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Engineering Economics Lect 4.

The document discusses inflation, how it is measured, and its costs. It defines inflation as the rate of increase in prices over time. Inflation is typically measured using the consumer price index (CPI), which tracks the prices of goods and services in a typical consumer's market basket. Calculating CPI involves fixing the basket, finding prices, computing costs, choosing a base year, and computing the inflation rate as the percentage change in CPI. Higher inflation imposes shoeleather, menu, and tax costs on the economy.

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Furqan Chaudhry
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54 views21 pages

Engineering Economics Lect 4.

The document discusses inflation, how it is measured, and its costs. It defines inflation as the rate of increase in prices over time. Inflation is typically measured using the consumer price index (CPI), which tracks the prices of goods and services in a typical consumer's market basket. Calculating CPI involves fixing the basket, finding prices, computing costs, choosing a base year, and computing the inflation rate as the percentage change in CPI. Higher inflation imposes shoeleather, menu, and tax costs on the economy.

Uploaded by

Furqan Chaudhry
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Engineering Economics

Lecturer: Muhammad Ali Abdullah Mirza


Inflation

Inflation is the rate of increase in prices over a given


period of time.
Measuring Inflation: CPI

• The consumer price index (CPI) is a measure of the


overall cost of the goods and services bought by a
typical consumer
• It measures changes in the cost of living over
time
• When the CPI rises consumers have to spend
more money to maintain the same standard of
living
Five Stages to Calculating CPI (1/2)

① Fix the Basket: Determine what prices are most


important to the typical consumer.
• The national statistical offices identify a market basket
of goods and services the typical consumer buys.
• The statistical offices conduct regular consumer surveys
to set the weights for the prices of those goods and
services.
② Find the Prices: Find the prices of each of the goods
and services in the basket for each point in time.
Five Stages to Calculating CPI (2/2)

③ Compute the Basket’s Cost:


• Use the data on prices to calculate the cost of the basket of
goods and services at different times.
④ Choose a Base Year and Compute the Index:
• Designate one year as the base year, making it the
benchmark against which other years are compared.
• Compute the index by dividing the price of the basket in one
year by the price in the base year and multiplying by 100.
⑤ Compute the inflation rate:
• The inflation rate is the percentage change in the price
index from the preceding period.
Calculating the Inflation Rate

• The inflation rate is calculated as follows:

CPI in Year 2 - CPI in Year 1


Inflation Rate in Year 2 =  100 %
CPI in Year 1
Calculating the Consumer Price Index and the Inflation Rate: An Example
Calculating the Consumer Price Index and the Inflation Rate: An Example
How an increase in Money Supply
might increase Inflation (1/2)

How to ban the “inflation monster“?


How an increase in Money Supply
might increase Inflation (2/2)

A helicopter (the “inflation monster”) drops money


on all individuals and firms
• Individuals and firms feel richer → demand more
consumption and investment goods
• But the economy cannot produce more because
production level is determined by real factors:
labor, human capital etc.
• Prices have to increase to curb demand
The Fisher Effect

• The Fisher effect refers to a one-to-one adjustment


of the nominal interest rate to the inflation rate.
• According to the Fisher effect, when the rate of
inflation rises, the nominal interest rate rises by the
same amount.
• The real interest rate stays the same.

Nominal interest rate = Real interest rate + Inflation rate


The Costs of Inflation

① Shoeleather costs
② Menu costs
③ Relative price variability
④ Tax distortions
⑤ Confusion and inconvenience
⑥ Arbitrary redistribution of wealth
Shoeleather Costs

• Inflation reduces the real value of money, so people


have an incentive to minimize their cash holdings.
• Less cash requires more frequent trips to the bank
to withdraw money from interest-bearing accounts.
These extra trips means time away from productive
activities.
Menu Costs

• Menu costs are the costs of adjusting prices.


– During inflationary times, it is necessary to
update price lists and other posted prices.
– This is a resource-consuming process that takes
away from other productive activities.
Relative-Price Variability

• Inflation distorts relative prices


• Consumer decisions are distorted, and markets are
less able to allocate resources to their best use
Inflation-induced Tax Distortion

• Inflation exaggerates the size of capital gains and increases the


tax burden on this type of income.
– With progressive taxation, capital gains are taxed more
heavily.
– The nominal interest earned on savings is treated as income
for income tax purposes, even though part of the nominal
interest rate merely compensates for inflation.
– The after-tax real interest rate falls when inflation rises,
making saving less attractive.
How inflation raises the tax burden on saving
Confusion

• When the central bank increases the money supply and


creates inflation, it erodes the real value of the unit of
account
• Inflation causes money at different times to have different
real values
• Therefore, with rising prices, it is more difficult to compare
real revenues, costs, and profits over time
Redistribution of Wealth
• Unexpected inflation redistributes wealth among
the population in a way that has nothing to do with
either merit or need
• These redistributions occur because many loans in the
economy are specified in terms of the unit of
account—money
Deflation
• Deflation where the price level actually falls
• Deflation can be as damaging as inflation because:
– There is little incentive to spend today if the
expectation is for cheaper prices tomorrow
– It might result in consumers not spending at levels
that provide incentives for firms to invest in new
capacity
– little or no growth and with that….increased
likelihood of unemployment
Thank You

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