CFA Level 1

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.



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