Economics Questions

DEFINITION OF INFLATION

INFLATION IS TYPICALLY DEFINED AS THE SUSTAINED OR PERSISTENT INCREASE IN THE GENERAL, AVERAGE OR OVERALL PRICE LEVEL FOR GOODS AND SERVICES IN A COUNTRY’S ECONOMY OVER TIME. IN OTHER WORDS, INFLATION OCCURS IN AN ECONOMY WHEN THE PRICES OF GOODS AND SERVICES SHOW A PATTERN OF INCREASES ON AVERAGE. THUS, DURING AN INFLATIONARY PERIOD IN AN ECONOMY SOME PRICES MAY FALL, SOME MAY BE FLAT I.E. THEY NEITHER INCREASE OR DECREASE THOUGH ON AVERAGE THE TREND IS THAT PRICES ARE GOING UP NOT DOWN OR FLAT.

SO IT’S IMPORTANT TO EMPHASIZE THAT INFLATION DOES NOT MEAN THAT THE PRICES OF ALL GOODS AND SERVICES ARE RISING IN A SUSTAINED WAY SINCE SOME PRICES MAY FALL AND OTHERS REMAIN FLAT SO LONG AS THE TREND LINE SHOWS THAT PRICES ARE RISING IN A SUSTAINED WAY AS A PATTERN OVER TIME.

RATE OF INFLATION

THE RATE OF INFLATION IS DEFINED AS THE RATE OR PACE AT WHICH PRICES FOR GOODS AND SERVICES I.E. THE GENERAL PRICE LEVEL OR THE AVERAGE PRICES FOR GOODS AND SERVICES INCREASES OVER TIME. THE RATE OF INFLATION UNLIKE INFLATION IS ALWAYS EXPRESSED IN RELATIVE OR PERCENTAGE TERMS SUCH AS 5%, 10%, 25% OR 100% PER MONTH, PER QUARTER OR PER YEAR.

THUS INFLATION AND THE RATE OF INFLATION WHILE THEY ARE RELATED, THEY ARE NOT SYNONYMS, I.E. THEY ARE NOT THE SAME CONCEPTS. SO THEY SHOULD NEVER BE USED INTERCHANGEABLY.

DEFINITION OF DEFLATION

FIRST, DEFLATION IS THE VERY OPPOSITE OF INFLATION.

SECOND, DEFLATION IS DEFINED AS THE SUSTAINED OR PERSISTENT DECREASE IN THE GENERAL, AVERAGE OR OVERALL PRICE LEVEL FOR GOODS AND SERVICES IN A COUNTRY’S ECONOMY OVER TIME. ALTERNATIVELY EXPRESSED, DEFLATION OCCURS IN AN ECONOMY WHEN THE PRICES OF GOODS AND SERVICES SHOW A PATTERN OF DECREASES ON AVERAGE. IN OTHER WORDS, DURING A DEFLATIONARY PERIOD IN AN ECONOMY SOME PRICES MAY RISE, SOME MAY BE FLAT I.E. THEY NEITHER INCREASE OR DECREASE THOUGH ON AVERAGE THE TREND IS THAT PRICES ARE GOING DOWN NOT UP OR FLAT.

THUS IT MUST BE EMPHASIZED THAT DEFLATION DOES NOT MEAN THAT THE PRICES OF ALL GOODS AND SERVICES ARE FALLING IN A SUSTAINED WAY SINCE SOME PRICES MAY RISE AND OTHERS REMAIN FLAT SO LONG AS THE TREND LINE SHOWS THAT PRICES ARE FALLING IN A SUSTAINED WAY AS A PATTERN OVER TIME.

THE RATE OF DEFLATION

THE RATE OF DEFLATION IS DEFINED AS THE RATE OR PACE AT WHICH PRICES FOR GOODS AND SERVICES I.E. THE GENERAL PRICE LEVEL OR THE AVERAGE PRICES FOR GOODS AND SERVICES DECREASES OVER TIME. THE RATE OF DEFLATION UNLIKE DEFLATION IS ALWAYS EXPRESSED IN RELATIVE OR PERCENTAGE TERMS SUCH AS 5%, 10%, 25% OR 100% PER MONTH, PER QUARTER OR PER YEAR.

CONSEQUENTLY, DEFLATION AND THE RATE OF DEFLATION WHILE THEY ARE RELATED, THEY ARE NOT SYNONYMS, I.E.THEY ARE NOT THE SAME CONCEPTS. SO THEY SHOULD NEVER BE USED INTERCHANGEABLY.

DEFINITION OF PRICE INDICES:

PRICE INDICES ARE METRICES OR INDICATORS THAT MEASURE THE AVERAGE UPS AND DOWNS I.E. THE AVERAGE FLUCTUATIONS IN THE GENERAL OR AVERAGE PRICE LEVEL FOR GOODS AND SERVICES IN A COUNTRY’S ECONOMY OVER TIME. PRICE INDICES ARE THEREFORE USED TO MEASURE INFLATIONARY AND DEFLATIONARY TRENDS IN ANY COUNTRY’S ECONOMY OVER TIME.

SOME OF THE MOST POPULAR PRICE INDICES ARE:

· CPI=CONSUMER PRICE INDEX: IS A MEASURE OF THE AVERAGE MOVEMENT OF CONSUMER PRICES (FOODS, CLOTHING, HEALTH CARE, EDUCATION, ELECTRONIC GADGETS, SHOES ETC) IN A COUNTRY’S ECONOMY OVER TIME.

· PPI=PRODUCER PRICE INDEX: IS A MEASURE OF THE AVERAGE MOVEMENT OF PRODUCERS’ PRICES (RAW MATERIALS, ENERGY, LABOR, CAPITAL, SEMI-PROCESSED INPUTS ETC) IN A COUNTRY’S ECONOMY OVER TIME.

· WPI=WHOLESALE PRICE INDEX: IS A MEASURE OF THE AVERAGE MOVEMENT OF WHOLESALE PRICES FOR (CARS, FOODS, CLOTHES BOUGHT BY WHOLESALERS FROM MANUFACTURERS ETC) IN A COUNTRY’S ECONOMY OVER TIME.

· RPI=RETAIL PRICE INDEX: IS A MEASURE OF THE AVERAGE MOVEMENT OF RETAIL PRICES (CARS, FOODS, CLOTHES BOUGHT BY CONSUMERS FROM RETAILERS ETC) IN A COUNTRY’S ECONOMY OVER TIME.

· GDP DEFLATOR OR IMPLICIT PRICE DEFLATOR: IS A MEASURE OF THE AVERAGE MOVEMENT OF ALL PRICES SUCH AS CONSUMERS, PRODUCERS, WHOLESALES’, RETAILS, EXPORT AND IMPORT PRICES OF ALL FINAL AND LEGITIMATELY PRODUCED GOODS AND SERVICES THAT ARE INCLUDED IN A COUNTRY’S GDP IN OVER TIME.

· EPI=EXPORT PRICE INDEX: IS A MEASURE OF THE AVERAGE MOVEMENT OF THE PRICES OF GOODS AND SERVICES THAT ARE EXPORTED FROM ONE COUNTRY TO THE ROW IN A COUNTRY’S ECONOMY OVER TIME.

· IPI=IMPORT PRICE INDEX: IS A MEASURE OF THE AVERAGE MOVEMENT OF THE PRICES OF GOODS AND SERVICES THAT ARE IMPORTED TO ONE COUNTRY FROM THE ROW IN A COUNTRY’S ECONOMY OVER TIME.

FORMULA TO CALCULATE THE RATE OF INFLATION AND THE RATE OF DEFLATION:

Ri =(PRICE INDEX in CP – PRICE INDEX in PP)/ PRICE INDEX in PP X 100

Ri>0→PRICE INDEX in CP > PRICE INDEX in PP

Rd<0→PRICE INDEX in CP < PRICE INDEX in PP

FORMULA TO CALCULATE THE RATE OF INFLATION AND THE RATE OF DEFLATION USING THE CPI AS A MEASURE OF INFLATION\DEFLATION:

SUPPOSE WE ASSUME THE FOLLOWING SITUATION FOR A HYPOTHETICAL ECONOMY:

Ri=RATE OF INFLATION

TIME SERIES = 1995-2005

CP=CURRENT PERIOD=2005

PP=PREVIOUS PERIOD=1995

CPI 2005= 180

CPI 1995 =160

APPLYING THE FORMULA FOR THE Ri=RATE OF INFLATION FOR 1995-2005 USING THE CPI AS THE PRICE INDEX TO MEASURE INFLATION YIELDS:

Ri 1995-2005=(CPI 2005 – CPI 1995)\CPI 1995 X 100

BY SUBSTITUTION, WE GET THE FOLLOWING:

Ri 1995-2005 = (180 -160)\160 X 100

Ri 1995-2005 = 20\160 X 100

Ri1995-2005= 12.5%>0- WHAT DOES IT MEAN? THAT CONSUMERS’ PRICES AS MEASURED BY THE CPI INCREASED ON AVERAGE BY NEARLY 13% BETWEEN 1995-2005!

Rd= RATE OF DEFLATION

TO CALCULATE THE Rd FOR THE SAME YEARS 1995-2005, WE WOULD GET THE FOLLOWING USING AGAIN THE CPI TO MEASURE DEFLATION:

Rd 1995-2005=(CPI 2005 – CPI 1995)\CPI 2005 X 100

BY SUBSTITUTION, WE GET THE FOLLOWING:

Rd 1995-2005 = (160 -180)\180 X 100

Rd 1995-2005 = -20\180 X 100

Rd1995-2005= -11.11%<0 WHAT DOES IT MEAN? THAT CONSUMERS’ PRICES AS MEASURED BY THE CPI DECREASED ON AVERAGE BY NEARLY -11% BETWEEN 1995-2005!

· TYPES OF INFLATION

· MODERATE OR CREEPING INFLATION: IS DEFINED AS THE TYPE OF INFLATION WHEREBY ON AVERAGE PRICES FOR GOODS AND SERVICES OR THE GENERAL PRICE LEVEL INCREASES BETWEEN (1%-4%) PER YEAR IN AN ECONOMY.

· GALLOPING INFLATION: IS DEFINED AS THE TYPE OF INFLATION WHEREBY ON AVERAGE PRICES FOR GOODS AND SERVICES OR THE GENERAL PRICE LEVEL INCREASES BETWEEN (10%-100%) PER YEAR IN AN ECONOMY.

· HYPERINFLATION: IS DEFINED AS THE TYPE OF INFLATION WHEREBY ON AVERAGE PRICES FOR GOODS AND SERVICES OR THE GENERAL PRICE LEVEL INCREASES BETWEEN (100%-1500%) PER YEAR IN AN ECONOMY

· THE MACROECONOMIC SIGNIFICANCE OF INFLATION\DEFLATION

· THE EROSION OF THE STANDARD OF LIVING OF PEOPLE:

· INFLATION DECIMATES THE PURCHASING POWER OF PEOPLE BY REDUCING THE VALUE OF THEIR WAGES AND SALARIES BY WHATEVER THE RATE OF INFLATION IS IN AN ECONOMY

· EXAMPLE IF THE RATE OF INFLATION IN AN ECONOMY IS 10% PER YEAR AND THE AVERAGE DISPOSABLE INCOME OF HOUSEHOLDS IS $80,000 PER YEAR IN REAL DOLLARS, HOUSEHOLDS PURCHASING POER WILL DECREASE BY $8,000. THUS, THOUGH HOUSEHOLDS OR PEOPLE WILL HAVE $80,000 IN NOMINAL DOLLARS (UNADJUSTED FOR INFLATION), IT WILL PURCHASE FOODS, CLOTHING ETC WORTH ONLY $72,000.

· INFLATION MAKES PEOPLE POORER, IT IS AN EQUAL OPPORTUNITY TAX AND AS SUCH POLITICIANS BECOME INTERESTED IN CURBING INFLATION VIA FISCAL\MONETARY POLICY BECAUSE IT POSES A THREAT TO THEIR POLITICAL CAREER AS THEIR CONSTITUENTS BECOME POORER I.E. THE POLITICAL ECONOMY OF INFLATION

· DEFLATION HAS THE VERY OPPOSITE EFFECT ON HOUSEHOLD DISPOSABLE INCOME ASSUMING A 10% RATE OF DEFLATION WOULD ACTUALLY INCREASE THEIR PURCHASING POWER BY $8000 IN REAL DOLLARS

· THE EFFECT OF INFLATION\DEFLATION ON PROFITS:

· ASSUMING A 10% RATE OF INFLATION, IF THE AVERAGE PROFITS OF BUSINESSES OR INVESTORS IS $1,000,000, IN REAL DOLLARS (ADJUSTED FOR INFLATION), IT WILL BE $900,000 THOUGH THE INVESTORS WILL HAVE $1M IN PROFITS IN THEIR BANK ACCOUNTS AND ACCOUNT BOOKS

· ON THE CONTRARY, A 10% RATE OF DEFLATION WITH THE SAME BUSINESS PROFITS OF $1,000,000 WILL ADD IN REAL DOLLARS $100,000 TO BUSINESS PROFITS

· THE IMPACT OF INFLATION\DEFLATION ON INVESTMENT (PRODUCTIVE-FINANCIAL INVESTMENTS):

· INFLATION DIMINISHES THE INCENTIVE TO INVESTMENT WHETHER IN FACTORIES, EXPANSION OF FACTORY SPACE, TECHNOLOGICAL INNOVATIONS ETC OR IN FINANCIAL MARKETS SUCH AS BONDS, STOCKS ETC.

· SO A RATE OF INFLATION OF 10% WILL REDUCE A CAPITAL INVESTMENT OF $10,000,000 IN A STEEL PLANT OR IN THE BOND MARKET BY $1,000,000 I.E. IN REAL DOLLARS, THE MARKET VALUE OF THE INVESTOR’S CAPITAL WILL BE $9,000,000 INSTEAD OF $10,000,000.

· ON THE CONTRARY, A RATE OF DEFLATION OF 10% WOULD HAVE THE OPPOSITE EFFECT ON INVESTMENT, ADDING $1,000,000 TO THE MARKET VALUE OF A $10M INVESTMENT WHETHER IN PRODUCTIVE OR FINANCIAL INVESTMENTS

· THE IMPACT OF INFLATION-DEFLATION ON WAGES, SALARIES, SAVINGS, GOVERNMENT SPENDING ETC.:

· A 10% RATE OF INFLATION REDUCES WAGES, SALARIES, SAVINGS, GOVERNMENTSPENDING, CONSUMPTION SPENDING AND OTHER NOMINAL AGGREGATES IN REAL TERMS BY 10%

· A 10% RATE OF DEFLATION INCREASES WAGES, SALARIES, SAVINGS, GOVERNMENT SPENDING, CONSUMPTION SPENDING AND OTHER NOMINAL AGGREGATES IN REAL TERMS BY 10%

· CAUSES OF INFLATION

· DEMAND-PULL INFLATION

· COST-PUSH INFLATION

· WAGE-PRICE SPIRAL

· EXCESSIVE GOVERNMENT SPENDING OR DEFICIT FINANCING

· EXCESSIVE MONETARY EXPANSION OR EXCESSIVE MONETARY GROWTH

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