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Macroeconomics: measuring the inflation rate and its impact on the economy

Inflation and deflation:

  • Inflation: an increase in the average price level of a nation's output over time.
    • If a country is experiencing inflation, the inflation rate must be positive. Inflation rate is the percentage change in the price level between one period and a previous period.
  • Deflation: a decrease in the average price level of a nation's output over time.
    • deflation means that the inflation rate must be negative. 
Inflation as a macroeconomic indicator:

  • Inflation reduces real incomes of households, thereby reducing their standard of living.
  • Deflation reduces the incentive for firms to invest, it negatively impact borrowers (both firms and households).
  • By knowing the rate of change in price level, policy-makers can implement targeted policies to keep the price level stable.
Shortcomings of inflation as an economic indicator:

  • Inflation is derived from a price index (e.g CPI), which estimates a change in prices based on a particular selection of goods. If the index fails to include a good/service commonly used by households, the index becomes less accurate at estimating changes in the cost of living for households.
  • Although the GDP deflator takes into account every goods and services in an economy, it does not take into account imported goods. This is why is makes sense to use the CPI to calculate inflation in relation to the standard of living of households. Furthermore, the CPI is updated every month whereas the GDP deflator is calculated every 3 months.
Measuring inflation and deflation:

  • A price index is weighted average of prices, it tracks changes in the prices of a selection of the goods produced in a nation in a given time period.
  • A price index is found by dividing the price of a basket of goods in one period by the price in of the identical basket of goods in a base period times 100.
    • Say you want to estimate how the prices have changed between January of this year and March (of the same year).  Use the following formula:
  • Pb stands for "price of basket" and the sub-index indicates the month. Notice that the price of the basket of goods in January is our based period.
Estimating the inflation rate using CPI:

  • Inflation rate is the percentage change in the average price of goods and services over time.
  • i denote a time period and i-1 denoted the time period that precedes i.
  • If the inflation rate is positive (negative), this means that purchasing power of the $ is decreasing (increasing). It takes more (less) dollars to buy the same basket of goods than in the previous time period.
Weighted categories in the CPI: 

  • the CPI is a weighted average, in order to account for the different proportions of an average household's disposable income that goes toward different types of goods.
  • This provides a more accurate reflection of the impact of inflation on the cost of living.
The cost of inflation:

  • Smaller purchasing power, in other words, it reduces the real household income.
    • Real income:
  • Ri stands for real income and Ni for nominal income. The denominator adjusts for the inflation rate. If the inflation rate is positive (negative), Ri must be lower (higher) than Ni.
  • Lowers real interest rates for savers:
    • Interest rates are the return on savings. Money saved in a bank grows by the amount of interest earned in a given time period.
  • the real interest rate is equal to the difference between the nominal interest rate and the inflation rate.

  • Borrowers benefit from inflation as it reduces how much (real) interest they have to pay.
  • If inflation is anticipated, banks will increase the nominal rates for borrowers.
  • nominal interest rate banks charge borrowers usually includes an inflation premium, based in the expected rate of inflation.
Inflation can lead to more inflation:

  • If there is inflation in an economy, firms and households will save less and spend more money, since inflation lowers the real interest rate.
  • More spending contributes to more inflation (higher short term demand). Workers will demand higher wages (increase in cost) causing also more inflation.
  • Governments and central banks try to keep prices roughly constant by keeping inflation around 2-3%.
Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 81-92.
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