6355 Lecture Notes - Lecture 11: Aggregate Supply, Price Level, Frictional Unemployment
Week 11 – Inflation and Unemployment
Inflation
Price level: a measure of the average prices of goods and services in the economy
Inflation: the sustained increase in the general level of prices in the economy
Deflation: is a sustained decline in the general price level
Inflation rate: the percentage increase in the general price level in the economy from one
year to the next
Consumer Price Index
- a measure of charges in retail prices of a basket of goods and services representative
of consumption expenditure by typical Australian households in capital cities
1 0 0
1 0 0
y e a r b a s ei n b a s k e t m a r k e t o fc o s t
y e a rc u r r e n t i n b a s k e t m a r k e t o fC o s t
C
t oe q u a la l w a y si sy e a rb a s ef o rC P I
xP I
=
Measuring Inflation
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Consumer Price Index =
1 2 21 0 0
$ 7 5 0
$ 9 1 5
)2 0 1 3(
1 2 01 0 0
$ 7 5 0
$ 9 0 0
)2 0 1 2(
1 0 01 0 0
$ 7 5 0
$ 7 5 0
)2 0 0 5(C
==
==
==
xC P I
xC P I
xP I
Inflation is measured as the rate of change in the CPI
Inflation rate =
1-t
1-t -t
C P I
C P IC P I
e.g. Inflation Rate (2012-12) =
%6 7.11 0 0
1 2 0
021 - 1 2 2
=
X
Is the CPI accurate?
- The CPI is the most widely used measure of inflation
- Four sources of bias in the CPI may lead to it overstating the inflation rate
- Substitution bias
- Increase in quality bias
- New product bias
- Outlet bias
The Costs of High Inflation
Some well-known costs include:
- Inflation erodes the purchasing power of money
- In general, loss of confidence, uncertainty, efficiency costs
- Costs of real resources (e.g. Menu costs, shoe leather costs etc).
- Adverse effects on incentives: ‘unearned’ redistributions of wealth. Loans and wages
in nominal contracts
- Higher effective tax rates due to ‘bracket creep’ in a progressive tax system, reducing
the incentive to work (more distortions)
Bracket Creep
Why inflation causes distortion in the tax system
10% increase in inflation and your nominal income:
Income Tax paid
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Document Summary
Price level: a measure of the average prices of goods and services in the economy. Inflation: the sustained increase in the general level of prices in the economy. Deflation: is a sustained decline in the general price level. Inflation rate: the percentage increase in the general price level in the economy from one year to the next. P i : f a measure of charges in retail prices of a basket of goods and services representative of consumption expenditure by typical australian households in capital cities. Inflation is measured as the rate of change in the cpi. The cpi is the most widely used measure of inflation. Four sources of bias in the cpi may lead to it overstating the inflation rate. In general, loss of confidence, uncertainty, efficiency costs. Costs of real resources (e. g. menu costs, shoe leather costs etc). Adverse effects on incentives: unearned" redistributions of wealth.