Macroeconomics The Consumer Price Index
Macroeconomics- Assignment 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:
- Too much demand
- Too little demand
- Too much government spending
- Steady increases in the money supply
- Trade deficits
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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?
Answer:
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.
