nominal income? The actual number of dollars received over a period of time 21

What is real income? The actual number of dollars received (nominal income) adjusted for changes in the CPI 22

*RI = Real income *NI = Nominal income *CPI = CPI as a decimal or CPI ÷ 100 NI RI = CPI 23

% in real income = % in nominal income _ % in CPI 24

What is wealth? The value of the stock of assets owned at some point in time 25

How is wealth affected by inflation? Inflation can benefit holders of wealth because the value of their assets tends to increase as prices rise 26

What will cause your real income to decline? The rate of inflation is greater than your rate of income 27

How does inflation affect borrowers and savers? They can win or lose depending on the rate of inflation 28

What is the interest rate? Interest per year as a percentage of the amount loaned or lent 29

What is the nominal interest rate? The actual rate of interest earned over a period of time 30

What is the real interest rate? The nominal rate of interest minus the inflation rate 31

What are the two basic types of inflation? Demand-pull Cost-push 32

What is demand-pull inflation? A rise in the general price level resulting from an excess of total spending (demand) 33

When does demandpull inflation occur? When the economy is operating at or near full employment 34

What is cost-push inflation? A rise in the general price level resulting from an increase in the cost of production 35

What can cause costpush inflation? Cost increases for labor, raw materials, construction, equipment, borrowing etc. 36

Do people’s expectations affect inflation? Yes, expectations can influence both demandpull and cost-push inflation 37

What is hyperinflation? An extremely rapid rise in the general price level 38

What is a wage-price spiral? A situation that occurs when increases in nominal wage rates are passed on in higher prices, which, in turn, result in even higher nominal wages and prices 39

How does the U. S. inflation rate compare with other countries? It is lower than some and higher than others 40

Key Concepts 41

Key Concepts • What is inflation? • What is the Consumer Price Index? • Which goods and services are included in the CPI? • How is the CPI computed? • What is a base year? • How is the inflation rate computed? • What is disinflation? 42

Key Concepts cont. • • • What does inflation do to people’s income? What is nominal income? What is real income? What is wealth? How is wealth affected by inflation? How does inflation affect borrowers and savers? • What are the two basic types of inflation? 43

Key Concepts cont. • • • What is demand-pull inflation? What is cost-push inflation? Do people’s expectations affect inflation? What is hyperinflation? How does the U. S. inflation rate compare with other countries? 44

Summary 45

Inflation is an increase in the general (average) price level of goods and services in the economy. 46

The consumer price index (CPI) is the most widely known price-level index. It measures the cost of purchasing a market basket of goods and services by a typical household during a time period relative to the cost of the same bundle during a base year. 47

The annual rate of inflation is computed using the following formula: 48

*ARI = Annual rate of inflation *CPIY = Consumer price index in given year *CPIPY = Consumer price index in previous year CPI - CPIPYX 100 ARI = CPIPY 49

Deflation is a decrease in the general level of prices. During the early years of the Great Depression, there was deflation. 50

Disinflation is a reduction in the inflation rate. Between 1980 and 1986, there was disinflation. This does not mean that prices were falling, but only that the inflation rate fell. 51

The inflation rate is criticized because (1) it is not representative, (2) it incorrectly adjusts for quality changes, and (3) it ignores the relationship between price changes and the importance of items in the market basket. 52

Nominal income is income measured in actual money amounts. Measuring your purchasing power requires converting nominal income into real income, which is nominal income adjusted for inflation. 53

The real interest rate is the nominal interest rate adjusted for inflation. If real interest rates are negative, lenders incur losses. 54

% in real income = % in nominal income _ % in CPI 55

Demand-pull inflation is caused by by pressure on prices originating from the buyers side of the market. 56

Cost-push inflation is caused by pressure on prices originating from the seller's side of the market. 57

Hyperinflation can seriously disrupt an economy by causing inflation psychosis, credit market collapses, a wage-price spiral, and speculation. 58

Chapter 17 Quiz © 2002 South-Western College Publishing 59

1. Inflation is a. an increase in the general price level. b. not a concern during war. c. a result of high unemployment. d. none of the above. A. Inflation is always a concern and it is not caused by a high unemployment rate. 60

2. If the consumer price index in 1996 was 300 and the CPI in 1997 was 315, the rate of inflation was a. 5 per cent. b. 15 per cent. c. 25 per cent. d. 315 per cent. A. CPI = 315 - 300 / 300 x 100 = 5% 61

3. Consider an economy with only two goods: bread and wine. In 1982, the typical family bought 4 loaves of bread at 50 cents per loaf and two bottles of wine for $9 per bottle. In 1996, bread cost 75 cents per loaf, and wine cost $10 per bottle. The CPI for 1996 (using a 1982 base year) is a. 100. b. 115. c. 126. d. 130. B. 62

*CYP = cost of the market basket of products at current-year prices *BYP = cost of the market basket of products at base-year prices CPI = 115 = CYP X 100 BYP $23 X 100 $20 63

Exhibit 5 Year CPI 1 2 3 4 5 100 115 120 125 64

4. As shown in Exhibit 5, the rate of inflation for Year 2 is a. 5 percent. b. 10 percent. c. 20 percent. d. 25 percent. B. A percent increase of decrease between two numbers is the difference divided by the original number. In this case, it is 10 / 100 = 10% 65

5. As shown in Exhibit 5, the rate of inflation for Year 5 is a. 4. 2 percent. b. 5 percent. c. 20 percent. d. 25 percent. A. A percent increase of decrease between two numbers is the difference divided by the original number. In this case, it is 5 / 100 = 4. 2% 66

6. Deflation is a (an): a. increase in most prices. b. decrease in the general price level. c. situation that has never occurred in U. S. history. d. none of the above. B. Inflation is an increase in most prices and deflation did occur in the U. S. during the Great Depression of the 1930’s. 67

7. Which of the following would overstate the consumer price index? a. Substitution bias. b. Improving quality of products. c. Neither (a) nor (b). d. Both (a) and (b). D. Substitution bias refers to the law of demand in which people buy less when the price rises. However, the CPI is based on a fixed market basket. Since quality is difficult to measure, a decline in quality understates inflation. 68

8. Suppose a typical automobile tire cost $50 in 1982 and had a useful life of 40, 000 miles. In 1995, the typical automobile tire cost $75 and had a useful life of 75, 000 miles. If no adjustment is made for mileage, the CPI would a. underestimate inflation between the two years. b. overestimate inflation between the two years. c. accurately measure inflation between the two years. B. Quality changes are difficult to measure. When the quality of items improves, increases in the CPI overstate the change 69 in prices.

9. When the inflation rate falls, the purchasing power of nominal income a. remains unchanged. b. decreases. c. increases. d. changes by the inflation rate minus one. nominal income C. Real income = CPI ÷ 100 70

10. Last year the Harrison family earned $50, 000. This year their income is $52, 000. In an economy with an inflation rate of 5 per cent, which of the following is correct? a. The Harrison’s nominal income and real income have both risen. b. The Harrison’s nominal income and real income have both fallen. c. The Harrison’s nominal income has fallen, and their real income has risen. . d. The Harrison’s nominal income has risen, and their real income has fallen. D. % change real income 52, 000 - 50, 000 - 5%, 50, 000 4% - 5% = -1% 71

11. If the nominal rate of interest is less than the inflation rate, a. lenders win. b. savers win. c. the real interest rate is negative. d. the economy is at full employment. C. The real rate of interest is negative because the lender is receiving less money back, in real terms, then was lent out. 72

12. Demand-pull inflation is caused by a. monopoly power. b. energy cost increases. c. tax increases. d. none of the above. D. Demand-pull inflation is caused by an excess of total spending (demand). Sellers regard by raising prices. 73

13. Cost-push inflation is due to a. excess total spending. b. too much money chasing too few goods. c. resource cost increases. d. the economy operating at full employment. C. Answers a, b, and d describe demand-pull inflation. 74

END 75