Inflation

An increase in the general (average) price level of goods and services in the
economy
What is Deflation?
A decrease in the general (average) price level of goods and services in the
economy
What is the most widely reported measure of Inflation?
The Consumer Price Index
What is the
Consumer Price Index?
The CPI is an index that measures changes in the average prices of
consumer goods and services
Pakistan Yearly Inflation rate

Period SPI CPI WPI

1991-
10.54 10.58 9.84
1992
1992-
10.71 9.83 7.36
1993
1993-
11.79 11.27 11.40
1994
1994-
15.01 13.02 16.00
1995
1995-
10.71 10.79 11.10
1996
1996-
12.45 11.80 13.01
1997
1997-
7.35 7.81 6.58
1998
1998-
6.44 5.74 6.35
1999
1999-
1.83 3.58 1.77
2000
2000-
4.84 4.41 6.21
2001
2001-
3.37 3.54 2.08
2002
2002-
3.58 3.10 5.57
2003
2003-
6.83 4.57 7.91
2004
2004-
11.55 9.28 6.75
2005
2005-
7.02 7.92 10.10
2006

Who reports the CPI?

The Bureau of Labor Statistics (BLS) of the Department of Labor
How is the CPI calculated?
Price collectors contact retail stores, homeowners, and tenants in selected
cities in the U.S. monthly
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.

Composition of the CPI

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

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
How is the CPI computed?
Current year prices are compared to prices of a similar basket of goods and
services in a base year
What is a Base Year?
A year chosen as a reference point for comparison with some earlier or later
year
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
*CYP = cost of the market basket of products at current-year prices
*BYP = cost of the market basket of products at base-year prices
CYP
BYP X 100
CPI =

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

What is Disinflation?
A reduction in the rate of inflation
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

20 The U.S. Inflation Rate 1929 -

16 1998
12
8
4
0
-4
-8

-12

1930 40 50 60 70 80 90 00

What does Inflation do to People’s Income?

A general rise in prices will shrink people’s income
What is Nominal Income?
The actual number of dollars received over a period of time
What is Real Income?
The actual number of dollars received (nominal income) adjusted for changes
in the CPI
*RI = Real income
*NI = Nominal income
*CPI = CPI as a decimal or CPI ÷ 100

What is Wealth?
The value of the stock of assets owned at some point in time
How is Wealth affected by Inflation?
Inflation can benefit holders of wealth because the value of their assets tends
to increase as prices rise
What will cause your Real Income to decline?
The rate of inflation is greater than your rate of income
How does Inflation affect Borrowers and Savers?
They can win or lose depending on the rate of inflation
What is the Interest Rate?
Interest per year as a percentage of the amount loaned or lent

What is the Nominal Interest Rate?

The actual rate of interest earned over a period of time
What is the Real Interest Rate?
The nominal rate of interest minus the inflation rate
What are the two basic types of Inflation?
Demand-pull
Cost-push
What is Demand-pull Inflation?
A rise in the general price level resulting from an excess of total spending
(demand)
When does Demand-pull Inflation occur?
When the economy is operating at or near full employment
What is Cost-push Inflation?
A rise in the general price level resulting from an increase in the cost of
production
What can cause Cost-push Inflation?
Cost increases for labor, raw materials, construction, equipment, borrowing
etc.
Do people’s Expectations affect Inflation?
Yes, expectations can influence both demand-pull and cost-push inflation
What is Hyperinflation?
An extremely rapid rise in the general price level
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
How does the U.S. inflation rate compare with other countries?
It is lower than some and higher than others
 84.6%
59.1%57.6%
36.1%

1.6% 1.0%
0.7%
Turkey Romania Ecuador U.S. France
Indonesia Germany

Summary
Inflation is an increase in the general (average) price level of goods
and services in the economy.
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:
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.
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.
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.
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.
The real interest rate is the nominal interest rate adjusted for inflation. If
real interest rates are negative, lenders incur losses.
 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.
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.

Quiz
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.
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%

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.

*CYP = cost of the market basket of products at current-year prices

*BYP = cost of the market basket of products at base-year prices

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

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%
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%
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.
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.

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.
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.

B. Real income = nominal income CPI ÷ 100

(A larger value for CPI decrease nominal income.)

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

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.
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.
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.