Chapter 2

INFLATION
NGUYEN BICH DIEP, PhD
nguyenbichdiep@vnu.edu.vn
Inflation definition

 Inflation is a general and ongoing rise in the level of prices in an entire economy.
 Inflation means that there is pressure for prices to rise in most markets in the
economy.
 Inflation implies an ongoing rise in prices, not one-time events due to shifts in the
demand and supply model.
Types of inflation by rate of increase

 Creeping inflation: 1-3%

 Walking inflation: 3-10%
 Running inflation: 10-20%
 Galloping inflation: 20-1000%
 Hyperinflation: > 1000%
Tracking inflation

 The price level is measured using a basket of goods and services consisting of
the different items individuals, businesses, or organizations typically buy.
 Economists calculate how the total cost of buying that basket of goods will
increase over time.
 Inflation rate is the percentage change between price levels over time.
Example
Index numbers

 The price level is usually expressed in terms of index numbers.

 To convert the money spent on the basket to an index number, economists
arbitrarily choose one year to be the base year. The base year, by definition, has
an index number equal to 100.
Example
The Consumer Price Index

 The most common measure of inflation is the Consumer Price Index (CPI), which
is based on the prices in a fixed basket of goods.
US CPI
components
 Other goods and
services, 3.53
Recreation, 4.55

Education, 6.17

Communication, 3.14
Food, 33.56

Transportation, 9.67

Vietnam CPI
components Medical care , 5.39

Beverages and
Household tobacco, 2.73
appliances, 6.74
Apparel, 5.7

Housing and utilities,

18.82
Exercise

Product 2020 2021 2022

P Q P Q P Q
Cakes 15 10 22 14 25 16
Apples 3 20 4 22 6 25
Gasoline 20 55 24 55 23 60

 Calculate the CPI for this economy, using a fixed basket of 10 units of cakes,
20 units of apples and 55 units of gasoline. The base year is 2020.
 Is the inflation rate calculated using the CPI different from the inflation rate
calculated using the GDP deflator?
Measuring changes in the cost of living

 The change in the total cost of buying a fixed basket of goods and services over
time is conceptually not quite the same as the change in the cost of living,
because the cost of living represents how much it costs for a person to feel that
their consumption provides an equal level of satisfaction or utility.
Measuring changes in the cost of living

 The rise in the price of a fixed basket of goods over time tends to overstate the
rise in a consumer’s true cost of living
 Substitution bias: the CPI does not take into account that the person can substitute
away from goods whose relative prices have risen.
 Quality/new goods bias: the CPI does not account for how improvements in the
quality of existing goods or the invention of new goods improves the standard of
living.
 There is trade-off between simplicity and interpretation when measuring
inflation (and other economic variables).
The core inflation index

 Core inflation index (core CPI): a measure of the overall cost of consumer goods
and services excluding volatile economic variables (food and energy).
 The CPI and the core inflation index serve different purposes:
 The CPI helps households understand their overall cost of living.
 The core inflation index is useful for government policy making.
Other measures of inflation

 The Producer Price Index (PPI): measure changes in the prices paid for supplies
and inputs by producers of goods and services.
 The GDP Deflator: includes all the GDP components, so its baskets are not fixed.
 …
The confusion over inflation

 Robert Shiller, a 2013 Nobel laureate, surveyed Americans in the 1990s. One of
his questions asked, “Do you agree that preventing high inflation is an important
national priority, as important as preventing drug use or preventing deterioration
in the quality of our schools?” Answers were on a scale from 1 (“Fully agree) to 5
(“Completely disagree”).
 For the U.S. population as a whole, 52% answered “Fully agree” and just 4% said
“Completely disagree.”
 Among professional economists, only 18% answered “Fully agree,” while the same
percentage of 18% answered “Completely disagree.”
The costs of inflation

 If all prices, wages, and interest rates adjusted automatically and immediately
with inflation, then people’s purchasing power, profits, or real loan payments
would not change.
 If other economic variables do not move exactly in sync with inflation, or if they
adjust for inflation only after a time lag, then inflation can cause three types of
problems: unintended redistributions of purchasing power, blurred price signals,
and difficulties in long-term planning.
The costs of inflation

 Unintended redistribution of purchasing power: Unexpected inflation will

tend to hurt those whose money received, in terms of wages and interest
payments, does not rise with inflation. In contrast, inflation can help those
who owe money that they can pay in less valuable, inflated dollars.
 People who invest their financial assets in a way that the nominal return does not
keep up with inflation will be affected. The problem can be worsened with taxes.
 Wage earners lose purchasing power if wages lag behind inflation.
 Borrowers gain from inflation while lenders lose.
Example
US minimum wage

After adjusting for

inflation, the federal
minimum wage
dropped about 30%
from 1965–2020, even
though the nominal
figure climbed from
$1.40 to $7.25 per hour.
The costs of inflation

 Blurred price signals: High and variable inflation means that the incentives in the
economy to adjust in response to changes in prices are weaker. Markets will
adjust toward their equilibrium prices and quantities more erratically and slowly,
and many individual markets will experience a greater chance of surpluses and
shortages.
 Problems of long-term planning: Over the medium and the long term, even low
rates of inflation can complicate future planning.
Any benefits of inflation?

 The impact of inflation will differ considerably according to its level. A low
annual inflation rate is usually not very harmful, and better than deflation which
occurs with severe recessions.
 Moderate inflation may help the economy by making wages in labor markets
more flexible. Wages tend to be sticky in their downward movements, which can
result in unemployment. A little inflation could help real wages to decline if
necessary. However, this argument is controversial.