Price Indexes and Inflation
Review: Unemployment and Production
Unemployment Up

Employment Down

Production Down
Review: A Way to Measure Production
Unemployment Down

Employment Up

Production Up
How many final goods and services does
the economy produce?
Nominal GDP for 2014 = Sum of the market values of all final goods and services produced
in the United States during 2014
2014
2014
2014
= PAuto
 Q2014
Auto + PBeer  Q Beer + ... = 17,420
Nominal GDP increases when: Production (Q’s) increase and/or prices (P’s) increase
Problem: We only want to measure changes in production (Q’s), not changes in prices (P’s).
Solution: Keep prices (P’s) constant.
Real GDP for 2014
= Sum of the market values of all final goods and services produced in
the United States during 2014 evaluated at base year (2009) prices
2009
2009
2014
= PAuto
 Q 2014
Auto + PBeer  Q Beer + ... = 16,090
Price Indexes
For the economy as a whole, what is the “average” price?
GDP Price Deflator
Consumer Price Index (CPI)
GDP Price Deflator
Nominal GDP for 2014 = Sum of the market values of all final goods and services produced
in the United States during 2014
2014
2014
2014
= PAuto
 Q2014
Auto + PBeer  Q Beer + ... = 17,420
Real GDP for 2014
= Sum of the market values of all final goods and services produced in
the United States during 2014 evaluated at base year (2009) prices
2009
2009
2014
= PAuto
 Q 2014
Auto + PBeer  Q Beer + ... = 16,090
Nominal GDP for 2014
 100
Real GDP for 2014
2014
2014
2014
PAuto
 Q2014
Auto + PBeer  Q Beer + ...
= 2009
×100
2014
2009
2014
PAuto  Q Auto + PBeer  Q Beer + ...
GDP Price Deflator for 2014 =
Since the base year (2009)
prices have risen by about
8 percent on average.

Hypothetical Questions:
What if prices were unchanged since 2009?
What if prices had doubled since 2009?
What if prices had tripled since 2009?
17,420
16,090
 100  108.3
GDP Price Deflator
100
200
300
GDP Price Deflation Inflation Rate: 1930-2014
GDP Price Deflator: 1930-2014
2009 = 100.0
15.0
120
10.0
100
5.0
80
0.0
60
-5.0
40
-10.0
20
0
1930
1940
1950
1960
1970
1980
1990
Rate
of
Inflation
-15.0
1930
1940
2010
=
Change in the
Price Index expressed
as a percentage
Year
2013
GDP Price Deflator
2009 = 100
106.7
2014
108.3
Rate of Inflation in 2014 =
1950
2000
108.3  106.7
106.7
=
1960
1.6
106.7
1970
1980
= 1.5%
1990
2000
2010
How Social Security Unfairly Calculates the Cost of Living for Retirees
8:38 am ET
Oct 20, 2015
DAVID BLANCHETT: Retirees got some bad news recently when it comes to Social Security:
Their Social Security benefits won’t increase in 2016. The reason, according to the Department of
Labor’s announcement on Oct. 15, was that living expenses were 0.4% lower in the third quarter
from a year before, primarily because of lower gas prices.
..
.
The Labor Department uses the Consumer Price Index for Urban Wage Earners and Clerical
Workers, or CPI-W, to measure inflation’s effects on Social Security beneficiaries’ costs. A costof-living increase for the following year’s benefits is determined by the average monthly CPI-W
value in the third quarter of the current year.
..
.
Consumer Price Index (CPI)
First, the Bureau of Labor Statistics decides upon the market basket of goods that is
purchased by the typical American household:
x pounds of chicken y pounds of beef
z gallons of gasoline
n cans of beer
Second, the Bureau of labor statistics calculates how much this market basket would have
cost in the base year and how much it costs now.
Third, it calculates the ratio of the costs and by convention multiplies the ratio by 100. The
result is the CPI:
Cost of the Market Basket in September 2015
× 100
CPI for September 2015 =
Cost of the Market Basket in Base Year
Consumer Price Index (CPI)
Market Basket: “Basket” of Goods consumed by the typical American household.
Cost of the Market Basket in September 2015
CPI for September 2015 =
Year Jan Feb Mar
2013 230.3 232.2 232.8
2014 233.9 234.8 236.3
2015 233.7 234.7 236.1
Apr
232.5
237.1
236.6
× 100
Cost of the Market Basket in Base Year
May Jun Jul Aug Sep Oct Nov Dec
232.9 233.5 233.6 233.9 234.1 233.5 233.1 233.0
237.9 238.3 238.2 237.9 238.0 237.4 236.2 234.8
237.8 238.6 238.6 238.3 237.4
Rate
of
Inflation
=
=
=
Change in the
Price Index expressed
as a percentage
237.4  238.0
238.0
.6
 100
 100 = .2%
238.0
The Effects of Inflation: Purchasing Power
Increase in
Nominal Per Capita
Increase in
Disposable Income (%)
CPI (%)
10.5
13.5
1979-80
2009-10
2.8
1.6
Change in Purchasing Power:
Change in Real Per Capita
Disposable Income (%)
3.0
1.2
Does the CPI Overstate or Understate the Effect of Inflation?
Substitution
Sept 2013
Sept 2014
Percent change
Smith household
CPI
234.1
238.0
1.7%
Ground Beef ($/lb)
3.50
4.10
17.1%
Turkey ($/lb)
1.82
1.58
13.2%
In September 2013, the Smith household was using all its income to purchase the
typical market basket of goods;
During the next year the household’s income rose by 1.7 percent, an amount just
equal to the increase in the CPI.
Could the Smiths continue to consume the typical market basket of goods? Yes
If so, the Smiths would be just as well off.
Would the Smiths continue to consume the typical market basket of goods? No
The Smiths would be better off.
Quality Improvements and New Products
Personal computers
Cell phones
Atypical Households
Elderly
Food and beverages
Housing
Apparel
Transportation
Medical care
Recreation
Percent of Income Spent
Urban
Workers
Elderly
15.70%
12.80%
39.20%
44.50%
3.60%
2.40%
18.70%
14.50%
5.60%
11.30%
5.50%
5.30%
Price of
Gasoline ($/gal)
September 2014
3.40
September 2015
2.40
Nominal Interest Rates: The interest rate that the bank advertises.
Question: What is the opportunity cost of holding cash? Answer: Nominal interest rate.
Question: What does opportunity cost refer to?
Inflation and Interest Rates:
Nominal and Real Interest Rates
Real
Interest =
Rate (r)
Nominal
Interest 
Rate (i)
Inflation
Rate ()
The Effects of Inflation: Purchasing Power
Save $100
for a year
Year
2007
2008
2014
Nominal Interest
Rate = 5%

$5 of
Interest
Nominal Interest
Rate (i)
5.2%
3.1%
0.1%
Inflation
Rate = 2%

$2 Erosion of
Purchasing Power
Inflation
Rate ()
2.8%
3.8%
1.6%
Real Interest
Rate = 3%

$3 Net Increase of
Purchasing Power
Real Interest
Rate (r)
2.4%
0.7%
1.5%
Aggregate Demand (AD) Curve
P
S
Review: Market for a Good
P*
Equilibrium:
Quantity Demanded = Quantity Supplied
D
Q
Market demand curve: How many cans of
beer would consumers purchase (the quantity
1.50
1.00
.50
demanded), if the price of beer were _____,
2.00
given that everything else relevant to the
demand for beer remains the same?
P
Question: Why
is the demand curve
If P = 2.00
downward sloping?
If P = 1.50
If P = 1.50
If P = 1.00
If P = 1.00
If P = .50
Q*
Market supply curve: How many cans of
beer would firms produce (the quantity
1.00
1.50
.50
2.00
supplied), if the price of beer were _____,
given that everything else relevant to the
supply of beer remains the same?
P
S
If P = 2.00
If P = .50
D
Q
Question: Why
is the supply curve
downward sloping?
Q
Aggregate Demand/Aggregate Supply Model
 (%)
AS
Equilibrium:
Goods and Services Purchased
Equals
Goods and Services Produced
AD
G&S
AD Question: How many final goods and
services would be purchased if the inflation
1.0 percent, given that all
2.0
3.0
4.0
rate () were _______
other factors relevant to demand remained
the same?
 (%)
If  = 4.0
If  = 3.0
If  = 3.0
If  = 2.0
If  = 2.0
If  = 1.0
AS Question: How many final goods and
services would be produced if the inflation
1.0 percent, given that all
2.0
3.0
4.0
rate () were _______
other factors relevant to supply remained the
same?
 (%)
AS
If  = 4.0
If  = 1.0
AD
G&S
G&S
 (%)
Aggregate Demand/Aggregate Supply Equilibrium
Goods and services
(G&S) purchased

AD

C + I + G
=
AS
Goods and services
(G&S) produced
=

AS
=

GDP
AD
G&S
Real GDP for 2014 = Sum of the market values of all final goods and
services produced in the United States during
2014 evaluated at base year (2009) prices
Goods and services
(G&S) purchased

AD
Goods and services
Goods and services
purchased by
purchased by
=
+
households
firms
=

C
+

I
Goods and services
purchased by
+
governments
+

G
NB: To keep our analysis more
straightforward we are ignoring net exports
for now.
Summary: Aggregate Demand/Aggregate Supply Model
AD Question: How many
final goods and services
would be purchased if the
inflation rate () were
_______ percent, given
that all other factors
relevant to demand
remained the same?
 (%)
AS
AD
G&S
AS Question: How many
final goods and services
would be produced if the
inflation rate () were
_______ percent, given
that all other factors
relevant to supply
remained the same?
Equilibrium
Goods and services
(G&S) purchased
Goods and services
(G&S) produced

AD

AS

C + I + G

GDP
Aggregate Demand Curve
AD Question: How many final goods and
services would be purchased if the inflation
1.0 percent, given that all
2.0
3.0
4.0
rate () were _______
other factors relevant to demand remained
the same?
 (%)
If  = 4.0

Fewer goods and services
purchased

The aggregate demand (AD) curve
is downward sloping.
If  = 3.0
If  = 2.0
If  = 1.0
Inflation rate () increases
AD
G&S
The Federal Reserve Board (Fed)
Question: Why is the aggregate
demand (AD) curve downward
sloping?
The Real Interest Rate: The Federal Reserve Board’s (Fed’s) Throttle on the Economy
Real interest rate (r) increases

Loans become more costly
Real interest rate (r) decreases

Loans become less costly

Households and firm purchase
fewer goods and services

Households and firm purchase
more goods and services

In the entire economy fewer goods
and services (G&S) purchased

In the entire economy more goods
and services (G&S) purchased

Economy “slows down”

Economy “speeds up”
Fed’s Goal: Use its throttle, the real interest rate, to stabilize the economy.
Taylor Principle
When the inflation rate () increases
the Fed “slows down” the economy
by increasing the real interest rate (r).
When the inflation rate () decreases
the Fed “speeds up” the economy by
decreasing the real interest rate (r).
The Federal Reserve Board and the Taylor Principle
Fed’s Goal: Use its throttle, the real interest rate, to stabilize the economy.
Taylor Principle
When the inflation rate () increases
the Fed “slows down” the economy
by increasing the real interest rate (r).
Inflation rate () increases

Real interest rate (r) increases

Loans become more costly
When the inflation rate () decreases
the Fed “speeds up” the economy by
decreasing the real interest rate (r).
Taylor principle

Households and firm purchase
fewer goods and services

In the entire economy fewer goods
and services (G&S) purchased

Economy “slows down”
Inflation rate () decreases

Real interest rate (r) decreases

Loans become less costly

Households and firm purchase
more goods and services

In the entire economy more goods
and services (G&S) purchased

Economy “speeds up”
Economy stabilizes
Taylor Principle and the Fed Policy (FP) Curve
Taylor
Principle

When the inflation rate () increases
the Fed “slows down” the economy
by increasing the real interest rate (r).
 (%)
4.0
When the inflation rate () decreases
the Fed “speeds up” the economy by
decreasing the real interest rate (r).
FP Question: What would the real interest
rate (r) equal, if the inflation rate () were
2.0 percent, given that the Fed does
1.0
3.0
_______
3.0%
1.0%
not change its inflation policy? 5.0%
FP
If  = 3.0
The Fed policy (FP) curve is
upward sloping to stabilize
the economy.
If  = 2.0
If  = 1.0
r (%)
1.0 2.0 3.0 4.0 5.0 6.0
If  =1.0%
If  =2.0%


r = 1.0%
r = 3.0%
Consumption Purchases (C)
1,530
1,300
Investment Purchases (I)
220
200
If  =3.0%

r = 5.0%
1,070
180
Deriving the Aggregate Demand (AD) Curve
 (%)
FP Question: What would the real interest
rate (r) equal, if the inflation rate () were
2.0
1.0 percent, given that the Fed does
3.0
_______
not change its inflation policy? 5.0%
3.0%
1.0%
 (%)
4.0
FP
AD Question: How many final goods and
services would be purchased, if the inflation rate
1.0 percent, given that all other
3.0
2.0
() were _______
factors relevant to demand remained the same?
2,000
2,250
1,750
The aggregate demand (AD)
curve is downward sloping.
If  = 3.0
If  = 2.0
If  = 1.0
AD
1.0 2.0 3.0 4.0 5.0 6.0
The Fed policy (FP) curve is
upward sloping to stabilize the
economy.

Consumption Purchases (C)
Investment Purchases (I)
Government Purchases (G)
Goods and Services Purchased (G&S)
G&S
r (%)
1,750
2,000
2,250
The aggregate demand (AD) curve
reflects the goods and services
purchased.
If  =1.0%

r = 1.0%
1,530
220
500
2,250
If  =2.0%

r = 3.0%
1,300
200
500
2,000
If  =3.0%

r = 5.0%
1,070
180
500
1,750
Summary of the Fed Policy (FP) and the Aggregate Demand (AD) Curves
 (%)
FP Question: What would the real interest
rate (r) equal, if the inflation rate () were
_______ percent, given that the Fed does
not change its inflation policy?
 (%)
AD Question: How many final goods and
services would be purchased, if the inflation rate
() were _______ percent, given that all other
factors relevant to demand remained the same?
FP
AD
G&S
r (%)
Inflation
rate ()
increases
Real interest
Loans
Households
Fewer goods
rate (r)  become  and firms  and services

increases
more costly
purchase less
purchased

Taylor principle
(FP curve)

C and I
decrease

AD = C + I + G
decreases