Inflation and the 2 Percent Target: AP Macroeconomics Study Guide

Play Inflation Target Challenge →

Measuring Inflation on the Exam

AP Macroeconomics expects you to compute an inflation rate from a price index, construct a simple index from a market basket, and convert between nominal and real values. The standard calculation is the change in the index between two years divided by the earlier year's index, multiplied by one hundred. Be ready to explain the limitations of a fixed-basket index: substitution bias, because consumers switch away from goods whose prices rise; quality change bias, because improvements are hard to separate from price increases; and new-product bias. Those three limitations are exactly the reasons the Fed prefers a chained index, which makes them a natural bridge between the measurement unit and the monetary policy unit.

The Dual Mandate and the Costs of Inflation

Know that the Fed's statutory goals are maximum employment and stable prices, and that the committee has defined stable prices as 2 percent inflation over the longer run. Be ready to explain why inflation is costly, since free-response questions ask for it: unanticipated inflation redistributes wealth from lenders to borrowers and from those on fixed nominal incomes to others; it creates menu costs and shoe-leather costs; and it distorts decisions by making relative price signals harder to read. Deflation carries its own costs, raising the real value of debts and encouraging households to delay purchases. The exam also tests the distinction between demand-pull and cost-push inflation.

Expectations and the Phillips Curve

The most heavily tested connection is between expected inflation and the short-run Phillips curve. An increase in expected inflation shifts the short-run curve up and to the right, so the economy faces a worse menu of inflation and unemployment combinations at every point — this is the graphical statement of what happened in the 1970s. The long-run Phillips curve is vertical at the natural rate of unemployment, meaning there is no permanent trade-off. An inflation target works precisely by holding expected inflation still, which keeps the short-run curve anchored. Pair this with the AD-AS diagram: a leftward shift of short-run aggregate supply corresponds to an outward shift of the short-run Phillips curve.

Key Terms to Know