AP Economics

Mr. Bernstein

Module 14: Inflation: An Overview

February 2, 2015

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AP EconomicsMr. Bernstein

Inflation: An Overview• Objectives - Understand each of the following:• The economic costs of inflation• How inflation creates winners and losers• Why policy makers try to maintain a stable rate of

inflation• The difference between real and nominal values of

income, wages and interest rates• The problems of deflation and disinflation

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AP EconomicsMr. Bernstein

Price Levels don’t matter, Relative Prices do• If the price of gas doubles, one can only drive half

as much…unless income also doubles!...in this case real income was flat

• The rate of change is therefore important, not the absolute value of price changes

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AP EconomicsMr. Bernstein

Price Levels don’t matter, Relative Prices do• Inflation rate = (Price level, year 2 – Price level,

year 1) / (Price level, year 1) x 100• Costs of inflation• Shoe leather costs

– Effort spent by consumers seeking lower prices or substitutes

• Menu costs– Effort spent by businesses realigning pricing strategies

• Unit of Account costs– Tax increases based on inflating asset values may not be

matched by income increases

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AP EconomicsMr. Bernstein

Winners and Losers from Inflation• Borrowers pay back loans in dollars with reduced

purchasing power• Nominal Interest Rates = Real Interest Rates +

Expected Inflation• So when inflation exceeds expectations, the borrower

benefits; when inflation is below expectations, the lender benefits

• Inflation can redistribute income from those that are hurt by rising prices to those who gain from rising prices

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AP EconomicsMr. Bernstein

Inflation is Easy; Disinflation is hard• Inflation is a rise in overall price levels• Deflation is a decline in overall price levels• Disinflation is the reduction in inflation rates• Most obvious policy to bring about disinflation is

Monetary Policy (reduce money supply)• Can be painful because it causes a reduction in the

demand for goods and services, which in turn causes a reduction in demand for labor