Lesson #17 - Inflation, Part II

Between the lockdown drill and chatting about Chapter 5, we didn't get to much of the inflation information. We'll do that today, and then we'll have you look at the auto industry bailout in preparation for a discussion/debate tomorrow.

Fiscal v. Monetary Policy - Let's make sure you understand the basics of these two concepts, since we'll come back to them again and again.

Inflation: We'll be looking at inflation today, since it might be the economic issue of most concern to policymakers and consumers. (I suppose that would be more true when the economy isn't facing its most serious challenges since the Great Depression...) This topic will come up several times, but we'll get some of the basics out of the way.

Defining "inflation": Inflation is a sustained increase in the overall level of prices. The most widely reported measurement of inflation is the consumer price index (CPI).

The Consumer Price Index measures prices of goods and services in a market basket of goods and services that is intended to be representative of a typical consumer's purchases. The percentages currently used to describe the categories of goods and services that market basket are as follows.

• Food and beverages 15 %
• Recreation 6 %
• Housing 42 %
• Education 3 %
• Clothing 4 %
• Communication 3 %
• Transportation 17 %
• Medical care 6 %
• Other goods and services 4 %

Inflation and the CPI, April 16, 2008 - This is the text of the most recent inflation report from the National Council on Economic Education. We can take a look at some of the graphs and charts for a minute.

Much of the following information is simply copied from the EconEd website for our convenience in class today...

Causes of Inflation: Over short periods of time, inflation can be caused by a decrease in production or an increase in spending. We get the names for the two major types from this: demand-pull and cost-push.

Inflation resulting from an increase in aggregate demand or total spending is called demand-pull inflation. Increases in demand, particularly if production in the economy is near the full-employment level of real GDP, pull up prices. It is not just rising spending. If spending is increasing more rapidly than the capacity to produce, there will be upward pressure on prices.

Inflation can also be caused by increases in costs of major inputs used throughout the economy. This type of inflation is often described as cost-push inflation. Increases in costs push prices up. The most common recent examples are inflationary periods caused largely by increases in the price of oil. Or if employers and employees begin to expect inflation, costs and prices will begin to rise as a result.

Over longer periods of time, that is, over periods of many months or years, inflation is caused by growth in the supply of money that is above and beyond the growth in the demand for money.

The Costs of Inflation: Here's one short summary of some of the costs of inflation.

• High rates of inflation mean that people and business have to take steps to protect their financial assets from inflation. The resources and time used to do so could produce goods and services of value.

• High rates of inflation discourage businesses planning and investment as inflation makes the forecasting of prices and costs more difficult. As prices rise, people need more dollars to carry out their transactions. When more money is demanded, interest rates increase.

• The adage "inflation hurts lenders and helps borrowers" only applies if inflation is not expected. For example, interest rates normally increase in response to anticipated inflation. As a result, the lenders receive higher interest payments, part of which is compensation for the decrease in the value of the money lent. Borrowers have to pay higher interest rates and lose any advantage they may have from repaying loans with money that is not worth as much as it was prior to the inflation.

• Inflation does reduce the purchasing power of money.

• Inflation does redistribute income. On average, individuals' incomes do increase as inflation increases. However, some peoples' wages go up faster than inflation. Other wages are slower to adjust. People on fixed incomes such as pensions or whose salaries are slow to adjust are negatively affected by unexpected inflation.

Debate - Auto Industry Bailout