Notes on Inflation
A. Why Is Inflation a Problem?
1. An economic upturn (boom) often causes the inflation rate to increase. 2. During a general inflation, all prices (including wages and salaries) will
increase at the same rate on average. Why is inflation a problem? 3. The key phrase is “on average.” Averages often don’t tell you much about
individuals and this one is no exception. Incomes and prices do not all
increase at the same rate during inflations. Some people’s income will rise
faster than others. Some benefit from inflation while others are hurt.
B. Defining Inflation
1. Not all price increases are inflation. Over any time period, prices of some
goods will rise and other prices will fall.
2. Inflation is an increase in the overall (average) price level. Deflation is a
decrease in the overall (average) price level.
3. Inflation happens when prices of many goods and services increase together. 4. Sustained inflation is inflation that continues over a significant period of time.
C. Price Indexes
1. Price indexes are used to measure average price levels.
2. The GDP deflator is the price index that covers all the goods and services
included in GDP.
3. The Consumer Price Index (CPI) is a price index computed each month by the
Bureau of Labor Statistics using a bundle that is meant to represent the
“market basket” purchased monthly by the typical urban consumer. The CPI
is the most commonly quoted price index.
a. The CPI is based on a bundle of goods and services that represent the
“market basket” purchased by a typical urban household.
b. The Bureau of Labor Statistics (BLS) conducts a survey every month
in order to get the most up-to-date prices.
The CPI is the measure that union wages, government retirement funds, and
social security benefits use as an index. If the CPI overstates inflation, then any
reported price increase will lead to a rise in the real incomes of those tied to
the index. Of course, this increase in income comes at the expense of those
whose incomes are not tied to the index.
4. Producer Price Indexes (PPI)) are also widely cited price indexes.
a. The PPIs are indexes of prices producers receive for products at
various stages of the production process.
b. The three main categories for which PPIs are constructed are
finished goods, intermediate materials, and crude materials. There
are subcategories within each.
D. The Costs of Inflation
1. Inflation Changes the Distribution of Income
a. Contrary to popular opinion, general inflation does not lower
purchasing power because nominal income keeps pace with the
average price level.
b. Inflation changes the distribution of income; some groups may be
hurt more than others.
c. Effects on Debtors and Creditors
2. Administrative Costs and Inefficiencies include changing price tags, more
frequent bank transactions. Some economists call these menu costs because
restaurants have to print new menus to raise prices.