Inflation and Real vs Nominal

Introduction

Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change in relative prices. A relative price change occurs when you see that the price of tuition has risen, but the price of laptops has fallen. Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the economy. In addition, price increases in the supply-and-demand model were one-time events, representing a shift from a previous equilibrium to a new one. Inflation implies an ongoing rise in prices. If inflation happened for one year and then stopped—well, then it would not be inflation any more.

A $550 Million Loaf of Bread?

Image of a 100 billion dollar bank note from Zimbabwe If you were born within the last three decades in the United States, Canada, or many other countries in the developed world, you probably have no real experience with a high rate of inflation. Inflation is when most prices in an entire economy are rising. But there is an extreme form of inflation called hyperinflation. This occurred in Germany between 1921 and 1928, and more recently in Zimbabwe between 2008 and 2009. In November of 2008, Zimbabwe had an inflation rate of 79.6 billion percent. In contrast, in 2014, the United States had an average annual rate of inflation of 1.6%.

Zimbabwe’s inflation rate was so high it is difficult to comprehend. So, let’s put it into context. It is equivalent to price increases of 98% per day. This means that, from one day to the next, prices essentially double. What is life like in an economy afflicted with hyperinflation? Not like anything you are familiar with. Prices for commodities in Zimbabwean dollars were adjusted several times each day. There was no desire to hold on to currency since it lost value by the minute. The people there spent a great deal of time getting rid of any cash they acquired by purchasing whatever food or other commodities they could find. At one point, a loaf of bread cost 550 million Zimbabwean dollars. Teachers were paid in the trillions a month; however this was equivalent to only one U.S. dollar a day. At its height, it took 621,984,228 Zimbabwean dollars to purchase one U.S. dollar.

Government agencies had no money to pay their workers so they started printing money to pay their bills rather than raising taxes. Rising prices caused the government to enact price controls on private businesses, which led to shortages and the emergence of black markets. In 2009, the country abandoned its currency and allowed foreign currencies to be used for purchases.

How does this happen? How can both government and the economy fail to function at the most basic level? Before we consider these extreme cases of hyperinflation, let’s first look at inflation itself.

Okay - So what is Inflation?

Inflation is an overall increase in the price level of an economy. Deflation is the opposite of inflation. Deflation is an overall decrease in the price level. A change in the price of just one or a few goods does not constitute inflation or deflation. After the price level increases, a dollar will buy less than it would before. When there is going to be inflation, people are better off buying now, before prices go up. After the price level falls (if it ever does), a dollar will buy more than it did before. When there is going to be deflation, people are better off waiting to buy later, when prices go down. If people anticipate inflation, they will build that expectation into their decisions. For example, workers will demand higher wages to keep their purchasing power the same if prices are expected to rise. Then, when inflation leads to higher prices, workers are not hurt or helped because their wages allow them to purchase the same amount of goods and services. However, when inflation is unanticipated, people do not build it into their decisions, and some people are hurt while others are helped.

For example, when there is unanticipated inflation, borrowers are helped while lender are hurt. People who borrow money receive a loan before prices rise, when the money will buy more. However, they pay the money back later, after prices rise, when the money won't buy as much. With inflation, the borrower gains while the lender loses.

Watch the video below to learn more about inflation.

The nominal value of any economic statistic means the statistic is measured in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.

Real GDP

To determine whether the economy of a nation is growing or shrinking in size, economists use a measure of total output called real GDP. Real GDP, short for real gross domestic product, is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices. Let us break that definition up into parts.

Notice that only “final” goods and services are included in GDP. Many goods and services are purchased for use as inputs in producing something else. For example, a pizza parlor buys flour to make pizzas. If we counted the value of the flour and the value of the pizza, we would end up counting the flour twice and thus overstating the value of total production. Including only final goods avoids double-counting. If the flour is produced during a particular period but has not been sold, then it is a “final good” for that period and is counted.

Watch the video below to learn more real GDP.

Nominal GDP

The nominal GDP is the value of all the final goods and services that an economy produced during a given year. It is calculated by using the prices that are current in the year in which the output is produced. In economics, a nominal value is expressed in monetary terms. For example, a nominal value can change due to shifts in quantity and price. The nominal GDP takes into account all of the changes that occurred for all goods and services produced during a given year. If prices change from one period to the next and the output does not change, the nominal GDP would change even though the output remained constant.

Watch the video below to learn more about the nominal GDP.

Inflation & Real vs Nominal

The presentation below will cover the of the fluctuations of the economy.

The Price Index

A price index is used to measure price changes in the economy. Price indices combine the prices of a bundle of goods and services and track changes in the price of that bundle over time. The Consumer Price Index, or CPI, is the most familiar price index. It measures changes in the price of a bundle of goods and services commonly bought by consumers. The CPI is based on a market basket of more than 200 categories of goods and services weighted according to how much the average consumer spends on them. Two other price indices are the Producer Price Index (PPI) and the GDP deflator. The PPI measures the average change over time in the selling prices received by domestic producers for their output. The GDP price deflator is the most inclusive index because it takes into account the prices of all goods and services produced.

To construct any price index, economists select a year to serve as the base year (the year used for comparison). The prices of other periods are expressed as a percentage of the base period. The value of a price index in the base year is 100, because prices in the base year are 100 percent of prices in that year. Inflation will raise the price of the market basket, and the price index will rise. Deflation will decrease the price of the market basket, and the price index will fall.

For the CPI, the formula used to measure price change from the base period is:

Cost of market basket in current year prices divided by cost of market basket in base year prices times 100 equals CPI

Watch the video below to learn about calculating CPI:

Review

Review what you have learned by completing the activity below.

In Summary . . .

What's Your takeaway? Icon When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the rate of inflation, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic means the statistic is measured in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.

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