Inflation and Deflation

Inflation is the primary driver of interest rate changes and Fed policy decisions. Understanding it first makes subsequent topics clearer.

Core Definitions:

• Inflation: A sustained increase in the general price level of goods and services over time
• Deflation: A sustained decrease in the general price level (opposite of inflation)
• Disinflation: A slowing in the rate of inflation (prices still rising, but more slowly)
• Stagflation: Combination of stagnant economic growth, high unemployment, and high inflation
• Hyperinflation: Extremely rapid, out-of-control inflation (prices rising dramatically)

Exam Tip: Gotchas

• Disinflation is not deflation; prices are still rising, just more slowly. Stagflation combines inflation with stagnation (high unemployment + low growth): the worst of both worlds. The exam tests these distinctions.

Effects of Inflation

• Erodes purchasing power of fixed-income investments (bonds, fixed annuities)
• Hurts lenders and fixed-income investors (receive dollars worth less)
• Benefits borrowers (repay debt with less valuable dollars)
• Real return = nominal return minus inflation rate

Effects of Deflation

• Increases purchasing power of money
• Benefits fixed-income investors (dollars received are worth more)
• Can signal severe economic weakness (reduced demand, falling prices, rising unemployment)

Key Inflation Measures

• Consumer Price Index (CPI) - the primary inflation gauge; measures price changes in a basket of goods and services commonly purchased by households
• Published monthly by the U.S. Bureau of Labor Statistics (BLS)
• The Fed monitors CPI to guide monetary policy decisions