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Unformatted text preview: The Price Level and Inflation
Measuring inflation and analyzing its effects on economic decisions and economic performance The Price Level
The price level is an indication of how high or low prices are on average in a given year compared to prices on average in a certain base period s The price level is measured by a price index whose value is set at 100 for a base period
s A fixed weight price index: Price Index = Cost of a market basket of products in current year Cost of the same market basket of products at prices prevailing in the base period x 100 The Consumer Price Index (CPI)
The CPI is computed monthly for a market basket of goods and services purchased by a typical urban family s Since 1988 an average of prices for the period 1982-1984 has been used as the base s CPI as of February 2009 = 212.2, which means that prices for the CPI market basket in 2009 were 112.2% higher than they were in 1983
s Using a Price Index to Deflate Nominal Values to Real Values
Real Value = Nominal Value s Current Index/100
s Example: Using the current CPI of 212.2 to deflate a current $30,000 income to 1983 base year dollars: Real income = $30,000/212.2 = $14,138 Real Income is measured in 1983 Dollars U.S. Price Level: 1913 - 2005 Annual rates of inflation:
Inflation is measured by the percentage change in a price index, such as the CPI, over a year s Pure inflation rarely exists because not all prices rise at the same rate of increase of the CPI s U.S. inflation in 2007 was 3.2 percent. Between February 2008 and February 2009 prices increased by only 0.2%
s U.S. Inflation: 1950 -2005 Other measures of the price level
The GDP deflator = (nominal GDP/real GDP)100. This measures an average of all prices for domestic products (not just consumer products) with a 2000 base = 122.5 for 2008 s Inflation in 2008 was running at an annual rate of 2.2 percent measured by the GDP deflator.
s Inflation and wages:
Real wages depend on both money wages and the price level s When inflation increases real wages will decline unless money wages rise at least as fast as the price level s Money wages tend to be set by contract at the beginning of a year. If there is unanticipated inflation, real wages will decline that year
s Inflation and Interest Rates
The real interest rate is the nominal rate of interest less the rate of inflation s For example if nominal interest rates this year are 6% while inflation is 3%, the real rate of interest is 6%-3% = 3% s When lending money, creditors estimate the rate of inflation for fixed interest loans, if they underestimate inflation, their real interest rate will be less than anticipated
s Effects of Inflation on the Economy
s s s s 1. When inflation increases unexpectedly, real wages decline and employers gain at the expense of workers while debtors gain at the expense of creditors. 2. Inflation can impair incentives to save and invest by reducing the real interest rate and increasing uncertainty. 3. Inflation distorts buying and selling decisions as people make choices not only on the benefits and costs of alternative but also on their estimates of future inflation. 4. As inflation becomes anticipated, nominal wages will rise and possibly feed a wage-price spiral. Interest rates will rise. Excessive inflation can lead to a recession as central banks cut back on credit to control inflation. Hyperinflation can result in social chaos. ...
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