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Chapter 8, Price Level and Inflation

by: Shannon Cummins

Chapter 8, Price Level and Inflation ECON 2006

Shannon Cummins
Virginia Tech
GPA 3.34

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These notes cover the differences between inflation and deflation and the definitions of each. They provide a formula for inflation rate, define consumer price index, and even explain how to compa...
Principles of Economics
Class Notes
Econ, 2006, Economics, Chapter, 8, inflation, rate, price, level, Consumer, index, CPI, deflation, concerns
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This 2 page Class Notes was uploaded by Shannon Cummins on Friday September 9, 2016. The Class Notes belongs to ECON 2006 at Virginia Polytechnic Institute and State University taught by Staff in Fall 2016. Since its upload, it has received 7 views. For similar materials see Principles of Economics in Macroeconomics at Virginia Polytechnic Institute and State University.

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Date Created: 09/09/16
The Price Level and Inflation—9.2.2016 Inflation – the growth in the overall level of prices in an economy (the average of price level changes for all goods increases). Deflation (opposite of inflation) – occurs when overall prices fall (the average of price level changes for all goods decreases). Consumer price index (CPI): a measure of the price level based on the consumption pattern of a typical consumer.  Price index = (basket price/basket price in base year) x 100 o Basket price – price of everything that the consumer uses. 9.7.2016 Inflation rate (i) = tP -t – 1Pt – 1100%  Change in CPI You can use inflation rate to compare prices across time.  Price today = price earlier x (price level today/price level earlier)  Ex. o Price earlier: $100 o Price level earlier: 100 Price today = $100 x o Price level today: 235 (235/100) o What is the price in today’s dollars? Price today = $235 9.9.2016 Concerns about CPI Accuracy 1. Substitution  When prices of goods rise, consumers look to substitute with cheaper options. 2. Quality changes  The quality of goods generally increases and the price increases with it. 3. New products and locations  New goods are introduced and new buying options become available. I.e., consumer baskets change with the addition of new technology, etc.  New businesses may be introduced to an area.  People may switch from in-store to online shopping to save money or for convenience. Costs of Inflation 1. Shoe-leather costs – resources that are wasted when people change behavior to avoid holding money.  As prices go up, it becomes more costly to hold money  Time, effort, and fuel costs that people bear when they try to use more money 2. Money illusion – people interpreting nominal wage or price changes as real price changes. 3. Menu costs – the costs of changing businesses.  Some businesses can change prices easily; some cannot! 4. Uncertainty about future price levels  Wage and other input contracts often have a long-term commitment. Firm may have to borrow today and pay back the money later.  May make borrowing risky 5. Wealth distribution  Wealth can be redistributed between borrowers and lenders  Ex. You borrow $50,000 and expect to pay back $60,000 in five years. i. If unexpected inflation occurs, wealth is redistributed from the bank to you (you are better off; the bank is worse off) ii. If inflation was expected, the bank would have required more in return for the loan 6. Price confusion  Market prices are signal to consumers and firms  Sometimes, when prices increase, businesses cannot distinguish between an increase in demand and inflation. 7. Tax distortions  Capital gains taxes are taxes on the gains realized by selling an asset for more than its purchase price  Price often rises due to inflation rather than an increase in the value of the good Nominal wage – the wage expressed in current dollars. Real wage – nominal wage adjusted for inflation (changes in the price level).


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