APMacro: Inflation

Consumer Price Index
Inflation is the increase in the general level of prices. The Consumer Price Index measures the prices of a market basket of goods purchased by the typical urban consumer. Demand-pull inflation is caused by an increase in demand (often due to an increase in the money supply) beyond the ability of firms to supply products. Cost-push inflation results from an increase in the cost of production, which causes firms to reduce supply and raise prices.

Inflation affects consumers by reducing the value of the dollar. Nominal income is the wage in current dollars, while real income removes the effects of inflation, measuring the value of what the paycheck will actually buy in the economy. Unanticipated inflation harms people on fixed incomes because they cannot buy as much with the same income. Savers are hurt because the real value of their savings declines. Creditors are hurt because the money repaid does not have the same purchasing power as the money that was originally loaned. Those who have cost-of-living adjustments (COLAs) in their salaries are unaffected by inflation, because their salaries increase with the rate of inflation, holding their purchasing power steady. Borrowers actually win from inflation, because they repay their debts with dollars that hold less value than the dollars they borrowed. Workers try to anticipate inflation by seeking COLAs or pay increases that match or exceed the inflation rate. Banks and other creditors anticipate inflation by adding the expected rate of inflation to the real interest rate, to determine the nominal interest rate they will charge their customers for loans.

Hyperinflation, the worst degree of inflation, is a situation in which inflation is increasing at a rate of several hundred percent a year. Hyperinflation can result in complete economic collapse. After Germany lost World War I, it was forced to pay heavy reparations to the victorious countries. Germany tried to pay this debt simply by printing more money. By November 15, 1923, it took 4.2 trillion marks (German currency) to equal the value of one U.S. dollar. Meaning that the mark was worth so little that even the paper on which it was printed had greater value.

Stagflation is a combination of economic stagnation or slowdown and high inflation. During a period of stagflation, gross domestic product growth is slow or zero, unemployment is high, and prices are rising. Early in the 1970s, the economy received a shock when the Organization of Petroleum Exporting Countries (OPEC) imposed an oil embargo on the United States and other oil importing countries. Supplies of oil dwindled, driving up the price of gas. The inflation rate, which had already reached worrying levels, soared into double digits. As the economy struggled with rising prices, business activity slowed and the unemployment rate climbed.

A decrease in the average price level of all goods and services in an economy is known as deflation. Deflation may occur when aggregate demand decreases more rapidly than aggregate supply. In such situations, sellers are forced to lower prices to attract buyers. As price decreases, the amount a dollar buys increases. Therefore, deflation boosts the real purchasing power of the dollar. The most prolonged and most recent deflationary period in U.S. history occurred during the Great Depression, when high unemployment coupled with reductions in wages caused aggregate demand and prices to fall.

Inflation is a rise in the general level of prices. When inflation occurs, each dollar of income will buy fewer goods and services than before. Inflation reduces the purchasing power of money. But inflation does not mean that all prices are rising. Even during periods of rapid inflation, some prices may be relatively constant while others are falling.




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