Inflation, Prices & Interest Rates
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Inflation
Definition
- Steady rise in the general level of prices
- Measured using Consumer Price Index (CPI)
Causes of Inflation
- Excess demand for goods and services
- Increasing costs of production
- Supply of money/credit rises faster than supply of goods and services
Effects of Inflation
- Reduces purchasing power
- Erodes real income
- Affects investment returns
Deflation
Definition
- Broad, sustained decline in prices of goods and services
- Hard to stop once it takes hold
Effects of Deflation
- Reduced corporate profits
- Declining home values
- Rising unemployment
- Lower incomes
- Result: Recession is normally the end result
Real Income vs. Nominal Income
Example: John Smith’s Raise
Given:
- Current salary: $37,000
- New salary: $38,600
- Raise amount: $1,600
- Current inflation: 4.0%
Calculating Nominal Income Change
Nominal change = (38,600 - 37,000) / 37,000 × 100 = 4.3%
Calculating Real Income Change
Real income change = Nominal change - Inflation
Real income change = 4.3% - 4.0% = 0.3%
Real Income in Dollars
Real income = Nominal income × (1 + real change)
Real income = $37,000 × (1 + 0.003) = $37,111
Analysis
- Nominal raise: $1,600
- Real economic progress: $111
- Lost to inflation: $1,489 ($1,600 - $111)
Interest Rates
Federal Funds Rate
- Definition: Rate that banks charge one another on overnight loans
- Benchmark for business and consumer loans
- Indicator of future Fed policy
How Fed Uses Interest Rates
When Economy Slows
- Fed reduces federal funds rate
- Lenders reduce rates for short-term loans
- Makes borrowing less costly
- Encourages spending
When Economy Grows Too Fast
- Fed raises federal funds rate
- Reduces borrowing
- Slows down economy
- Controls inflation
Key Formulas
Nominal Income Change
Nominal change % = (New income - Old income) / Old income × 100
Real Income Change
Real change % = Nominal change % - Inflation rate %
Real Income in Dollars
Real income = Nominal income × (1 + real change as decimal)
Key Terms & Definitions
| Term | Definition |
|---|---|
| Inflation | Steady rise in general price level |
| CPI (Consumer Price Index) | Measure of inflation |
| Deflation | Sustained decline in prices |
| Nominal Income | Actual dollar amount earned |
| Real Income | Income adjusted for inflation |
| Federal Funds Rate | Rate banks charge each other for overnight loans |
| Purchasing Power | What money can actually buy |
Important Relationships
Inflation Impact Chain
- Money supply increases faster than goods supply
- Prices rise (inflation)
- Purchasing power decreases
- Real income falls even if nominal income rises
Fed Interest Rate Policy
Economy Slowing → Lower rates → Cheaper borrowing → More spending → Growth
Economy Overheating → Raise rates → Expensive borrowing → Less spending → Cooling
Practical Applications
Evaluating a Raise
Steps:
- Calculate nominal income change percentage
- Subtract inflation rate
- Result = real income change
- Convert to dollars to see actual benefit
Forecasting Interest Rates
Watch for:
- Changes in federal funds rate
- Economic growth indicators
- Inflation trends
- Fed policy announcements
Exam Tips
- ✅ Know how to calculate real vs. nominal income
- ✅ Understand the difference between inflation and deflation
- ✅ Remember: deflation leads to recession
- ✅ Federal funds rate is a benchmark for other rates
- ✅ Fed lowers rates when economy slows, raises when it overheats
- ✅ Real income = Nominal income adjusted for inflation
- ✅ Practice the calculation: Real change = Nominal change - Inflation
Common Mistakes to Avoid
- ❌ Confusing nominal and real income
- ❌ Forgetting to convert percentages to decimals in calculations
- ❌ Thinking a raise always means more purchasing power
- ❌ Confusing inflation (rising prices) with deflation (falling prices)
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