Macroeconomics ECON202
Guided notes
Chapter 8 The Price Level and Inflation
Big Questions to study
A. How is inflation measured?
• The inflation rate is calculated as the percentage change in the overall level of prices
• Economists use the consumer price index (CPI) to determine the general level of price in the economy
• Determining which prices to include in the CPI can be challenging for several reasons: consumers
change what they buy over time; the quality of goods and services changes; and new goods, services,
and sales locations are introduced
B. What problems does inflation bring?
• Inflation imposes shoe-leather costs: it causes people to waste resources as they seek to avoid holding
money
• Inflation can cause people to make decisions based on nominal rather than real monetary values, a
problem known as money illusion
• Inflation adds menu costs, as sells need to physically change prices
• Inflation introduces uncertainty about future price levels. Because uncertainty makes it difficult for
consumers and producers to plan, it impedes economic progress
• Unexpected inflation redistributes wealth from lenders to borrowers
• Inflation creates price confusion: that is, it makes it difficult for producers to read price signals
correctly. The result may be a misallocation of resources
• Inflation distorts people’s tax obligations
1
,C. What is the cause of inflation?
• Inflation is caused by increase in a nation’s money supple relative to the quantity of real goods and
services in the economy
• Governments often increase the money supply too quickly when they are in debt or when they desire a
short-run stimulus for the economy
• The equation of exchange offers a simple summary of the long-run relationship between the inflations
ate and quantity of money in an economy
Flow of Chapter 8
Inflation – computation of CPI
7 problems of inflation
Cause of inflation
Motivating examples:
a. Do US families really earn more over time?
b. Which movie has the really highest box office receipts?
A. How is inflation measured?
Inflation: general increase in the price level of the economy.
Inflation is measured as the percentage change in the general price level
Deflation: fall in the price level.
But, what is price level?
In chapter 6, we learned GDP deflator: the price level to calculate real GDP.
GDP deflator includes prices of all goods produced, e.g., tractors, wind turbines and so on.
2
, News seldom reports inflation as the percentage increase in GDP deflator.
GDP deflator is too broad a measure. Consumers do not care about prices of some goods, like tractors
and wind turbines.
• Inflation: the growth in the overall level of prices in an economy
• When overall prices rise —> this affects our budget - it limits how much we can buy with our income
• If overall prices fall —> our income goes further and we can buy more goods
• Hyperinflation: an extremely high rate of inflation, and it completely stymies economic activity
• Example: In 2008 in Zimbabwe —> the inflation rate reached almost 80 billion% each month.
Average citizens could barely afford necessities like bread and eggs
• Over the past 25 years in the U.S. —> the long-run average inflation rate was just 2.25% - which is a
benchmark for evaluating current inflation rates
• Deflation: occurs when overall prices fall
• Measuring inflation is a little tricky —> prices don’t move all together; some prices fall even when
others rise
• Some prices affect consumers more than others as well
• Example: a 10% increase in housing prices is more painful than a 10% increase in hot do gprices
• In the U.S. —> the Bureau of Labor Statistics (BLS) measures and reports inflation data
• The BLS’s goals:
• Determine the price of all the goods and services a typical consumer buys
• Identify how much of a typical consumer’s budget is spent on these particular items
A1. The Consumer Price Index
3
Guided notes
Chapter 8 The Price Level and Inflation
Big Questions to study
A. How is inflation measured?
• The inflation rate is calculated as the percentage change in the overall level of prices
• Economists use the consumer price index (CPI) to determine the general level of price in the economy
• Determining which prices to include in the CPI can be challenging for several reasons: consumers
change what they buy over time; the quality of goods and services changes; and new goods, services,
and sales locations are introduced
B. What problems does inflation bring?
• Inflation imposes shoe-leather costs: it causes people to waste resources as they seek to avoid holding
money
• Inflation can cause people to make decisions based on nominal rather than real monetary values, a
problem known as money illusion
• Inflation adds menu costs, as sells need to physically change prices
• Inflation introduces uncertainty about future price levels. Because uncertainty makes it difficult for
consumers and producers to plan, it impedes economic progress
• Unexpected inflation redistributes wealth from lenders to borrowers
• Inflation creates price confusion: that is, it makes it difficult for producers to read price signals
correctly. The result may be a misallocation of resources
• Inflation distorts people’s tax obligations
1
,C. What is the cause of inflation?
• Inflation is caused by increase in a nation’s money supple relative to the quantity of real goods and
services in the economy
• Governments often increase the money supply too quickly when they are in debt or when they desire a
short-run stimulus for the economy
• The equation of exchange offers a simple summary of the long-run relationship between the inflations
ate and quantity of money in an economy
Flow of Chapter 8
Inflation – computation of CPI
7 problems of inflation
Cause of inflation
Motivating examples:
a. Do US families really earn more over time?
b. Which movie has the really highest box office receipts?
A. How is inflation measured?
Inflation: general increase in the price level of the economy.
Inflation is measured as the percentage change in the general price level
Deflation: fall in the price level.
But, what is price level?
In chapter 6, we learned GDP deflator: the price level to calculate real GDP.
GDP deflator includes prices of all goods produced, e.g., tractors, wind turbines and so on.
2
, News seldom reports inflation as the percentage increase in GDP deflator.
GDP deflator is too broad a measure. Consumers do not care about prices of some goods, like tractors
and wind turbines.
• Inflation: the growth in the overall level of prices in an economy
• When overall prices rise —> this affects our budget - it limits how much we can buy with our income
• If overall prices fall —> our income goes further and we can buy more goods
• Hyperinflation: an extremely high rate of inflation, and it completely stymies economic activity
• Example: In 2008 in Zimbabwe —> the inflation rate reached almost 80 billion% each month.
Average citizens could barely afford necessities like bread and eggs
• Over the past 25 years in the U.S. —> the long-run average inflation rate was just 2.25% - which is a
benchmark for evaluating current inflation rates
• Deflation: occurs when overall prices fall
• Measuring inflation is a little tricky —> prices don’t move all together; some prices fall even when
others rise
• Some prices affect consumers more than others as well
• Example: a 10% increase in housing prices is more painful than a 10% increase in hot do gprices
• In the U.S. —> the Bureau of Labor Statistics (BLS) measures and reports inflation data
• The BLS’s goals:
• Determine the price of all the goods and services a typical consumer buys
• Identify how much of a typical consumer’s budget is spent on these particular items
A1. The Consumer Price Index
3
