03 inflation

1. 1
Chapter 17
Inflation
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing

2. 2
In this chapter, you will
learn to solve these
economic puzzles:
What is the inflation rate of
your college education?
Can a person’s income
fall even though he or
she received a raise?
Can an interest
rate be negative?
Does inflation harm
everyone equally?

3. 3
What is Inflation?
An increase in the
general (average) price
level of goods and
services in the economy

4. 4
What is Deflation?
A decrease in the general
(average) price level of
goods and services in
the economy

5. 5
What is the most
widely reported
measure of Inflation?
The Consumer Price Index

6. 6
What is the
Consumer Price Index?
The CPI is an index that
measures changes in the
average prices of consumer
goods and services

7. 7
Who reports the CPI?
The Bureau of Labor
Statistics (BLS) of the
Department of Labor

8. 8
How is the CPI
calculated?
Price collectors contact
retail stores, homeowners,
and tenants in selected
cities in the U.S. monthly

9. 9
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

10. 10
Composition of the CPI
Food and Beverages
Housing
Apparel and Upkeep
Transportation
Medical Care
Recreation
Education & Communication
All other goods & services
16.3%
39.6%
4.9%
17.6%
5.6%
6.1%
5.6%
6.9%

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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

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

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

14. 14
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

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

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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

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

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8
4
0
-4
1930405060
12
70 80 9000
-8
-12
16
20 The U.S. Inflation Rate 1929 - 1998

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What is Disinflation?
A reduction in the
rate of inflation

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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

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What does Inflation do to
People’s Income?
A general rise in prices will
shrink people’s income

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What is
Nominal Income?
The actual number of
dollars received over
a period of time

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

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

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

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

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

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What will cause your
Real Income to decline?
The rate of inflation
is greater than your
rate of income

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How does Inflation affect
Borrowers and Savers?
They can win or lose
depending on the
rate of inflation

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What is the
Interest Rate?
Interest per year as a
percentage of the
amount loaned or lent

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What is the
Nominal Interest Rate?
The actual rate of interest
earned over a period of time

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What is the
Real Interest Rate?
The nominal rate of interest
minus the inflation rate

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

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

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When does Demand-pull
Inflation occur?
When the economy is
operating at or near
full employment

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

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What can cause Cost-
push Inflation?
Cost increases for labor, raw
materials, construction,
equipment, borrowing etc.

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Do people’s Expectations
affect Inflation?
Yes, expectations can
influence both demand-pull
and cost-push inflation

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

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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

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

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84.6%
59.1%
57.6%
36.1%
1.6%
1.0%
0.7%
TurkeyRomaniaIndonesiaEcuadorU.S.GermanyFrance

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Key Concepts

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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?

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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?

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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?

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Summary

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

49. 49
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.
The annual rate of inflation is
computed using the following formula:

50. 50
ARI =
CPI - CPIPY
CPIPY
*ARI = Annual rate of inflation
*CPIY = Consumer price index in
given year
*CPIPY = Consumer price index
in previous year
X 100

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Deflation is a decrease in the
general level of prices. During the
early years of the Great Depression,
there was deflation, and the CPI
declined at about a double digit rate.

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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.

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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.

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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.

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

56. 56
% D in real
income
% D in
nominal
income
% D in
CPI
=
_

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Demand-pull inflation is caused
by by pressure on prices originating
from the buyers side of the market.
On the other hand, cost-push
inflation is caused by pressure on
prices originating from the seller's
side of the market.

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Hyperinflation can seriously
disrupt an economy by causing
inflation psychosis, credit market
collapses, a wage-price spiral, and
speculation. A wage-price spiral
occurs when increases in nominal
wages cause higher prices and, in
turn, higher wages and prices.

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Chapter 17 Quiz
©2000 South-Western College Publishing

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1. Inflation is
a. an increase in the general price level.
b. not a concern during war.
c. a result of high unemployment.
d. an increase is the relative price level.
A. Inflation is always a concern and it is not
caused by a high unemployment rate.

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2. If the consumer price index in Year X was
300 and the CPI in Year Y 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%

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3. Consider an economy with only two goods:
bread and wine. In 1982, the 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.

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CPI =
CYP
BYP
*CYP = cost of the market basket of
products at current-year prices
*BYP = cost of the market basket of
products at base-year prices
X 100
$23
$20
X 100115 =

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Year
1
2
3
4
5
CPI
100
110
115
120
125
Exhibit 5

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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%

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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%

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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. decrease in the inflation rate.
B. Inflation is an increase in most prices
and deflation did occur in the U.S. during
the Great Depression of the 1930’s.

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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.

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8. Suppose a typical automobile tire cost $50 in the base
year and had a useful life of 40,000 miles. Ten years
later, 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.
d. not measure inflation in this case.
B. Quality changes are difficult to measure.
When the quality of items improves, increases
in the CPI overstate the change in prices.

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9. When the inflation rate rises, the
purchasing power of nominal income
a. remains unchanged.
b. decreases.
c. increases.
d. changes by the inflation rate minus one.
nominal income
CPI ÷ 100
A larger value for
CPI decrease
nominal income.
B. Real income =

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-1%
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.
52,000 - 50,000
50,000
- 5%,
4% - 5% =
D. % change real income

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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.

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12. Demand-pull inflation is caused by
a. monopoly power.
b. energy cost increases.
c. tax increases.
d. full employment.
D. Demand-pull inflation is caused by an
excess of total spending (demand) at or
close to full employment real GDP.
Sellers respond by raising prices
because they do not have the capacity to
produce more goods.

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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.

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END