Inflation & the Business Cycle

You’ll be able to

Calculate the inflation rate using the Consumer Price Index
Distinguish nominal from real values and identify who is helped or hurt by inflation
Identify the four phases of the business cycle and the output gaps they produce

Measuring inflation with the CPI

Inflation is a sustained rise in the general price level, which erodes the purchasing power of money. The main gauge is the Consumer Price Index (CPI), which tracks the cost of a fixed market basket of goods and services a typical urban household buys. The CPI is set to 100 in a base year; the inflation rate between two years is the percentage change in the index. Because the basket is fixed, the CPI can overstate inflation when consumers substitute away from goods that get pricier (substitution bias), and it can miss quality improvements.

Nominal vs. real, and who inflation redistributes

A nominal value is measured in current dollars; a real value is adjusted for inflation and reflects actual purchasing power. The real interest rate ≈ nominal interest rate − inflation rate (the Fisher relationship). Unexpected inflation redistributes wealth: it hurts lenders and savers (they are repaid in dollars worth less) and those on fixed incomes, while it helps borrowers (they repay with cheaper dollars). If inflation is fully anticipated, lenders build it into the nominal rate and the redistribution shrinks.

The business cycle

Real GDP does not grow smoothly; it fluctuates around a long-run upward trend in the business cycle. The cycle has four phases: expansion (real GDP rising, unemployment falling), peak (the top, often with inflationary pressure), contraction/recession (real GDP falling, unemployment rising — technically two consecutive quarters of falling real GDP), and trough (the bottom, before recovery). During a boom the economy can exceed potential output (an inflationary gap); during a recession it falls below potential (a recessionary gap with cyclical unemployment).

Inflation rate from the CPI

Inflation rate = [(CPI_new − CPI_old) / CPI_old] × 100

A simple percentage change in the index. The same formula finds the rate between any two years once you know the CPI for each.

Worked example

The CPI was 200 last year and 210 this year. A worker’s nominal wage rose from $50,000 to $52,000. Calculate (a) the inflation rate and (b) whether the worker’s real wage rose or fell.

1.Inflation rate = [(210 − 200) / 200] × 100 = (10 / 200) × 100 = 5%.
2.The nominal wage rose from $50,000 to $52,000, an increase of 2,000/50,000 = 4%.
3.Compare: nominal wages grew 4% but prices grew 5%.
4.Because wage growth (4%) is less than inflation (5%), the real wage fell by roughly 1%.

Answer: Inflation was 5%, but the worker’s nominal wage rose only 4%, so the real wage fell by about 1%. The worker can buy less than before despite earning more dollars — the difference between nominal and real income.

Checkpoint

A bank lends money at a fixed nominal interest rate of 6%, expecting 2% inflation. Instead, inflation turns out to be 5%. Who benefits from this unexpected inflation?

Watch out

Do not confuse a change in the price level with a change in real income. A raise that is smaller than inflation is actually a cut in real terms. Always compare nominal changes to the inflation rate before judging whether people are better off.

Checkpoint

An economy is producing real GDP well above its potential (full-employment) output, and the unemployment rate has dropped below the natural rate. This situation is best described as:

On the exam

Link the indicators together: at a peak, expect low unemployment and rising inflation (inflationary gap); in a recession, expect high cyclical unemployment and falling prices or disinflation (recessionary gap). Free-response questions often ask you to connect the business-cycle phase to both unemployment and inflation.

Answer the 2 checkpoints as you read.