Economic Activity and Prices

Economic Activity and Prices Inflation, Deflation Just as there are "fiscal" and "monetary" explanations for changes in the business cycle, there are two basic sets of explanations for price changes. "Inflation" is defined as a price increase for the same output. Economic output doesn't change; just the price changes. If prices drop for the same unit of output, this is termed "deflation." In our economy, inflation is prevalent. The measures of inflation levels in the economy are: Consumer Price Index (CPI) The CPI is a "market basket" of selected goods and services in various cities across the country. Components of the CPI include housing costs, food, clothing, medical, transportation, etc. Producer Price Index (PPI) The PPI is an index of the price of various items such as farm products and industrial commodities. This index does not include the value of services (which are in the CPI). The "leading" indicator of inflation trends is the PPI. As producer costs rise, they are then "passed on" to consumers and ultimately are reflected in the CPI. There are many theories for the root causes of inflation. These include: Cost-Push Inflation: This theory states that rising material costs and increasing wage demands from workers force producers to raise their prices. Demand-Pull Inflation: This theory states that inflation is caused by the national demand for goods and services outstripping the productive potential (national supply) of the economy. Monetarist Theory: Monetarists state that the cause of inflation is the Federal Reserve's expansion of the money supply at a faster rate than economic growth. Since more "money" is chasing the output of the economy, prices are forced up. (This is discussed more fully in the next section.) Inflation Rates Tend to Increase during Economic Expansions As a generalization, during periods of economic expansion, inflation rates tend to increase, while during periods of economic contraction, inflation rates tend to fall. This makes sense, because during periods of prosperity, consumers are not as concerned with price increases, while during "hard times," consumers will cut back on spending if prices rise too quickly. Real Interest Rate Interest rates are "inflation sensitive." If the inflation rate rises, then interest rates rise. Interest rates are said to have two components - the "real cost" of money and an "inflation premium." For example, if short-term T-Bill rates (a risk-free rate) are at 3%

and inflation is running at 1% per year, then the real interest rate is 2%. Nominal Interest Rate Changes Interest rates measure the "cost of money" in the economy. Whereas nominal interest rates (the interest rate placed on the bond at the time of issuance that reflects the current market rate of interest for that type of security) change over time; real interest rates do not change.