INFLATION
Instructor: Vo Thi Xuan Hanh, MBA
I. INFLATION
1.1 Definition
Inflation is defined as a persistent increase in the
average price level in the economy, usually
measured through the calculation of a consumer
price index (CPI).
Inflation is a sustained rise in the general level of
prices – the price level.
The inflation rate is the rate at which the price
level increases.
Real vs. Nominal Variables
▪ Nominal variables are measured in monetary
units.
Examples: nominal GDP,
nominal interest rate (rate of return measured in $)
nominal wage ($ per hour worked)
▪ Real variables are measured in physical units.
Examples: real GDP,
real interest rate (measured in output)
real wage (measured in output)
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Real vs. Nominal Variables
Prices are normally measured in terms of money.
▪ Price of a compact disc: $15/cd
▪ Price of a pepperoni pizza: $10/pizza
A relative price is the price of one good relative to
(divided by) another:
▪ Relative price of CDs in terms of pizza:
price of cd $15/cd
= = 1.5 pizzas per cd
price of pizza $10/pizza
Relative prices are measured in physical units,
so they are real variables.
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Real vs. Nominal Wage
An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $15/hour
P = price level = price of g&s, e.g., $5/unit of output
Real wage is the price of labor relative to the price
of output:
W $15/hour
= = 3 units output per hour
P $5/unit of output
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I. INFLATION
1.2 Cost of inflation
Loss of purchasing power
Effect on saving: Nominal interest rates and
inflation rate.
Effect on interest rates: Nominal and real
interest rates
Effect on international competitiveness: Higher
inflation rate leads to lower export
competitiveness.
Uncertainty: Higher inflation – Lower
investment
Labor unrest: Wages and salaries – Inflation rate
1.3 Measuring inflation:
The Consumer Price Index: The goods were
consumed in the economy
Choose a base year and compute the index.
The CPI in any year equals
100 x cost of basket in current year
cost of basket in base year
CPI(t) = ∑PtQ0 / ∑P0Q0 *100
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Measuring inflation:
The Consumer Price Index: The goods were
consumed in the economy
Compute the inflation rate.
The percentage change in the CPI from the
preceding period.
Inflation CPI this year – CPI last year
= x 100%
rate CPI last year
Inflation rate = ( CPI(t) – CPI(t-1) )/ CPI(t-1)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What’s in the CPI’s Basket?
4% 3% Housing
6%
Transportation
6%
Food & Beverages
6% 43%
Medical care
Recreation
Education and
15%
communication
Apparel
17% Other
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
EXAMPLE basket: {4 pizzas, 10 lattes}
price of price of
year
pizza latte
2010 $10 $2.00
2011 $11 $2.50
2012 $12 $3.00
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 1
Calculate the CPI price price of
CPI basket: of beef chicken
{10 lbs beef,
2010 $4 $4
20 lbs chicken}
2011 $5 $5
The CPI basket cost $120
in 2010, the base year. 2012 $9 $6
A. Compute the CPI in 2011.
B. What was the CPI inflation rate from 2011–2012?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.