MACROEconomicsUnit 4: Price Stability and

Inflation

Some idea of inflation comes from seeing a youngster get his first job at a salary you dreamed of as the culmination of your career.

- Bill Vaughan

Created:2012

by Jim Luke.This work is licensed

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NonCommercial License

MACROEconomics

Society's Goals for Macro System

GrowthStable Prices & Money

Full EmploymentStability of Business Cycle

MACROEconomics

Money: an elastic measuring stickMoney: an elastic measuring stick

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MACROEconomics

Inflation is a sustained and generalized increase in most prices.

Money loses real value Most observed (nominal)

prices are rising

MACROEconomics

The Inflation Rate is the % change (annual rate) in most prices as measured by a price index.

MACROEconomics

Deflation is a generalized decrease in most prices.

MACROEconomics

Disinflation is a reduction in the rate of inflation.

MACROEconomics

Terms:

- Nominal Prices: actually observed

- Real Values: estimated value of goods using “base year” prices.

MACROEconomics

Inflation erodes financial wealth and fixed incomes.

MACROEconomics

But inflation also helps debtors and owners of real wealth.

MACROEconomics

Hyper-inflation Can Destroy.

MACROEconomics

Deflation Is Very Undesirable (any amount of deflation)

MACROEconomics

Practical Policy Goal: Low, stable inflation.

MACROEconomics

Measuring Price Stability

“Price Index”: wtd average of sample of pricesSeveral Price Indices

CPI PPI GDP Deflator

Index Number: base year = 100

Inflation Rate = % increase in the Price Index each year

MACROEconomics

Measuring Inflation Rate requires a price index.

MACROEconomics

A price index establishes price levels relative to an arbitrary “base year”.

MACROEconomics

Price Index: wtd average of prices based upon comparing the cost of “market basket” of goods each year.

MACROEconomics

Inflation Rate = percentage increase from year-to-year in price index

MACROEconomics

There are a lot of different price indices such as CPI, GDP Deflator, PPI, and Billion Prices Project.

MACROEconomics

Price indices are imprecise due to quality changes, new products, and shifts in preferences.

MACROEconomics

Inflation needs “momentum”, not just isolated increases. Attempts to measure it use “core inflation”.

MACROEconomics

What causes inflation? More demand in general than supply.

MACROEconomics

Nominal Interest Rates include a “real rate” component and an implied/assumed future inflation rate.