Inflation Inflation n Inflation at its simplest just

Inflation

Inflation n Inflation at its simplest just means a “general increase in prices”. n A more complicated way to look at it is that inflation is a decrease in the Purchasing Power of your money. ¨ Purchasing power means your money’s ability to purchase goods and services

Measuring Inflation n We measure inflation by looking at ‘price levels’ and ‘price indexes’. n Price level is an average of the prices of all the goods and services made in one year. n Price Index is an average of the prices of a certain set of goods

CPI n The most famous price index is the “Consumer Price Index” or CPI n It is an index of the prices of a set of items intended to represent the “market basket” of a typical consumer. n In other words, it’s an index of the goods and services the government thinks most people buy in a year.

Official CPI Composition

Determining the Inflation Rate n n n n Inflation Rate: the percentage change in price level over time. It is essentially the same formula as measuring Economic Growth Start with the CPI of the later year (CPI 2) Subtract from it the CPI of the earlier year (CPI 1) Divide by CPI 1 Multiply by 100 ((CPI 2 – CPI 1) ÷ CPI 1) x 100 = Inflation Rate

Calculating the Inflation Rate So if the CPI for 2003 is 184 n And the CPI for 2004 is 188. 9 n What was the inflation rate? n ((188. 9 – 184) ÷ 184) x 100 n (4. 9 ÷ 184) x 100 n. 027 x 100 = 2. 7% n In other words the average price of EVERYTHING rose by 2. 7% in one year. n

A Few More Terms n Core Inflation Rate: the rate of inflation excluding food and energy prices. ¨ Used because food and energy prices can sometimes shift rapidly n Hyperinflation: inflation that is out of control

What Causes Inflation? There are several theories, including 3 that the government uses to fight inflation. n However, the simplest way to understand it is The Wage-Price Spiral n

The Wage-Price Spiral Let’s use Home Depot as an example: • HD employees want more money • HD gives pay raises. • To pay for higher wages, HD must raise prices of its goods. • All the companies that buy HD goods must raise their prices so they can afford HD’s new prices • HD workers find their money doesn’t buy as much at all other businesses. • HD employees want more money.

Effects of Inflation Reduced purchasing power Sometimes reduces income. 1. 2. - You get a 4% raise. Inflation raises prices 5% this year You actually make less money this year than last year. Sometimes negates interest rates. 3. - You put your money in an account that pays you 3. 5% interest. The interest rate for the year is 4. 0% The money in your account effectively shrunk.