inflation - Notes on Principles of Macroeconomics Vijaya...

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Notes on Principles of Macroeconomics Vijaya Raj Sharma, Ph.D. INFLATION, MEASUREMENT, AND EFFECTS INFLATION Inflation is a phenomenon of continuous rise in the general price level of goods and services. Inflation is not a rise in the prices of one or just few goods, and it is also not a just one-time rise in the prices of most commodities. During inflationary periods, prices of few goods may fall, but prices of most goods rise. Inflation can also be defined as a decline in the value or purchasing power of dollar. If the supply of dollar (money) rises faster than the supply of goods and services in the country, one would expect a decline in the value of dollar. Thus, an increase in money supply can be a reason of inflation. But, there may be other reasons too. If the demand for goods and services continuously rises faster than their supply, prices of goods and services shall rise too. This is called demand-pull inflation . On the other hand, a continuous fall in supply of goods and services or a continuous rise in cost of production pushes up the general price level. This is called cost-push inflation . CONSUMER PRICE INDEX (CPI) For measuring inflation, an aggregate representation of prices of commodities is needed. Such a general price level is represented through a price index; GDP deflator is one such price index that we briefly introduced in an earlier chapter. There are other price indices also, most notably the Consumer Price Index (CPI) and the Producer Price Index (PPI). CPI is the cost of purchasing a hypothetical market basket of consumption goods bought by a typical consumer during a given period of time (generally a month), relative to the cost of purchasing the same market basket in the base year. The U.S. Bureau of Labor Statistics publishes the CPI every month. The Bureau sends 250 surveyors to 21,000 stores around the nation to record prices of 364 consumption goods that go into the market basket. Let us demonstrate the method of computing CPI with a hypothetical example in Table 1. Table 1: Market Basket and Construction of Price Index Monthly Market Basket 1985 Prices 1996 Prices Cost of market basket in 1985 Cost of market basket in 1996 60 hamburgers $1.60 $3.20 $96.00 $192.00 4 T-shirts 10.00 18.00 40.00 72.00 2 jeans 24.00 24.00 48.00 48.00 1 compact disc 16.00 12.00 16.00 12.00 Total Cost of Basket $200.00 $324.00 CPI 100 162 Let 1985 be the base year. When constructing a price index, its value is normalized to 100 in the base year. Then, the value of price index in any year t can be calculated as:
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(Equation 1) 100 x Year Base in basket market of Cost t Year in basket market of Cost PI t = According to the above equation, CPI in 1996 = (324/200)*100 = 162, which implies that the general price level increased by 62 percent during the 11-year period from 1985 to 1996. The above is a general formula for calculation of any price index. GDP deflator and PPI also are calculated similarly. The formula is the same for any price index, the
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This note was uploaded on 02/07/2011 for the course ECON 3461 taught by Professor Spencer during the Spring '10 term at Golden West College.

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inflation - Notes on Principles of Macroeconomics Vijaya...

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