The document defines inflation as a general rise in price levels. It discusses how the Consumer Price Index (CPI) is used to measure inflation by comparing the price of a market basket of goods from the current year to a base year. An inflation rate of 2.8% in 2011 is provided as an example. The effects of inflation, such as how it redistributes income and impacts different groups, are examined.

2. Definition:
Inflation is a rising general level of prices (not all prices
rise at the same rate, and some may fall).
Consumer price index (CPI)
 The main index used to measure inflation is the
Consumer Price Index (CPI).
 CPI = (Price of the Most Recent Market Basket in the
ParticularYear)/(Price estimate of the Market Basket
in 2010-2011) *100
 Market basket
 300 goods and services
 Typical urban consumer
 2 year updates

3.  To measure inflation, subtract last year's
price index from this year's price index and
divide by last year's index; then multiply by
100 to express as a percentage.
 The CPI was 207.3 in 2011, up from 201.6 in
2010, thus, Rate of inflation = 207.3 –
201.6/201.6 * 100 = 2.8%

5.  “Rule of 70” permits quick calculation of the
time it takes the price level to double:
 Divide 70 by the percentage rate of inflation
and the result is the approximate number of
years for the price level to double.
 If the inflation rate is 7 percent, then it will
take about 10 (=70/7) ten years for prices to
double.

6.  In the past, deflation has been as much a
problem as inflation.
 For example, the 1930s depression was a period
of declining prices and wages.
 The prospect of deflation was a concern of
economic policymakers earlier this decade.
 All industrial nations have experienced the
problem Some nations experience enormous
rates of inflation
 Zimbabwe's was 585 percent in 2005.

7.  Types of Inflation
 Demand pull, Cost-push
Demand pull inflation
 Spending increases faster than production. It is
often described as “too much spending chasing
too few goods.“
 as the increased money supply caused inflation
and reduced the purchasing power of each
dollar.
 It could be caused by an over-issuance of money
by the central bank.

8.  Prices rise because of rise in per-unit production costs
 per-unit production costs =total input cost
units of output
 Output and employment decline while the price level is rising.
 Supply shocks have been the major source of cost-push inflation.
 These typically occur with dramatic increases in the price of raw
materials or energy. e.g., in the mid-1970's, output and
employment were both declining while the general price level was
rising.
 Rising per-unit production costs squeeze profits and reduce the
amount of output firms are willing to supply.
 The economy's supply of goods and services declines and the price
level rises.

9.  It is difficult to distinguish between demand pull and cost push causes of
inflation, e.g., a significant increase in total spending occurs in a fully
employed economy, causing demand-pull inflation.
 This stimulus works its way through various product and resource
markets, individual firms and their wage costs, material costs, and fuel
prices rising.
 It may appear to be cost-push inflation to business firms and to
government.
 Demand-pull inflation will continue as long as there is excess total
spending.
 cost-push inflation is automatically self-limiting, it will die out by itself.
 Demand-pull inflation will continue as long as there is excess total
spending.Generates a recession which makes households and
businesses concentrate on keeping their resources employed, not on
pushing up the prices of those resources.

10. Inflation redistributes real income.
 This redistribution helps some people, hurts some others,
and leaves many people largely unaffected.
Nominal and real income
 Nominal income is the number of dollars received as wages,
rent, interest, or profits.
 Real income is income adjusted for inflation. i.e. Real income
= Nominal income/price index
 The price index is used to deflate nominal income into real
income.
 Inflation may reduce the real income of individuals in the
economy, but won't necessarily reduce real income for the
 economy as a whole (someone receives the higher prices
that people are paying).
 %age change in real income=%age change in nominal income-
%age change in price level

11. Anticipated vs. unanticipated inflation
 Unanticipated inflation has stronger impacts;
those expecting inflation may be able to
adjust their work or spending activities to
avoid or lessen the effects.

12. Fixed-income receivers
 Fixed income groups will be hurt because their real
income users.Their nominal income does not rise
with prices.
Savers
 Savers will be hurt by unanticipated inflation,
because interest rate returns may not cover the
cost of inflation.
 Their savings will lose purchasing power.
Creditors

13. Flexible-income receivers
 Cost-of-living adjustments (COLAs)
Debtors
 Debtors (borrowers) can be helped and lenders
hurt by
 unanticipated inflation.
 Interest payments may be less than the inflation
rate, so borrowers receive “dear” money and are
paying back “cheap” dollars that have less
purchasing power for the lender.

14.  If inflation is anticipated, the effects of
inflation may be less severe, since wage and
pension contracts may have inflation clauses
built in, and interest rates will be high enough
to cover the cost of inflation to savers and
lenders.
 e.g., the prolonged inflation that began in the
late 1960s prompted many labor unions in
the 1970s to insist on labor contracts with
cost-of-living adjustment clauses.

15. Deflation
 Unexpected deflation, a decline in price level, will have the
opposite effect of unexpected inflation.
 People with fixed nominal incomes will find their real
incomes enhanced.
 Creditors will benefit at the expense of debtors.
 Savers will discover their purchasing power grows.
Mixed effects
 Many families are simultaneously helped and hurt by
inflation because they are both borrowers and earners and
savers.
Arbitrariness
 Effects of inflation are arbitrary, regardless of society's
goals.

16.  Inflation affect an economy's level of real output.
 And thus its level of real income.
Cost-push inflation and real output
 Cost push inflation, where resource prices rise
unexpectedly, could cause both output and
employment to decline. Real income falls. e.g.,
in late 1973, OPEC quadruple the price of oil.
 This generated rapid price-level increases in the
1973-1975 period, and the U.S. unemployment
rate rose from 5% in 1973 to 8.5% in 1975.

17.  Mild inflation (< 3%) has uncertain effects. It may
be a healthy by-product of a prosperous
economy, or it may have an undesirable impact
on real income.
 Defenders of mild inflation say that it is much
better for an economy to err on the side of
strong spending, full employment, economic
growth, and mild inflation than on the side of
weak spending, unemployment, recession, and
deflation.

18.  Danger of creeping inflation turning into
hyperinflation, which can cause speculation,
reckless spending, and more inflation.
 Japan followingWorldWar II, and Germany
followingWorldWar I.