AP Economics – Inflation, GDP Changes, & Interest Rates



AP Economics – Inflation, GDP Changes, & Interest Rates

I. INFLATON:

General increase in the weighted average _price_____ level of the economy. Inflation is a problem because the economy depends on prices to __allocate_______ resources _efficiently_________. If prices are _inflated___________ then it is more costly to plan, which results in a less efficient __economy_________.

Real GDP = _Nominal GDP_________ minus __inflation_______

A. DEMAND-PULL INFLATION:

Occurs when consumer __demand_________ outpaces supplier’s ability to __supply__________ goods and services in the market.

Have them draw an AD/AS graph at full-employment equilibrium and then shift the AD curve to the right. Have them note that the PL or inflation has increased and the u% has decreased (under 5%) Also have them add that this inflation will continue as long as there is excessive AD.

B. COST-PUSH INFLATION:

Occurs when producers supply _fewer________ goods because of increased cost of __production___________.

Here have them draw an AD/AS graph beginning at full-employment equilibrium and then shift the AS curve to the left. Have them note that both the inflation and unemployment rates will increase (“stagflation”). Also have them note the following causes for Cost Push Inflation: 1. Negative Supply Shocks (oil prices rising), 2. Oligopolies or Monopolies increasing prices as they control the market. 3. Labor Unions negotiating wage increases.

Also, I have them note that Cost Push Inflation is self-correcting for the following reason: When the AS curve shifts left, the unemployment rate goes down. Consumer purchases decline, thus causing prices to decrease. When prices decrease, the per-unit cost of production goes down. When this happens, the AS curve shifts right, restoring full-employment (however, this is a long-term phenomenon) The problem is that politicians want to solve the unemployment problem (in order to get re-elected) and this just makes the inflation worse (by increasing G or reducing taxes). The best thing to do is control the inflation. That is what former Fed Chairman Paul Volker did in 1982, when he chose to decrease the money supply and raise interest rates. He knew it would hurt people and increase unemployment, but it was the only way to improve the economy. By decreasing the money supply, the prime rate increased to 22%, car loans/home loans were over 20% and the economy slowed down. It worked, however, and the inflation rate dropped to 4 or 5% within the year from 11% in 1982 (by the way u% was 12% before he took the action). After that businesses and consumers could plan again and the economy had the longest growth period (6 years) post WWII.

C. QUANTITY THEORY OF INFLATION:

Occurs when too much money is printed in the economy, thus causing the buying power of a nation’s currency to go down (inflation). It is based on the Quantity Theory of Money, which states that there is a direct relationship between the amount of money in an economy and the prices of products sold. The foundation for the Quantity Theory is the Fischer Equation or Equation of Exchange shown below:

MV = PQ

Where:

M = Money Supply

V = Velocity of Money (how many times a dollar is spent in a year)

P = Today’s prices

Q = Quantity or output

PS. PQ = Nominal GDP and Q = Real GDP

D. WHO IS HURT BY INFLATION?

Inflation reduces the dollar’s __buying_______ power.

1 Lenders (creditors) are hurt by inflation if it _erodes______ their _earnings_. Inflation erodes

the interest they are earning on _fixed____ rate

loans.

2. Savers are hurt when unexpected inflation _reduces___ returns on investment. If inflation is expected, then savers will be compensated with higher rates of return, which offsets the inflation effect. The higher rate reflects an inflation premium.

3. People on fixed incomes are hurt, because their buying power is reduced by inflation. The only

exception is if they have a COLA (Cost of Living

Adjustment) which keeps up with the inflation

rate.

E. WHO IS HELPED BY INFLATION?

1. Flexible Income Receivers. People who have several _sources of income like _stocks__ and bonds______, salaries, _real___ _estate, etc. can overcome the effects of inflation.

2. Debtors (borrowers): Borrowers with fixed rate loans are helped because they pay back their loans with money that costs them less (“cheaper dollars“).

Inflation is a not a problem if prices and incomes rise at the same rate. It’s all _anticipated__. If inflation

outpaces income, then standards of living

fall. One way to adjust for the effects of inflation is to include ___COLA______ adjustments to those on fixed incomes.

Expecting inflation can become a self-fulfilling prophecy. Consumers expect prices to rise, therefore, they buy more now, this, in turn results in demand-pull inflation.

F. MEASURING INFLATION:

1. CPI:

I A _market _basket_ of goods determined by the Bureau of Labor Statistics. This involves _300___ commonly purchased goods/services bought by _urban_ households. These items are also weighted.

Weakness of the CPI:

1. index is only adjusted periodically

2. the composition of the index is only adjusted

periodically

3. does not include I, G, or Xn spending

2. PPI:

Index of goods used in the _production_ process. The PPI is a good early indicator of consumer inflation.

3. GDP DEFLATOR (or Price Index):

Measures changes in total _spending__. It is adjusted _annually_ and includes C, I, G, and Xn spending (preferred by

economists)

III. CHANGES IN REAL GDP, WAGES, & INTERST

RATES:

Once we know inflation, we can adjust nominal figures to arrive at real figures.

1. Real Income = __Nominal Income_____ minus inflation.

2. Real Interest Rate = Nominal Interest Rate minus inflation.

3. Real GDP = _Nominal GDP__ minus inflation.

4. Percentage Change in Real Income = %Change in Nominal Income

minus % change in _price level (inflation).

Ex: if Joe’s nominal income rose by 5% and inflation rose by 3%, what is his percentage change in real income (5% minus 3% or 2%). He is better off. (Nominal Income is what you get paid, Real Income is what you can buy).

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