Inflation

1
Inflation

• Chapter 13 Section 1

2
Objectives

• What is inflation?
• How is inflation measured?
• What causes inflation?
• What are the effects of inflation?

3
Question

• What causes prices to go up and down?

4
Inflation
An INCREASE in the price level (average level
of prices)
The average of all prices is called the price
level.
5
How Do We Measure Inflation?

• Calculate the percentage change of the
• Consumer Price Index (CPI)

6
Calculate the Inflation Rate

• Last Year CPI 110
• This Year 121

CPI (Later Year)
-
CPI (Earlier Year)
Inflation Rate

100
X
CPI (Earlier Year)
-
121
110
100

X
110
10

7
Demand Side Inflation

• An increase in the price level originates on the
  demand side of the economy

Price Level
AS
P2
P1
AD
AD
Quantity (Goods Services)
8
Supply Side Inflation

• An increase in the price level originates on the
  supply side of the economy

Price Level
AS
AS
P2
P1
AD
Quantity (Goods Services)
9
Aggregate Demand
gt
Aggregate Supply
Price Level
AS
AS
P2
P1
AD
AD
Quantity (Goods Services)
When aggregate demand increases by more than
aggregate supply, the price level
increases
inflation occurs.
and
10
The Simple Quantity Theory of Money
The simple quantity theory of money presents a
clear picture of what causes inflation.
Before examining the theory, we need to
understand two terms

• Velocity

• Exchange Equation

11
Velocity

• Average number of times a dollar is spent to buy
  final goods and services.

3 5 6 3 3

20
times
5

Velocity of 4
12
The Exchange Equation
M
V

P
Q
X
X

Quantity of Output
Price Level
Money Supply
Velocity
X
X
13
A Little Algebra
2 x 6 4 x 3
12 12
Double
Double
x 6 x 3
8
4
24 24
14
The Simple Quantity Theory of Money Explanation
Double
Double
M x V P x Q
If V and Q are held constant,
a change in money supply (M) will lead to a
proportional change in the price level (P).
15
Rates of Growth in the Money Supply and the
Inflation Rate

• The simple quantity theory of money predicts that
  changes in the money supply will bring about

proportional changes in the price level.

• The greater the increase in the money supply, the
  greater the increase in the

price level.
16
The Effects of Inflation

• Individuals on Fixed Incomes
• Income stays the same, but prices go up.
• Savers (saving accounts)
• If inflation rate surpasses interest rate, you
  suffer a decrease in buying power.

17

• Past Decisions
• Costly mistakes in bidding contracts
• Hedging against Inflation
• We use resources to hedge against inflation when
  we could be using them to increase productivity.

18
Assessment

• What is inflation?
• How is inflation measured?
• What causes inflation?
• What are the effects of inflation?

19
Small Groups

• What is inflation how is it measured? Give an
  example.
• Explain 3 causes of inflation?
• Explain the Simple Quantity Theory of Money.
• Explain 4 effects of inflation.