RMIT Classification: Trusted

Chapter 21
The Price Level and
Inflation

Copyright © 2021 by W. W. Norton & Company, Inc.

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Big Questions

1. How is inflation measured?​

2. What problems does inflation bring?​

3. What is the cause of inflation?​

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The Price Level and Inflation

Inflation CPI

• What is inflation?​ • What is CPI?​

• Problems​ • How to calculate it​

• What causes inflation?​ • Concerns

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Inflation

What is inflation?​

Hyperinflation: An extremely _____ rate of inflation.​

Deflation: Occurs when overall prices _____.​

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Inflation in the United States, 1970–

2018

In the past 25 years, inflation in the United States has averaged

_____%.​

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Consumer Price Index (1/2)

• Consumer Price Index (CPI): A measure of the price level

based on the _______________ _________ of a typical consumer.​

• Goal:

• Calculated by the ________ ___ ______ __________ (BLS).​

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Consumer Price Index (2/2)

The weights are based on the spending patterns of a typical consumer

in the United States.​

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Bureau of Labor Statistics

Bureau of Labor Statistics (BLS):​

What are the goals of the BLS?​

Each month, the BLS collects price information

• on over _______ goods and services each month​

• in _____ categories​

• for ____ geographic locations.​

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Practice What You Know—1

Which of the following spending categories makes up the

largest portion of the CPI market basket?​

A. Travel (includes paying for gas)​

B. Housing​

C. Entertainment​

D. Food​

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Computing the CPI (1/2)

Calculating the price index:

𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 = × 10

Using the price levels, we can find inflation with the percentage

change formula:

−
𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 =

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Computing the CPI (2/2)

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CPI and Inflation in the Long Run

(1965–2018)

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Price Movements (1/2)

• Clearly, most prices ______ over time (see the previous figure)

• Travel

• Education

• _______ _______

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Price Movements (2/2)

• However, some prices _______ over time

• Consumer electronics

• Usually due to a result of great

technological advancements

• Tube TV 1997: $7,000

• Flat panel TV 2012: $500

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Practice What You Know—2

If inflation is a general rise in the price level, why have consumer

electronic prices fallen over time?
A. The demand for electronics has decreased.
B. Electronics are not counted in the CPI.
C. Electronics are getting smaller in size so the price is falling as
well.
D. Increases in technology have greatly reduced production costs
for these goods.

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Using the CPI to Compare Dollar

Values across Time

Prices from different time periods can be ______________.

• In 1924, you could buy a fully constructed house for $1,969.

• To compare prices over time, we can transform past prices into a

price in today’s dollars.

𝑃𝑟𝑖𝑐𝑒 𝑇𝑜𝑑𝑎𝑦 = ×

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Concerns about CPI Accuracy

CPI overstates true inflation (_________ ______) for three possible

reasons:

1.

2.

3.

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Substitution Bias

When the price of A _______, consumers buy more B.

Since 1999, the BLS has used a formula that accounts for price

changes and shifts in goods consumption.

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Changes in Quality

Prices may _______ because the quality of goods is ________.

Example:

• Early 1990s: tube TVs

• Now: flat-screen HD TV

Since 1999, the BLS has used a careful adjustment method to account

for quality changes.

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New Products and Location

Previously, the BLS updated CPI after long delays, causing upward
bias for two reasons:

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Traditional versus Chained CPI

In order to keep track of

these price drops a new

_________ _____ was

instituted in 2000.

• More difficult to measure.

• Current reports not yet

based on chained CPI.

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Costs of Inflation

1.

2.

3.

4.

5.

6.

7.

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Shoe-Leather Costs

As prices go up, it becomes more ________ to hold money

Shoe-leather costs: Resources are wasted when people change

behavior to _______ holding money.

People bear ______, _______, and ______ _______ when they try

to use more money.

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Money Illusion (1/3)

What is money illusion?

If prices and wages all go up by 2%, there is no real change in

purchasing power. People with money illusion think they are richer in

this case

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Money Illusion (2/3)

Nominal wage:

Real wage:

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Money Illusion (3/3)

Another money illusion example:

Suppose nominal wages increase by __% and prices go up by

__%.

Money illusion may cause you to think of yourself as wealthier,

but your real wages have actually decreased!

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Practice What You Know—3

Suppose that prices and wages both double next year. What is true

about next year compared to this year?

A. Nominal wages are higher and real wages remained constant.

B. Nominal wages and real wages are both higher.

C. Nominal wages are higher and real wages are lower.

D. Nominal wages increased and real wages decreased.

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Menu Costs

What are menu costs?

Example:

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Future Price Uncertainty

Wage and other input contracts often have ____________________

commitments.

Example: Would you be willing to sign a contract and be paid the

same for the next five years?

Uncertainty about prices may make borrowing ___________.

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Wealth Redistribution (1/2)

Wealth redistribution

Example: Suppose you borrow $50,000 and expect to pay back

$60,000 in five years.

• If unexpected inflation occurs, you are ________ off, bank is

________ off.

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Wealth Redistribution (2/2)

• If the inflation was expected the bank would have required more in

return for the loan (i.e., you’d have to repay $75,000 in five years)

• If unexpected deflation occurs, you are ________ off, bank is

_________ off.

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Tax Distortions (1/2)

What are capital gains taxes?

Problem: Often, the price rises due to inflation rather than an increase

in the value of the good

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Tax Distortions (2/2)

Example: If you buy a house in 1980 for $80,000 and sell the house in

2012 for $230,000:

Capital gains = $_________

You have to pay taxes on this $__________

However, CPI rose from ____ to _____ in those years, so the

real value of the house is the same!

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Costs of Inflation Summary

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Cause of Inflation

No debate on the cause of inflation.

Inflation is caused by expansions in the nation’s _____________.

Milton Friedman:“Inflation is always and everywhere a monetary

phenomenon.”

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Equation of Exchange—1

Equation of exchange: Specifies the long-run relationship between

the _____________, the ________ _____, _________, and the
___________ of money.
𝑀×𝑉 =𝑃×𝑌

M:

V:

P:

Y:
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Equation of Exchange—2

In growth-rates:

%ΔM + %ΔV =%ΔP + %ΔY

If we assume that the velocity of money is constant:

%ΔP ___ 0 if %ΔM > %ΔY

%ΔP ___ 0 if %ΔY > %ΔM

%ΔP ___ 0 if %ΔM = %ΔY

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Inflation and Money Growth Rates,

1996–2016

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Why Governments Inflate the Money

Supply
Inflation can have significant costs but there are two reasons why
governments inflate their money supply:

1. ________ ______________ ________ often spur governments to

choose to increase the money supply rapidly so they can pay off
the debts.

2. Surprise increases in the money supply can temporarily

_________________________ toward more rapid growth rates.

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Conclusion (1/2)

• CPI is the foundation of inflation calculations.

• Computation can be difficult because the typical basket of

consumer goods changes over time.

• The BLS tries to adjust for this.

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Conclusion (2/2)

• The macroeconomic costs of continued price rises include:

• future price level uncertainty

• signal extraction problems

• menu costs

• money illusion

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