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Macroeconomics- Study Guide- The Consumer Price Index (CPI)

is the most common inflation measure. measures consumer goods only.

is a weighted index (an increase in the price of eggs is more important than an increase in the price of black-and-white televisions).

Unit 7 - Inflation

The GDP Deflator

measures price increases of all goods and services based on real and nominal GDP calculations

Equals nominal GDP divided by real GDP.

Example: nominal GDP=\$120, and real GDP=\$100.

GDP deflator = \$120/\$100=1.2.

What causes steady price increases in the long run:

1. Too much demand
2. Too little demand
3. Too much government spending
4. Steady increases in the money supply

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Unit 7 - Inflation

• The Cause of Inflation

In the long run, a steady increase in the nation’s money supply is the only cause of constantly rising prices.

The Cause of Inflation

Let’s look at a very simplified economy with only two products to understand the cause of price changes.

Assume, for simplicity, that in year 1, an economy produces only 2 products: oranges and hammers.

Unit 7 - Inflation

Assume that there are 10 orange producers.

Each producer makes 2 oranges, so total production of oranges is 20.

Unit 7 - Inflation

Assume that there are 5 hammer producers.

Each producer makes 1 hammer, so total production of hammers is 5.

Unit 7 - Inflation

Assume that the price of an orange is the same as the price of a hammer and that consumers spend their entire income (no savings) on oranges and hammers.

Then what is the average equilibrium price per product?

Money supply is \$100.

Total production is 25 (20 oranges and 5 hammers). The equilibrium price is \$100 / 25, or \$4.

If the price is less than \$4, there is a surplus of money.

If the price is more than \$4, there is a surplus of products.

Unit 7 - Inflation

Assume that in year 2, the money supply increases to \$200.

Now what is the equilibrium price per product?

Unit 7 - Inflation

Year 2 money supply is \$200.

Total production is 25.

Equilibrium price is \$200 / 25, or \$ 8.

If the price is less than \$8, there is a surplus of money.

If the price is more than \$8, there is a surplus of products.

Unit 7 - Inflation

Without an increase in production, an increase in the money supply causes average prices to increase.

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