Definition: Inflation refers to the general increase in the level of prices of goods and services, often called price inflation.
Historical Context: Initially, the term inflation also referred to monetary inflation or an increase in the money supply.
Clarification: Today, when discussing inflation, it primarily means price inflation.
Relationship Between Money Supply and Inflation
Money Supply: Defined as the total amount of money in circulation, including printed dollars, lending activities, and transaction volumes.
Impact of Money Supply:
If money supply grows faster than real productivity, it typically leads to price increases.
Other factors, such as supply shocks, can also cause price inflation.
Supply Shock Example
Definition: A sudden scarcity of a good that drives prices up.
Historical Example: Oil crises of the 1970s where oil scarcity led to increased prices in oil and gas, affecting the prices of other goods (e.g., bananas).
Perspectives on Inflation
Moderate Inflation: A little inflation (1%-3% annually) is generally viewed as positive for the economy.
Excessive Inflation: Anything above these levels can be dangerous and may lead to hyperinflation.
Deflation: Negative inflation is also a concern, leading to economic stagnation.
Measuring Inflation: Consumer Price Index (CPI)
CPI Overview: In the U.S., inflation is measured using the Consumer Price Index (CPI).
CPI-U: The most commonly reported index, which stands for CPI for Urban Consumers. It reflects the economic experience of most of the population.
Calculation of CPI
Basket of Goods: CPI is calculated based on a basket of goods consumed by urban consumers during a base year.
Example Calculation:
Assume consumers spend 60% on apples and 40% on bananas.
Base prices set at: Apples = 100, Bananas = 100.
Current Year Prices: Apples rise to 150 (+50%), Bananas rise to 180 (+80%).
CPI Calculation:
Weighted average formula:
From base year: 0.6 * 100 + 0.4 * 100 = 100.
Current Year: 0.6 * 150 + 0.4 * 180 = 162.
CPI growth: From 100 to 162 = +62% or an increase in the CPI of 62%.
Conclusion
The next lecture will discuss the actual basket of goods used for CPI calculations in the U.S.
Understanding CPI is crucial for analyzing economic trends and inflation impacts on consumers.