Jim’s Notes

Price Stability and Inflation

Inflation:

Definition:

sustained and generalized increase in most prices

the ‘sustained’ part is critical. A one-time boost in certain commodity prices does not constitute inflation.

Money loses value in terms of the real things it can buy

Most observed (nominal) prices are rising

Price Level in Macro vs. Prices In Micro:

Supply and Demand –> Prices change up/down

Real Exchange values

Money is assumed constant value

Money as ‘measuring stick’ of value

But what if the measuring stick itself shrinks?

That’s Inflation.
The effect is all prices appear higher.

Policy Goal: Price Stability

Unstable Prices – different scenarios

High, Rising Inflation Is Undesirable
Relative prices obscured
Hurts fixed nominal incomes
Destroys $-based wealth
Arbitrary redistribution of wealth
Reduced ability to plan
Increased transaction costs.
Higher nominal interest rates reduces attractiveness of investments
Deflation Is Very Undesirable (any amount of deflation)
Sustained drop in real prices, particularly asset prices
Spending reduced as people wait for prices to drop more
Reduced spending reduces incomes
Negative feedback loop
Deflation makes debt repayments more burdensome in real terms, reducing current expenditures
deflation produces depression conditions
Significant Part of Great Depression
Hyperinflation
Inflation rising at extraordinary rates, often accelerating
Prices such as 100% or 1000% or more per year
Hyperinflation Can Destroy an Economy
Zimbabwe 2007
Weimar Germany 1923-24
Bolivia, 1983-84
Russia, 1994-96
Inflation produces unequal effects
Winners from inflation (losers from deflation)
Borrowers and debtors
People w/ real and tangible assets
Losers from inflation (winners from deflation)
People on fixed incomes
Lenders and creditors (such as banks)
People owning purely financial assets (bonds, cash, etc)

Goal: Absence of high Inflation or Deflation

Inflation rate is stable
Real World:
Maybe 2% inflation or slightly higher

Measuring Inflation Rate

requires estimation of a ‘price index’

% increase in the Price Index each year from previous year

NOT the absolute change in the index

Related Terms and Concepts

Inflation Rate:

Generalized annual % increase in prices

Deflation:

Money gains real value
Most observed prices dropping

Disinflation:

Reduction in rate of inflation compared to previous year’s inflation rate
Prices are still going up, just going up at a slowing rate
Disinflation =/= Deflation
reducing high inflation rates to low inflation rates is ‘disinflation’

Nominal Prices:

$ amount actually paid
Observable

Real Goods Price:

Value in real goods and services required for the trade, not money

Real Price:

Estimate of Goods Price
Estimated using value of money from a different year
Calculated from nominal price and price index

Real Interest rates:

payment to lender for use of money over time

Nominal interest rates:

nominal rates = real rate + risk premium + estimated inflation rate

Measuring Inflation and Price Indices

‘Price Index’: wtd average of sample of prices

based on a defined market basket of goods
market basket may be adjusted for quality changes

Index Numberbase year = 100

market basket cost in base year = 100
all other years’ cost of market basket are relative to base year

Inflation Rate = percentage increase from year-to-year in price index

Several Price Indices

CPI: Consumer Price Index
most common used when people refer to ‘inflation’
multiple versions depending on localities, type of consumer, etc.
PPI: Producer Price Index
sometimes called wholesale price index
represents input prices to firms for production
GDP Deflator
broad index used to deflate nominal GDP measures

‘Core’ inflation and othe refined measures

Since ‘sustained’ price increases are an important part of the definition but some prices in our market basket might be highly volatile, often the most volatile prices are ignored and the mean or core is tracked.