Macroeconomics - Inflation

Determining Inflation

Inflation vs. Price-Level
The term price-level refers to the prices that must be paid in order to acquire a basket of good and services. The phenomenon of inflation refers to a continual rise of the price-level. When inflation occurs, the purchasing power of a unit of money (the dollar in the United States) is declining.

The inflation rate is calculated by comparing the price level in one time period to the price level of a previous period. Suppose the price level is currently 110, and the price level of the previous year is 100. The annual rate of inflation would then be 10%.

The inflation rate in general can be stated as:

Formula 4.6

Inflation Rate = ((P1 - P0) / P0) X 100

P1 is the price level of the later time period, and P0 is the price level of the previous time period.

Causes of Inflation

Two main types of impulses for inflation in an economy include:
·Demand-pull - aggregate demand rising more rapidly than aggregate supply

·Cost-push - there is a decrease in aggregate supply

Factors creating a demand-pull inflation include an:

·Increase in government spending

·Increase in the supply of money

·Increase in the price level in the rest of the world - if prices increase in other countries, residents of those countries will want to buy goods from domestic producers; i.e., exports will increase

The main factors which induce a cost-pull inflation include an:

·Increase in wage rates

·Increase in raw material costs

Demand-pull inflation represents an increase in aggregate demand, which will shift the aggregate demand curve to the right. Cost-push inflation will involve the aggregate supply curve shifting to the left.Both result in higher price levels.

Unanticipated Inflation
Unanticipated inflation in the labor market will cause workers to work for less wages then what they would knowingly work for. Employers may get higher profits due to the higher prices. The result will be a transfer of income from workers to employers. There is also a possibility that employment will be higher than "full employment".

Unanticipated inflation in the financial capital market also begets a transfer of income. In this case, borrowers gain at the expense of lenders. The amount of borrowing and lending will not be optimal, as lenders will unwittingly loan out too much funds.

Anticipated vs. Unanticipated Inflation
Inflation that comes as a surprise to most people is called unanticipated inflation. If changes in price levels are widely anticipated, then that inflation is referred to as anticipated inflation. In general, steady rates of inflation can be anticipated successfully by economic decision makers.

There are many harmful consequences to inflation. Some of the consequences include:

  • Individuals Apply their Efforts to Protecting Themselves from Inflation Instead of to Production - People will spend a great deal of time and money acquiring information about how to protect themselves (and/or profit) from inflation. Capital flows towards speculative assets such as gold and art objects, instead of productive investments such as buildings and machinery and the incentive to speculate instead of work increases.
  • Inflation Increases the Risk of Investments - Wild fluctuations in price levels make forecasting future earnings more difficult; this tend to discourage investment.
  • The Information Delivered by Prices is Distorted by Inflation - Some price changes are restrained by long-term contracts, while others respond quickly to changes in the general price level.
  • Unanticipated inflation can change relative prices. These distorted prices may provide poor signals to producers and resource suppliers.
Phillips Curve


Related Articles
  1. Retirement

    Inflation: What Is Inflation?

    Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys ...
  2. Retirement

    Inflation: Conclusion

    After reading this tutorial, you should have some insight into inflation and its effects. For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, ...
  3. Economics

    Macroeconomics: Inflation

    By Stephen Simpson Inflation is a key concept in macroeconomics, and a major concern for government policymakers, companies, workers and investors. Inflation refers to a broad increase in prices ...
  4. Forex

    Inflation

    An in-depth look at inflation
  5. Fundamental Analysis

    What Causes Inflation in the United States

    Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out.
  6. Entrepreneurship

    Cost-Push Inflation Versus Demand-Pull Inflation

    Gain a deeper understanding of aggregate supply and demand, forces which raise the price of goods and services.
  7. Economics

    Cost-Push Inflation Versus Demand-Pull Inflation

    Do you remember how much less you paid for things ten years ago? That’s inflation at work.
  8. Investing Basics

    Inflation's Impact On Stock Returns

    When stocks are divided into growth and value categories, the evidence is clear that value stocks perform better in periods of high inflation, and growth stocks perform better during periods ...
  9. Fundamental Analysis

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  10. Professionals

    Price Changes in the Economy

    FINRA Series 6 Exam Study Guide - Price Changes in the Economy. In this section, two types of Inflation, demand-pull and cost-push inflation. Deflation, contrary to inflation, is the persistent ...
RELATED TERMS
  1. Inflation Trade

    A method of investing that seeks to profit from an overall increase ...
  2. Base Effect

    The consequence of abnormally high or low levels of inflation ...
  3. Inflation Protected

    The types of investments that provide protection against inflation ...
  4. Cost-Push Inflation

    A phenomenon in which the general price levels rise (inflation) ...
  5. Inflation Targeting

    A central banking policy that revolves around meeting preset, ...
  6. Demand-Pull Inflation

    A term used in Keynesian economics to describe the scenario that ...
RELATED FAQS
  1. How can inflation be good for the economy?

    Find out why some economists and public policy makers believe that inflation is a good, or even necessary, phenomenon to ... Read Answer >>
  2. What is inflation and how should it affect my investing?

    Inflation, an economic concept, is an economy-wide sustained trend of increasing prices from one year to the next. The rate ... Read Answer >>
  3. Why are P/E ratios generally higher during times of low inflation?

    Inflation affects equity prices in several ways. Most importantly, investors are willing to pay less for a certain level ... Read Answer >>
  4. How does inflation affect fixed-income investments?

    Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... Read Answer >>
  5. What does the current cost of living compare to 20 years ago?

    Find out how inflation has affected the dollar since 1994, and how the cost of living has changed above and beyond what can ... Read Answer >>
  6. What are the advantages and disadvantages of a wage price spiral?

    Read about the so-called wage-price spiral, a Keynesian explanation for rising prices that exist concurrently with rising ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center