February 06, 2017

Inflation

• A general rising level of prices, reduces the “purchasing power” of money
• Example: takes $6 to buy today what $1 bought in 1961

Three causes of inflation

• 1) printing too much money (quantity theory)
• 2) demand-pull inflation

“Too many dollars chasing too few goods” caused by excess of demand

• 3) cost-push inflation

Higher production costs increase prices

Standard inflation rate

• 2-3%

Formula for inflation rate

• ((current year price index  - base year price index)/base year price index)*100

Rule of 70

• Used to calculate the number of years it will take for the price level to double at any given rate of inflation
• Formula: 70/annual inflation rate

Deflation

• General decline in the price level

Disinflation

• Occurs when the inflation rate declines

Real investment rates

• The percentage increase in purchasing power that a borrower pays to the lender (adjusted for inflation)
• Formula: nominal interest rate - expected inflation

Nominal interest rates

• The percentage in money that the borrower pays back to the lender not adjusting for inflation

Nominal vs Real interest rate

• Example: You lend out $100 with 20% interest. Inflation is 15%. A year later you get paid back $120. The nominal interest would be 20% and real interest rate would be 5%.

Unanticipated inflation - unexpected inflation

• Hurt by inflation
• Lenders - people who lend money (at fixed interest rates)
• People with fixed income
• savers
• Helped by inflation
• Borrowers - people who borrow money
• A business where the price of the product increases faster than the price of resources