Inflation, Deflation and Price Stability

inflation, deflation, purchasing power, overall price level, consumer price

index, “market basket”, inflation rate, “individual basket”, individual rate of
inflation, price stability, living standards, hyperinflation

Text A
Inflation and Deflation
Inflation and deflation are important economic phenomena that have negative
consequences for the economy. Basically, inflation is defined as a general, or
broadly-based, increase in the prices of goods and services over an extended
period which consequently leads to a decline in the value of money and thus its
purchasing power.
Deflation is often defined as the opposite of inflation, namely as a situation in
which the overall price level falls over an extended period.
When there is no inflation or deflation, we can say that there is price stability
if, on average, prices neither increase nor decrease but stay stable over time. If,
for instance, EUR 100 can buy the same basket of goods as it could, say one
and two years ago, then this can be called a situation of absolute price stability.

Movements in individual prices and in the general price level

It is important to make a distinction between movements in prices of any
individual good or service and movements in the general price level. Frequent
changes in individual prices are quite normal in market-based economies, even
if there is price stability overall. The changes in supply and / or demand
conditions of individual goods or services inevitably lead to changes in their
price. For example, in recent years we have seen substantial declines in the
prices of computers and mobile phones, mainly resulting from rapid
technological progress. However, from the beginning of 1999 to mid-2006, oil
and other energy prices increased, partly as a result of concerns regarding the
future supply of energy and partly as a result of increased demand for energy,
in particular from fast-growing economies. On the whole, inflation in most
industrialized countries remained low and stable – stability in the general price
level can go hand-in-hand with substantial changes in individual prices as long
as falling and rising prices offset each other so that the overall price level
remains unchanged.
Measurement issues
How can inflation be measured? There are millions of individual prices in an
economy. These prices are subject to continuous moves which basically reflect
changes in the supply of and the demand for individual goods and services and
thus give an indication of the “relative scarcity” of the respective goods and
services. It is obvious that it is neither feasible nor desirable to take all of these
prices into account, but neither is it appropriate to look at just a few of them,
since they may not be representative of the general price level.

Consumer Price Index

Most countries have a simple common-sense approach to measuring inflation,
using the so-called “Consumer Price Index” (CPI). For this purpose, the
purchasing patterns of consumers are analyzed to determine the goods and
services which consumers typically buy and which can therefore be considered
as somehow representative of the average consumer in an economy. As such
they do not only include those items which consumers buy on a day-to-day
basis (e. g. bread and fruit), but also purchases of durable goods (e. g. cars,
PCs, washing machines, etc.) and frequent transactions (e. g. rents). Putting
together this “shopping list” of items and weighting them according to their
importance in consumer budgets leads to the creation of what is referred to as a
“market basket”. Each month, a host of “price surveyors” checks on the prices
of these items in various outlets. Subsequently, the costs of this basket are then
compared over time, determining a series for the price index. The annual rate
of inflation can then be calculated by expressing the change in the costs of the
market basket today as a percentage of the costs of the identical basket the
previous year.
However, the developments of the price level as identified by such a basket
only reflect the situation of an “average” or representative consumer. If a
person’s buying habits differ substantially from the average consumption
pattern and thus from the market basket on which the index is based, that
person may experience a change in the cost of living that is different to the one
shown in the index. There will therefore always be some people who
experience a higher “inflation rate” for their “individual basket” and some who
face a lower “individual rate of inflation”. In other words, the inflation
measured by the index is only an approximate measure of the average situation
in the economy; it is not identical to the overall price changes faced by each
individual consumer.

Measurement problems
For various reasons, there are some difficulties associated with any attempt to
express the overall change in prices as one number.
First, an existing basket usually becomes less and less representative over
time, as consumers increasingly substitute more expensive goods for cheaper
ones. For example, higher petrol prices might lead some people to drive less
and buy a higher quantity of other goods instead. Therefore, if the weights are
not adjusted, the change in the index may slightly overestimate the “true” price
increases. Second, changes in quality are sometimes difficult to incorporate
into the price index. If the quality of a product improves over time and the
price also rises, some of the change in price is due to the improved quality.
Price increases which are due to quality changes cannot be considered as
giving rise to inflation, as they do not reduce the purchasing power of money.
Changes in quality are commonplace over long periods of time. For example,
today’s cars differ considerably from those manufactured in the 1970s, which
in turn were very different from those of the 1950s. Statistical offices spend a
lot of time making adjustments for quality changes, but by their very nature
such adjustments are not easy to estimate. Apart from new varieties of existing
goods (e. g. the introduction of new breakfast cereals), an important and
difficult subject is the inclusion of new products. For example, after DVD
players came on the market, there was an inevitable time lag until they could
be captured in price statistics, since information on the market shares, the main
distribution channels, the most popular makes, etc., was needed. But if it takes
too long to incorporate new products into the price index, the price index fails
to fully reflect the actual average price changes that consumers are facing.

Nominal and real variables

As is explained above, in the case of inflation, a given amount of money can
buy increasingly fewer goods. This is the same as saying that there is a fall in
the value of money or a decrease in its purchasing power. This observation
brings us on to another important economic issue: the difference between
nominal and real variables. A nominal variable is one that is measured in
current prices. Such variables usually move with the price level and therefore
with inflation. In other words, the effects of inflation have not been accounted
for. Real variables, however, such as real income or real wages, are variables
where the effects of inflation have been deducted or “taken out”.
Let us assume that a worker’s earnings increase by 3 % in nominal (i.e. in
money) terms per year, in other words, his monthly earnings increase from,
say, EUR 2000 to EUR 2060. If we further assume that the general price level
were to increase by 1.5 % over the same period, which is equivalent to saying
that the rate of inflation is 1.5 % per annum, then the increase in the real wage
is ((103/101.5) – 1) x 100 ≈ 1.48 % (or approximately 3 % – 1.5 % = 1.5 %).
Therefore, the higher the rate of inflation for a given nominal wage increased
the fewer goods the worker can buy.
Another important distinction is between nominal and real interest rates (see
also Box 3.2 below). By way of an example, let us suppose that you can buy a
bond with a maturity of one year at face value which pays 4 % at the end of the
year. If you were to pay EUR 100 at the beginning of the year, you would get
EUR 104 at the end of the year. The bond therefore pays a nominal interest
rate of 4 %. Note that the interest rate refers to the nominal interest rate, unless
otherwise stated.
Now let us suppose that the inflation rate is again 1.5 % for that year. This is
equivalent to saying that today the basket of goods will cost EUR 100, and
next year it will cost EUR 101.50. If you buy a bond with a 4 % nominal
interest rate for EUR 100, sell it after a year and get EUR 104, then buy a
basket of goods for EUR 101.50, you will have EUR 2.50 left over. So, after
factoring in inflation, your EUR 100 bond will earn you about EUR 2.50 in
“real” income, which is equivalent to saying that the real interest rate is about
2.5 %. It is obvious that if inflation is positive then the real interest rate is
lower than the nominal interest rate.

Vocabulary list
1. inflation – инфляция
2. deflation - дефляция
3. hyperinflation - гиперинфляция
4. general price level – общий уровень цен
5. to offset - компенсировать
6. to be subject to something – подвергаться, подчиняться
7. feasible – осуществимый, возможный
8. Consumer Price Index (CPI) – индекс потребительских цен
9. consumption pattern – структура потребления
10. the cost of living – стоимость жизни
11. price stability – ценовая стабильность
12. living standard(s) – уровень жизни
syn. standard of living

Ex 1. Suggest the Russian equivalents:

economic phenomena – экономическое явление

broadly-based increase in the prices of goods – широко обоснованное
повышение цен на товары и услуги
overall price level falls over an extended period – общий уровень цен
падает в течение длительного периода
market-based economies – рыночная экономика
stability can go hand-in-hand with substantial changes – стабильность
может идти рука об руку со значительными изменениями
relative scarcity of the respective goods and services – относительный
дефицит соответствующих товаров и услуг
it is neither feasible nor desirable – нецелесообразно и нежелательно
the purchasing patterns of consumers – покупательная способность
потребителей
the creation of what is referred to as a “market basket” – создание так
называемой “рыночной корзины”
a change in the cost of living – изменение стоимости жизни

Ex 2. Find in the text the English equivalents for the following:

привести к падению стоимости денег – to lead to a fall in the value of
money
ситуация абсолютной ценовой стабильности – a situation of absolute
price stability
неизбежно – inevitably
цены подвержены постоянным колебаниям – prices are subject to
continuous moves/fluctuations
принимать во внимание – to take into account
годовой уровень инфляции – the annual rate of inflation
измеряемая индексом инфляция – the inflation measured by the index
умножить количество товаров на соответствующие цены – multiply
the number of products by the corresponding prices
высчитывать индекс цен – to calculate the price index
дать общую картину – to give a general picture

Ex 3. Match each term with the appropriate explanation.

price-level, Consumer Price Index, inflation, deflation, consumer durables
1. An increase in the general price level, e.g. in the CPI over an extended
period.
inflation
2. A sustained decline in the general price level, e.g. in the CPI, over an
extended period.
deflation
3. The economic indicator which measures the prices of a fixed market basket
of some 300 consumer goods and services purchased by a typical urban
consumer.
Consumer Price Index
4. Goods that are intended to be used over a period of time.
consumer durables
5. The average of all prices in a country at particular time.
price-level

Ex 4. Answer the questions.

1. What economic phenomena may have negative consequences for the
economy? What do they imply?
The economic phenomena that may have negative consequences for the
economy is inflation. Negative consequences imply: an increase in the prices,
a decline in the value of money and thus its purchasing power.

2. What is called the situation when there is no inflation or deflation?

Price stability.

3. Why is it important to differentiate between movements in prices of any

individual good or service and movements in the general price level?

4. How can stability in the general price level go in line with substantial
changes in individual prices?
Stability in the general price level can go in line with substantial changes in
individual prices as long as falling and rising prices offset each other so that
the overall price level remains unchanged.

5. How can inflation be measured? Why measure it?

We can measure inflation using the “Consumer Price Index”. This measure is a
good way of keeping track of how prices change in the economy.

6. What is “market basket”?

It is a variety of consumer goods and services used to calculate a consumer
price index.

7. What is CPI? How it is calculated?

The “Consumer Price Index” with which help purchasing patterns of
consumers are analyzed to determine the goods and services which consumers
typically buy and which can be considered as representative of the average
consumer in an economy.

Inflation rate = ((CPI current-CPI base year)/CPI base)*100

8. How is the annual rate of inflation calculated?

The annual rate of inflation can be calculated by expressing the change in the
costs of the market basket today as a percentage of the costs of the identical
basket the previous year.
9. What is implied in “average consumption pattern”? who is an “average
customer”?

Ex 5. Find in the text the words and expressions that characterize or

name:
1) the situation when prices neither increase nor decline
Price stability.
2) the purchasing patterns of consumers
Market basket.
3) the overall price changes faced by each individual consumer
Deflation.
4) a means for giving a general picture of what is happening to many prices
CPI.

Ex 6. Comment on the following:

1. Frequent changes in individual prices are quite normal in market-based
economies, even if there is price stability overall.
2. The inflation measured by the index (CPI) is only an approximate measure
of the average situation in the economy.
It is not identical to the overall price changes faced by each individual
consumer.

3. The price index may rise despite some prices actually declining.

Text B
The information given in the previous text explains why inflation and deflation
are generally undesirable phenomena.
Indeed, there are substantial disadvantages and costs related to inflation and
deflation. Price stability prevents these costs from arising and brings about
important benefits for all citizens. There are several ways in which price
stability helps to achieve high levels of economic welfare, e. g. in the form of
high employment.
Price stability supports higher living standards by helping to reduce
uncertainty about general price developments and thereby improve the
transparency of relative prices.
First, price stability makes it easier for people to identify changes in the prices
of goods expressed in terms of other goods (i.e. “relative prices”), since such
changes are not concealed by fluctuations in the overall price level. For
example, let us suppose that the price of a certain product increases by 3 %. If
the general price level is stable, consumers know that the relative price of this
product has increased and may therefore decide to buy less of it. If there is
high and unstable inflation, however, it is more difficult to find out the relative
price, which may have even declined. In such a situation it may be better for
the consumer to buy relatively more of the product of which the price has
increased by “only” 3 %. In the case of general deflation, consumers may not
be aware of the fact that a fall in the price level of a single product merely
reflects general price developments and not a fall in the relative price level of
this good. As a result, they may mistakenly buy too much of this product.
Consequently, if prices are stable, firms and consumers do not run the risk of
misinterpreting changes in the general price level as relative price changes and
can make better informed consumption and investment decisions.
Uncertainty about the rate of inflation may also lead firms to make wrong
employment decisions. To illustrate this, let us suppose that in an environment
of high inflation, a firm misinterprets the increase in the market price of its
goods by, say, 5 %, as a relative price decrease as it is not aware that the
inflation rate has recently fallen from, say, 6% to 4%. The firm might then
decide to invest less and lay off workers in order to reduce its production
capacities, as it would otherwise expect to make a loss given the perceived
decrease in the relative price of its goods. However, this decision would
ultimately turn out to be wrong, as the nominal wages of employees due to
lower inflation may increase by less than that assumed by the firm. Economists
would describe this as a “misallocation” of resources. In essence, it implies
that resources have been wasted, as some employees would have been made
redundant because of instabilities in price developments.
Price stability reduces inflation uncertainty and therefore helps to prevent the
misallocation of resources described above. By helping the market guide
resources to where they can be used most productively, lasting price stability
increases the efficiency of the economy and, therefore, the welfare of
households.
Hyperinflation
A situation in which the rate of inflation is very high and/or rises constantly
and eventually becomes out of control is called “hyperinflation”. Socially,
hyperinflation is a very destructive phenomenon which has far-reaching
consequences for individuals and society as a whole. Although there is no
generally accepted definition of hyperinflation, most economists would agree
that a situation where the monthly inflation rate exceeds 50% can be described
as hyperinflation.
Hyperinflation and periods of very high inflation occurred several times during
the 20th century. Below are some examples of countries that experienced such
high annual rates of inflation and the respective figures for the years indicated:
1922 Germany 5,000 %
1946 Hungary 41,900,000,000,000,000%
1985 Bolivia more than 10,000 %
1989 Argentina 3,100 %
1990 Peru 7,500 %
1993 Brazil 2,100 %
1993 Ukraine 5,000 %

The post-WWII hyperinflation of Hungary holds the record for the most rapid
monthly inflation increase ever. It means prices doubled every 13,5 hours.
Let us briefly illustrate the consequences of such a phenomenon. An inflation
rate of 50 % per month implies an increase of more than 100-fold in the price
level over a year and an increase of more than two million-fold over three
years. There is no doubt that such rates of inflation place a heavy burden on
society. In fact, in Germany, the hyperinflation that followed World War I and
peaked in 1923 had devastating economic, social and – as is widely agreed –
political consequences.
As many people lost their savings, this led to a substantial loss in wealth for
broad segments of the population. The realization that price levels were
constantly rising sparked a vicious circle. People naturally asked for higher
wages, anticipating higher price levels in the future. These expectations
became a reality, since higher wages translated into higher costs of production,
which again meant higher prices. In the same vein, people started to pass on
their money – which lost its value – by spending faster and faster.
The Government reacted to the decline in the value of money by adding more
and more zeros to the paper currency, but over time it became impossible to
keep up with the exploding price level. Eventually these hyperinflation costs
became intolerable. Over time money completely lost its role as a store of
value, unit of account and medium of exchange. Barter became more common
and unofficial monies, such as cigarettes, which did not lose their value due to
inflation, started to replace official paper money.
The first country to hyperinflate in the 21 st century is Zimbabwe. In 2008, a
loaf of bread cost 1.6 trillion Zimbabwe dollars. Officials in Zimbabwe blamed
it on rising global food prices and international sanctions. The Zimbabwean
dollar bank note holds the record for the greatest number of zeros shown
(100,000,000,000,000). Hungary holds the record for the largest banknote ever
issued, but its bank note did not depict all the zeros – the amount was spelled
out.
 Vocabulary list
1. fluctuation – колебание, неустойчивость
2. to misinterpret – неправильно оценить
3. redundant – излишний, убыточный; уволенный, потерявший работу
4. to place a heavy burden (on) – возлагать тяжелое бремя (на)
5. to keep up (with) – соответствовать чему-либо

Ex 1. Suggest the Russian equivalents:

substantial disadvantages and costs related to inflation and deflation –

существенные недостатки и издержки, связанные с инфляцией и
дефляцией
to identify changes in the prices of goods expressed in terms of other goods
– выявлять изменения цен на товары, выраженных в терминах других
товаров
fluctuations in the overall price level – колебания общего уровня цен
to make better informed consumption and investment decisions –
принимать более обоснованные решения о потреблении и инвестициях
to misinterpret the increase in the market price – неверно истолковывать
увеличение рыночной цены
to turn out to be wrong – оказаться ошибочным
ultimately – в конечном счете, в конце концов
to have devastating economic social and political consequences – иметь
разрушительные экономические социальные и политические последствия
a substantial loss in wealth – существенная потеря благосостояния
broad segments of the population – широкие слои населения
to keep up with the exploding price level – гнаться за стремительно
растущим уровнем цен

Ex 2. Find in the text the English equivalents for the following:

высокий уровень занятости – high employment
увеличиться на 3% – increase by 3 %
осознавать что-либо – to be aware of
идти на риск – run the risk
сократить производственные мощности – in order to reduce its
production capacities
из-за более низкой инфляции – due to lower inflation
неустойчивость – instability
тяжелое бремя – a heavy burden
высокие заработки привели к увеличению производственных
издержек – higher wages translated into higher costs of production
стать невыносимым – to become intolerable
неофициальные деньги – unofficial monies

Ex 3. Match each term with the appropriate explanation.

hyperinflation, misallocation of resources, redundancy, relative prices,
living standard, price stability
1. Changes in the prices of goods expressed in terms of other goods
relative prices
2. The degree to which a person and their families, or a community, are able to
satisfy their needs.
living standard
3. Taking wrong decisions as to application of capital, labour etc.
misallocation of resources
4. A situation where the rate of inflation is rising and becoming uncomfortable.
hyperinflation
5. Maintaining the annual inflation rate at below but close to 2% (for the euro
area) over the medium term.
price stability
6. A situation when an employee is no longer needed by his employer.
redundancy

Ex 4. Answer the questions and do the assignments.

1. How can price stability help to achieve high level of economic welfare?
2. What is implied in “economic welfare”?
3. What stands for the transparency of relative prices?
4. What happens if a firm misinterprets the increase in the market price of its
goods (in an environment of high inflation)?
5. Give examples of “misallocation” of resources.
6. What stands for the nation “hyperinflation”? Give examples of this
phenomenon occurring in different countries.

Ex 5. Increase your vocabulary.

A. Fill in prepositions where necessary.
1. The changes in the cost of living were related to inflationary processes in
the economy.
2. The price of buckwheat has increased by more than 50% lately.
3. An inflation rate of 250% per month implies an increase …-… of more than
50-fold in the price level over a year.
4. The inflation rate has recently fallen from 8% to 6%, which has caused a
substantial decrease in some consumer prices.
5. Prices stability makes it easier for people to identify changes in the prices
…-… goods expressed in terms of other goods. Such changes are not
concealed by fluctuations in the overall price level.

B. Match the words that are similar in meaning.

Fluctuation - instability
expect - anticipate
welfare - prosperity
lay off - dismiss
misinterpretation - misunderstanding
related - connected
decrease - reduce
consequence - effect
devastating - destructive
increase - rise

C. Study the word combinations with the word “price”. Use them
in the sentences of your own.
 acceptable price – приемлемая цена
 attractive price – привлекательная цена
 fixed price – фиксированная цена
 average price – средняя цена
 competitive price – конкурентная цена
 consumer price – цены на потребительские товары
 cost price - себестоимость
 fair price – справедливая цена
 falling/rising price – снижающаяся/растущая цена
 at a (high, low) price – по цене
 price per unit - цена за единицу
 to fix (establish) a price – устанавливать цену
 to price – назначать цену
  a price of, for – цена чего-либо

Other adjectives: cut, current, discount, inflated, high (heavy), low (keen), just,
stable (steady), fluctuating, retail, wholesale.
Verbs: to bargain over, to cut, to increase/decrease, to raise, to reduce, to
buy/sell at a price, to pay/meet the price, to go down/up in price.

D. Translate into English.

1. Растущие цены на продукцию, даже на потребительские товары -
отличительная черта инфляции.
2. Мы не можем покупать ваши товары по таким высоким ценам.
3. Себестоимость этого товара достаточно низка. Это позволит нам
продать его на рынке по привлекательной цене.
4. В условиях плановой экономики правительство устанавливает
фиксированные цены на все товары.
5. Если вы поторгуетесь, вам, может быть, удастся купить эту вещь по
более приемлемой цене.
6. Во время кризиса цены на многие товары и услуги значительно
снижаются.
7. Наша компания установила конкурентные оптовые цены на это
оборудование.
8. Текущие цены на топливо достаточно высоки.
9. Если урожай в этом году будет ниже ожидаемого, цены на
сельскохозяйственную продукцию возрастут.
10. Средняя цена за единицу продукции ниже рыночной.

1. Rising prices for products, even for consumer goods, are a distinctive
feature of inflation.
2. We cannot buy your products at such high prices.
3. The cost of this product is quite low. This will allow us to sell it on the
market at an attractive price.
4. In a planned economy, the government sets fixed prices for all goods.
5. If you bargain, you may be able to buy this thing at a more reasonable price.
6. During the crisis, the prices of many goods and services are significantly
reduced.
7. Our company has set competitive wholesale prices for this equipment.
8. Current fuel prices are quite high.
9. If the harvest this year is lower than expected, prices for agricultural
products will increase.
10. The average unit price is lower than the market price.