Inflation: Definitions Essay

Inflation: A persistent increase in the price level, measures how much more expensive a set of goods and services has become over a certain period, usually a year. Consumers believe that low stable and predictable inflation is best for economy, too high and too low are not good. Measuring Inflation: To measure the average consumers cost of living, government agencies conduct household surveys to identify a basket of commonly purchase items and then track the cost of purchasing this basket over time. Consumer Price Index: (CPI) The cost of the basket when measuring inflation at a given time expressed relative to a base year. Consumer Price Inflation: The percentage change in the CPI over a certain period, most widely used measure of inflation. Ex: base year CPI is 100 and the current CPI is 110 inflation is 10 percent over the period. Core Consumer Inflation: Excludes prices set by the government and the more volatile prices of products such as food and energy that are most affected by seasonal factors or temporary supply conditions focuses on the underlying and persistent trends in inflation and is also watched closely by policymakers. Deflation: A persistent decline in the price level GDP Deflator: A measure comparing the prices of all goods and services produced in the economy during a given year to the prices of those goods and services purchased in a base year. Gross Domestic Product Deflator: (GDP) The overall inflation rate for not just consumption good but all goods produced in an economy, more broader coverage than the CPI. Inflation Rate: The percentage increase in the price level from one year to the next. Inflation Targeting: A policy used to maintain low and stable inflation used by many central bankers. Introduction of New Goods: Increase variety, allows consumers to find products that more closely meet their needs. In effect, dollars become more valuable, which lowers the cost of, maintain the same level of economic well-being. The CPI misses this effect because it uses a fixed basket of goods, thus the CPI overstates increases in the cost of living. Nominal GDP: Values output using current prices. It is not corrected for inflation. GDP measured in terms of current market prices, value of all final goods and services produced in the economy during a given  year, calculated using the prices current in the year in which the output is produced. Price Indices: Are designed to remove the effect of price changes. Price Level: A measure of the average prices of goods and services in the economy. Quantity Theory of Money: The relationship between money supply and the size of the economy. Real GDP: Values output using the prices of a base year. Real GDP is correct for inflation. GDP measured using constant base year prices. It is the total value of the final goods and services produced in the economy during a given year, calculated using the prices of a selected base year. Real Income: A proxy for the standard of living, when real incomes are rising, so is the standard of living and vice versa. Real Interest Rate: The nominal rate minus the inflation rate. Substitution Bias: Over time some prices rise faster than others, consumers substitute towards goods that become relatively cheaper, the CPI misses the substitution because it uses a fixed basket of goods. Thus, the CPI overstate increase in the cost of living. Supply shocks: Disrupt production, such as natural disasters or raise production costs such as high oil prices. Can reduce overall supply and lead to cost push inflation in which the impetus for price increases comes from disruption in supply. Unmeasured Quality Change: Improvements in the quality of goods in the basket also increase the value of a dollar. The BLS tires to account for quality changes but probably misses some, as quality is hard to measure. Thus, the CPI overstates increases in the cost of living.