Subject 4. Inflation

Inflation is a continuing rise in the general level of prices of goods and services. It can also be defined as a decline in the value (the purchasing power) of the monetary unit. There is too much money chasing too few goods.

  • It is a rise in the price level, not in the price of a particular commodity. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs.
  • It is an ongoing process, not a one-time jump in the price level.

There are different types of inflation.

  • Deflation is a decrease in the general price level of goods and services.
  • Disinflation is a slowing in the rate of increase in the general price level.
  • Hyperinflation indicates a very high and increasing rate of inflation.

The annual inflation rate is simply the percentage change in the price index (PI) from one year to the next:

For example, the CPI is 115 for 2010 and 120 for 2011. The inflation rate during 2011 is: (120 - 115)/115 = 4.35%.

The Laspeyres index uses the same group of commodities purchased in the base period.

  • Advantages: It requires quantity data from only the base period. This allows a more meaningful comparison over time. The changes in the index can be attributed to changes in the price.
  • Disadvantages: It does not reflect changes in buying patterns over time. It may also overweight goods when prices increase.

The Paasche index uses the current composition of the basket. It tends to understate inflation.

The Fisher index is the geometric mean of the two indices.

Many countries use their own consumer price indices to track domestic inflation. These indices have different names and baskets.

Inflation is not simply a matter of rising prices. In the long run, inflation occurs if the quantity of money grows faster than potential GDP. In the short run, there are endemic and perhaps diverse reasons for causes at the root of inflation.

Inflation can result from either an increase in aggregate demand (demand-pull inflation) or a decrease in aggregate supply (cost-push inflation).

  • Cost-push inflation is a result of decreased aggregate supply as well as increased costs of production (itself a result of different factors). It basically means that prices have been "pushed up" by increases in the costs of any of the production factors (money wage rate and money price of raw materials) when companies are already running at full production capacity. Increased costs are passed on to consumers, causing a rise in the general price level (inflation).

    • The non-accelerating inflation rate of unemployment (NAIRU), or the natural rate of unemployment (NARU), is defined as the rate of unemployment when the rate of wage inflation is stable.
    • The unit labor cost (ULC) indicator is calculated as total compensation per worker divided by total output per worker. Higher labor costs may pass through to prices.

  • Demand-pull inflation occurs when total demand for goods and services exceeds total supply. Buyers, in essence, "bid prices up" and cause inflation. This excessive demand usually occurs in an expanding economy.

    The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, the authorities may allow the money supply to grow faster than the ability of the economy to supply goods and services, so there is "too much money chasing too few goods." Increases in government purchases and depreciations of local exchange rates can also increase aggregate demand and start demand-pull inflation. However, only an ongoing increase in the quantity of money can sustain it.

If an economy identifies what type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to rectify (if necessary) rising prices and loss of purchasing power.

User Contributed Comments 9

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cong: recession + inflation = stagflation.
SaeedAlam: What if the Fed does nothing?
tommathew: Stagfaltion has happened in 2008 as well.
EMerkert: If the Fed does nothing or ceases to exist, the world would be a much happier and better place.

The U.S. would no longer have the money to support its bogus wars and pass the inflation off to its citizens.
leftcoast: Thanks EMerkert. I'm sure your personal opinions will really help people pass the test.
Mijalko: If the Fed ceases to exist than US government will take the responsibility of printing money hopefully in accordance with needs of real sector that is as GDP moves. But without charging interest, thus removing debt spiral which will (if nothing is changed) collapse the US economy. Maybe this doesn't help pass the exam but this is a must know if you want to be good economist.
schweitzdm: This section was brutal in my opinion.
kay136: LOL leftcoast
guest: Can anyone check the corrections of this notes?
*AD= aggregate demand
*AS= aggregate supply

1. recessionary gap- cause by decrease in AD
2. inflationary gap- increase in AD
3. stagflation- decrease AD and AS
4. cost push- decrease in AS
5. demand- increase in AS