ECONOMICS TOPIC 7 LESSON 5

ECONOMICS TOPIC 7 LESSON 5

INFLATION AND DEFALTION

ESSENTIAL QUESTION

WHY SHOULD YOU CARE HOW THE ECONOMY IS DOING?

OBJECTIVES

Interpret data that reflect the rate of inflation.

Explain the effects of rising prices.

Identify the causes of inflation.

Describe recent trends in the rate of inflation.

How Rising Prices Affect You

Inflation

Josephine and Jack Barrow have owned the same house for 50 years. Recently, they had a real estate agent estimate their home’s present market value. The Barrows were astounded. The house that they had bought for $12,000 was now worth nearly $150,000—a rise in value of more than 1,100 percent.

How Rising Prices Affect You

How could the value of a house, or anything else, increase so much? The main reason is inflation. Inflation is a general increase in prices across an economy. Over the years, prices generally go up. Since World War II, real estate prices have risen greatly.

How Rising Prices Affect You

The Barrows were pleased their house was worth so much. Then they realized that inflation had raised the prices of all houses, just as it had also raised wages and the prices of most other goods and services. As a result, they could not buy a similar house in their area for $12,000 or even $120,000.

Open Ended

Analyze Graphs What happened to the price of a 1 lb loaf of white bread between 1990 and 2010?

How Rising Prices Affect You

Purchasing Power

Another way to look at the Barrows’ situation is that inflation had shrunk the value, or purchasing power, of the Barrows’ money. Purchasing power is the ability to purchase goods and services. As prices rise, the purchasing power of money declines. That is why $12,000 buys much less now than it did 50 years ago.

Multiple Choice

Generate Explanations Why does purchasing power change over time?

• because the supply of goods and services increases

• because demand for goods and services decreases

• because goods and services get used up

• because the prices of goods and services change

Price Indexes

A price index is a measurement that shows how the average price of a standard group of goods changes over time. A price index produces an average that economists compare to earlier averages to see how much prices have changed over time.

How Price Indexes Are Used

Price indexes help consumers and business owners make economic decisions

The government also uses indexes in making policy decisions. A member of Congress, for example, might push for an increase in the minimum wage if she thinks inflation has reduced purchasing power.

The Consumer Price Index

The Consumer Price Index (CPI) is computed each month by the Bureau of Labor Statistics (BLS). The CPI is determined by measuring the price of a standard group of goods meant to represent the “market basket” of a typical urban consumer. 

Open Ended

Draw Conclusions How are most people likely to adjust their spending when prices for consumer goods are rising?

Calculating the Inflation Rate

The inflation rate can be calculated between any two points in time, typically between two years. An inflation rate calculated from many years ago to today shows how inflation has changed over a longer period of time. To calculate the inflation rate, use the following formula: CPI for Year A – CPI for Year B/ CPI for Year B x 100.

Calculating CPI

To determine the CPI, the BLS establishes a base period to which it can compare current prices. Currently, the base period is 1982–1984.

Calculating CPI

The BLS determines the CPI for a given year using the following formula:

CPI = updated cost ÷ base-period cost x 100

For example, suppose the market basket cost $200 during the base period and costs $360 today. The CPI for today would be:

$360 ÷ $200 x 100 = 180

Types of Inflation

core inflation rate is the rate of inflation excluding the effects of food and energy prices.

 hyperinflation, or inflation that is out of control. During periods of hyperinflation, inflation rates can go as high as 100 or even 500 percent per month, and money loses much of its value. 

Multiple Choice

Construct How is the Consumer Price Index calculated?

• base-period cost multiplied by 100 and then divided by updated costs

• updated cost divided by base-period cost and then multiplied by 100

• base-period cost divided by 100 and then multiplied by updated cost

• updated cost multiplied by base-period cost and then multiplied by 100

Identifying Causes of Inflation

The quantity theory of inflation states that too much money in the economy causes inflation.

Changes in Aggregate Demand

Inflation can occur when demand for goods and services exceeds existing supplies.

Identifying Causes of Inflation

Changes in Aggregate Supply

Finally, inflation occurs when producers raise prices in order to meet increased costs. Higher prices for raw materials can cause costs to increase. Wage increases, however, are most often the biggest reason, because wages are the largest single production cost for most companies.

Identifying Causes of Inflation

The process by which rising wages cause higher prices, and higher prices cause higher wages, is known as the wage-price spiral. 

Multiple Choice

Identify Which of the following factors does not affect inflation?

• a stable money supply

• growth of the money supply

• changes in aggregate demand

• changes in aggregate supply

Interpreting Effects of Inflation

Effects on Purchasing Power

In an inflationary economy, a dollar will not buy the same number of goods that it did in years past. 

Interpreting Effects of Inflation

Effects on Income

Inflation sometimes, but not always, erodes income. If wage increases match the inflation rate, a worker’s real income stays the same. People who do not receive their income as wages, such as doctors, lawyers, and businesspeople, can often increase their incomes by raising the prices they charge in order to keep up with inflation.

Interpreting Effects of Inflation

Effects on Income

People living on a fixed income are hit especially hard by inflation. A fixed income is income that does not increase even when prices go up. 

Open Ended

Summarize Explain why inflation sometimes, but not always, erodes income.

Interpreting Effects of Inflation

Effects on Interest Rates

People receive a given amount of interest on money in their savings accounts, but their true return depends on the rate of inflation.

Interpreting Effects of Inflation

Effects on National Economies

In the 1970s and early 1980s, the United States experienced high inflation. Prices rose at times more than 10% per year. People with savings and fixed incomes saw the value of their money fall. As a result, inflation discouraged savings and investment, and economic growth suffered.

Multiple Choice

Analyze Data Which scenario gives the saver the greatest purchasing power?

• an interest rate of 5 percent and an inflation rate of 3 percent

• an interest rate of 3 percent and an inflation rate of 4 percent

• an interest rate of 6 percent and an inflation rate of 6 percent

• an interest rate of 4 percent and an inflation rate of 1 percent

Recent Trends in the Rate of Inflation

Americans under age 30 have experienced fairly low inflation rates for most of their lifetimes. In the late 1990s, unemployment levels were low.

Deflation

deflation a sustained drop in the price level.

The 2008 Recession

By the end of 2008, the economy was in crisis. A severe recession led to a slowdown in economic activity. Global demand for oil dropped, and the price of gasoline plunged by 30 percent in one month. The CPI was 3 percent lower than it had been just three months earlier. The record decline in retail prices and sales put added pressure on the federal government to solve the economic crisis and avoid a renewed threat of deflation.

Multiple Choice

Explain How does low unemployment lead to higher inflation?

• Low unemployment leads to an increase in wages.

• Low unemployment leads to an increase in workers.

• Low unemployment leads to a decrease in wages.

• Low unemployment leads to a decrease in workers.

Open Ended

WHY SHOULD YOU CARE HOW THE ECONOMY IS DOING?