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Inflation

©2006 South-Western College Publishing

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What is inflation?

An increase in the general (average) price level of goods and services in the economy

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What is the most widely reported

measure of inflation?The Consumer Price Index

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What is theConsumer Price Index?

The CPI is an index that measures changes in the average prices of consumer goods and services

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Who reports the CPI?The Bureau of Labor Statistics (BLS) of the Department of Labor

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How is the CPI calculated?

Price collectors contact retail stores, homeowners, and tenants in selected cities in the U.S. monthly

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Which goods and services are included

in the CPI?The BLS records average prices for a “market basket” of different items purchased by the typical urban family

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Composition of the CPI

Food

Housing

Apparel

Transportation

Medical Care

Entertainment

Education & communication

All other goods

15.7%

40.9%

4.4%

17.1%

5.8%

6.0%

5.8%

4.3%Economic Report of the President, 2005

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Does the makeup of the CPI change?

As people’s tastes and preferences change, some of the goods and services that go into the basket change

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How is the CPI computed?

Current year prices are compared to prices of a similar basket of goods and services in a base year

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What is a base year?A year chosen as a reference point for comparison with some earlier or later year

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Why is the CPI always 100 in the base year?The numerator and the denominator of the CPI formula are the same in the base year

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How is theinflation rate computed?

The annual inflation rate is computed as the percentage change in the official CPI from one year to the next

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30 40 50 60 70 80 90 00

The U.S. Inflation Rate 1929 - 2004

05

16

8

4

0

-4

12

-8

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The Most Popular Movies of All Time, Inflation Adjusted

FilmYear ofRelease

Total domestic grossin millions of 1999 dollars

1. Gone with the Wind 1939 $920

2. Star Wars 1977 798

3. The Sound of Music 1965 638

4. Titanic 1997 601

5. E.T.–The Extra Terrestrial 1982 601

6. The Ten Commandments 1956 587

7. Jaws 1975 574

8. Doctor Zhivago 1965 543

9. The Jungle Book 1967 485

10. Snow White and the Seven Dwarfs 1937 476

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What is disinflation?A reduction in the rate of inflation

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What are some criticisms of the CPI?• It can overstate or

understate the impact of inflation for certain groups

• Does not measure quality• Substitutes are ignored

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What does inflation do to people’s income?

A general rise in prices will shrink people’s income

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What isnominal income?The actual number of dollars received over a period of time

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What is real income?The actual number of dollars received (nominal income) adjusted for changes in the CPI

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What will cause your real income to decline?

The rate of inflation is greater than your rate of income

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How does inflation affect borrowers

and savers?They can win or lose depending on the rate of inflation and interest

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What is theinterest rate?

Interest per year as a percentage of the amount loaned or lent

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What is thenominal interest rate?The actual rate of interest earned over a period of time

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What is thereal interest rate?

The nominal rate of interest minus the inflation rate

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What is hyperinflation?An extremely rapid rise in the general price level