Inflation

Inflation = sustained rise in the GENERAL price level.

Not the same as a one-off price rise of one good — must be general AND sustained.

Consumer Price Index (CPI). Most common measure.

1. Identify a "basket" of goods typical households consume.
2. Weight each by share of typical household spending.
3. Track total cost of the basket over time.
4. CPI = (current cost / base year cost) × 100.

Inflation rate = % change in CPI year over year.

Worked example. If a basket cost $200 last year and$206 this year, inflation = 3%.

Limitations of CPI:

• Substitution bias — basket fixed; consumers substitute toward cheaper goods.
• Quality changes — products improve over time.
• New products take time to enter.
• Different households have different baskets (rural vs urban; rich vs poor).

Other measures: PPI (producer prices), GDP deflator (all goods, including investment and government).

Causes of inflation:

Demand-pull inflation. AD rises faster than the economy's ability to expand output.

• AD shifts RIGHT along upward-sloping SRAS.
• Price level and real GDP both rise.
• Common when fiscal/monetary stimulus is too strong or recovery overheats.

Cost-push inflation. Production costs rise → SRAS shifts LEFT.

• Causes: oil shocks, rising wages (e.g. union demands), depreciating currency raising import costs, indirect taxes.
• Real GDP falls AND price level rises — STAGFLATION pattern (e.g. 1970s).

Combined demand-pull and cost-push can create high inflation episodes — e.g. 2021-2022 with strong post-pandemic demand AND supply chain bottlenecks AND rising energy costs.

Costs of moderate inflation:

• Reduced purchasing power of savings and fixed incomes.
• Uncertainty — firms and households reluctant to invest / save when future prices unclear.
• Menu costs — businesses must update price lists, labels.
• Shoe-leather costs — people make more trips to bank to avoid holding cash.
• Tax distortions — taxes designed in nominal terms become unfair as inflation erodes thresholds.
• Income redistribution — borrowers benefit (repay in cheaper dollars); savers lose.

Hyperinflation (>50%/month) destroys money's value, paralyses economy. Historical examples: Weimar Germany (1923), Zimbabwe (2008), Venezuela (recent).

Deflation (sustained falling prices) is also harmful:

• Consumers delay purchases (expecting cheaper next month) → AD falls → deeper deflation.
• Real value of debt rises → defaults.
• Investment falls.
• Wages sticky downward → unemployment rises.

Examples: Japan's "Lost Decades" (1990s-2010s); fears of deflation in eurozone 2014-2015.

Disinflation = inflation FALLING but still POSITIVE. Less harmful than deflation; usually achieved by tight monetary policy.

Central bank target. Most central banks (Fed, ECB, BoE) target ~2% inflation — low enough to avoid major distortion, high enough to keep above zero with margin (sticky wages benefit from small positive inflation, and there's space for rate cuts in recession).