What is inflation?
Inflation is rising general level of prices and it reduces the purchasing power of money. Basically the money loses value. When inflation occurs each dollar of income will buy fewer goods than before. Unexpected inflation helps borrowers but hurts lenders and people on fixed income.
Nominal wage refers to the wages that are measured by dollas rather than purchasing power. Your nominal wage might seem to be very high but if you consider the growth of your wages to the growth of inflation, you could technically be worse off. If your wages are not rising at the same rate of inflation then you are making less money than you did. If your wages are rising higher than the rate of inflation it means your wage as actually increased and the effect of rising prices (inflation) won’t hit you.
Real wage refers to the wages that are adjusted for inflation. Inflation raises the general prices and it also reduces the purchasing power of money. Therefore, the real wage will determine what your money is really worth.
Nominal Interest Rate
Nominal interest rates do not take inflation into account. It is the interest rate that is quoted on bonds and loans.
Real Interest Rate
Real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real rate of a bond or a loan. To calculate the real interest rate you first need the nominal interest rate.
Causes of inflation
- Government prints too much money
Governments who print more and more money just to pay back debts will impact their own economy with hyperinflation.
- Demand pull inflation
As you may already know, demand pulls prices upwards! The more demand there is in the market, the more consumer spending there will be. This will result in businesses hiring more people and people getting more jobs and higher pay. This means businesses will also seek to increase prices to boost their profit margin as well as paying more wages! If you demand the goods that much, surely you will pay a bit extra for it. Not long after this, everything in the economy will have risen in price!
- Cost pull inflation
Costs of production will affect the prices of goods and services released into the market, the higher the production cost, the higher the price. This is because businesses seek to maintain their profit margin. Although this type of inflation is from the business side and not the consumer side, prices end up rising. This is referred to as a negative supply shock.
Consumer Price Index (CPI)
The consumer price index (CPI) is the most common method of measuring inflation for consumers. It aims to compare the price of necessities referred to as a basket of consumer goods and services, such as transportation, food and medical care (everyday goods). It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Therefore the CPI is also a good indicator to assess the changes in cost of living as well as inflation! When everyday goods are priced a lot higher than the base year or previous years, we can say that the period of inflation is starting and vice versa.
CPI vs GDP Deflator
The GDP deflator measures the price of all goods and services produced, where as the CPI measures prices of the goods and services bought by consumers.
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