Inflation is part of the IB syllabus for macroeconomics . It is also part of the AP Macroeconomics syllabus for Economic Basics, Measurement of Economic Performance, and Inflation, Unemployment and Stabilization Policies



Inflation is the rise in price level of goods and services in an economy that happens over a period of time, inflation generally happen when the country GDP is higher then the natural rate of GDP. In other words tje increase in the price level. It is usually measured by the consumer price index and the producer price index. Over time, as the cost of goods and services increases, the dollar will lose its value because a person will not be able to purchase as much with that dollar than they used to. Purchasing power is the relationship between a currency and the amount of goods that certain currency equates to.Inflation is also when real GDP>Natural Real GDP and unemployment rate<natural employment rate. The phrase "too much money chasing too few goods" is often used to describe the situation of inflation. Those who are employed are getting paid the same amount of money, but because of inflation they feel as if they are getting paid less. The amount is the same, but the value decreased.


Deflation, appropriately is the complete opposite of what inflation is. It is the decline in the economy's price levels on goods and services. It is when annual inflation falls below zero percent. This will allow you to buy more goods with the same amount of money. People will believe they have more purchasing power. Deflation can happen when there is a recession or when there aren't enough jobs. When a lack of jobs exists, less people are working and therefore less goods are produced. Thus less goods are bought, and less money is in the system. This creates a downward spiral; as the value of money increases, less people are required to work for a company to produce the same number of goods, and so workers are fired. The cycle repeats itself.

Deflation is not quite as likely in nearly any given system as is inflation, as populations tend to grow with money being stretched even thinner.

Costs of Inflation and DeflationEdit

When Inflation occurs the money value (or the purchasing power of the dollar) will decrease. With the money value decreasing the money that people have will be worth less and lead to a decrease in consumption. The GDP is lower than the natural GDP. Also shown in a recessionary gap. As consumption decreases AD will also decrease because consumption is a component of AD.

When deflation occurs the opposite happens. The money value will increase and that will make the people seem to be richer than before, causing consumption to increase and therefore AD to increase as well.

Anticipated Inflation:

Johnny says, "If I see inflation rising, I will act differently!"

Betty says, "I was going to wait and get some coffee, but if coffee is going to cost more tomorrow, then I think I'll just get some now! YUM!"

A lender anticipates inflation by trying to account for inflation within the interest rate. The nominal interest rate charged is the real interest rate, plus the anticipated rate of inflation. A person saving money wants an interest rate that is above the level of inflation in the economy so their savings does not depreciate with time.

Problems of anticipated inflation are:

1) Breakdown of the monetary economy
- money becomes completely worthless
- "hyper inflation." Hyper inflation is inflation when it has become so high that it has become unreasonably out of control.
- As Demand increases, Prices increase also
2) Imports become more expensive
- Inflation cause decrease value of currency because less buying power
-foreign food is expensive
3) Updating prices is not free
- "menu costs" meaning... the increase in rate of inflation = the change of price (increases)

Unanticipated Inflation:

Some people will benefit from the people that think "If I see inflation rising, I act differently!". When a lender does not accurately anticipate inflation the borrower wins by being under charged for the loan. They pay less money than they actually received in the original loan.

Problems of unanticipated Inflation:
1) Lenders and savers get hurt
- ex. If inflation 5%, you charge 5% interest and actual inflation is 10% = you lose $$$
2) Uncertainly restricts growth
- being cautious about investments or consumption plans = spend less
3) Comparing prices is not free
- "shoe leather costs" meaning... Wasting time comparing prices because of assumption of infaltion rate. Waste of time, energy, and gas.

- This problem has become a little less severe with the use of the internet now.

Causes of InflationEdit

Cost/Supply Push

Cost push inflation occurs when the price of a staple good (Ex: Oil) increases. Input costs are a determinant of supply, so as the cost of a staple good increases, the supply curve shifts to the left, thus raising prices. This price increase phenomenom occurs on an aggregate level with the short-run aggregate supply shifting to the left. Inflation ensues. The same for the other way around. When the price of a staple good decreases, it would be shown just as that on a graph. The supply curve would shift to the right, causing prices to go down.

Demand Pull

When AD increases, quantity produced and price level temporarily increase (point 1). However, since only a set amount of production can be reached in the long run, quantity supplied must eventually return to equilibrium. This is reflected by the stationary LRAS curve--if businesses were able to produce more goods, LRAS would shift to the right. Since AD has increased, the new equilibrium will be at the same quantity but a higher price level. (point 2). This process could repeat itself and drive price levels higher if AD continues to increase.&nbsp

Demand Pull Graph 1

Demand Pull Inflation

Excess monetary growth

Methods of Measuring InflationEdit

  • One way to measure inflation is to calculate an inflation rate of the Consumer Price Index. By comparing data of the value of goods/services that people would buy between two different years/time periods, one can find a percentage change that can be then designated as the inflation rate (based on the CPI).
  • Another way to measure inflation is to utilize the GDP deflator. The GDP deflator measures the prices of goods and services in the Gross Domestic Product. By dividing the nominal GDP by real GDP, one can calculate a percentage much like the CPI inflation rate, and find an inflation rate based on the nominal/real values of GDP.

Problems of the Methods of Measuring InflationEdit

Inflation is measured by using a weighted basket of goods and looking at the changes in price. However, there are many difficulties in the measuring of inflation that can lead to inaccurate results. A single price change does represent general inflation in an overall economy. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item by the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are then combined to calculate the overall price. There are issues in the measurement of inflation with this basket though. It will not account for changes in the quality of a good, just its price. Furthermore, the weighting is very subjective and technically everyone's inflation is slightly different.

Phillip's CurveEdit

The Phillips curve is a curve that originally showed the inverse relationship between wage inflation and unemployment. It more often shows the relationship between price inflation and unemployment. Unemployment is considered high or low relative to the natural rate of unemployment. Inflation is considered high and low relative to the expected inflation rate.

The reasoning behind the Phillips curve is that as inflation decreases, unemployment increases. They are inversely related, which is shown by the fact that the SRPC is sloping downwards. When one is high, the other is low. This is because money increases in value as inflation decreases, and so it will buy more goods. As the prices of goods increase, companies will fire workers because they are producing more products than are being sold. The point is that companies can make the same income as before, but with fewer workers, as the equilibrium price of goods has been raised. Thus, companies make more income with less loss to worker salary. As inflation decreases, unemployment will continue to increase. Thus, it is most often healthier to have a constant inflation than a constant deflation.

Below is a graph of the Phillips Curve

Phillips curve

y-axis Inflation, x-axis Unemployment

The Long Run Phillips curve shows the relationship between unemployment rate and inflation in the long run. It is also the natural rate of unemployment. The natural rate of employment is the rate of unemployment at which inflation is equal to the expected inflation. The natural rate of unemployment is where there is zero cyclical unemployment. The long run Phillip's curve will always have the same unemployment rate for any rate of inflation. Therefore it is a vertical line. While the rate of inflation varies in increase and decrease. Therefore it is represented as a curved line.

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