Warm Up: Get out the
Unemployment Handout from
Monday. Have you completed it?
Warm Up
In the following scenarios, has inflation created: (a) winners
and losers at no net cost to the economy, or (b) a net cost to
the economy? If you have chosen (b), which type of cost is
the inflation generating?
1. During a period of rapid unexpected inflation, Sam’s Meat
Market must change the price of his products on a weekly
basis.
2. The First Bank of Reffville has made many long-term loans
with fixed interest rates assuming a stable inflation of 3%
every year. For the last two years inflation has been even
lower at 1.5%.
Inflation: Module 14 & 15
WHAT IS INFLATION?
Inflation is a general rising
level of prices
It reduces the “purchasing
power” of money
Examples:
•It takes $2 to buy today what
$1 bought in 1982
•It takes $6 to buy today what
$1 bought in 1961
•When inflation occurs, each
dollar of income will buy fewer
goods than before.
The Natural Rate
• The real wage is the wage rate divided by the price level.
• Real income is income divided by the price level.
• The inflation rate is the percent increase in the overall
level of prices per year.
year 2 – Price level in year 1 x 100
Inflation rate = Price level inPrice
level in year 1
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Inflation and Deflation
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Inflation and Deflation
• High rates of inflation impose significant economic
costs.
• Shoe-leather costs are the increased costs of
transactions caused by inflation.
• Menu cost is the real cost of changing a listed
price.
• Unit-of-account costs arise from the way
inflation makes money a less reliable unit of
measurement.
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Winners and Losers from Inflation
• Inflation changes the dollar repayment of a loan will be
because the loan contract is stated in nominal terms.
• The nominal interest rate is the interest rate expressed
in dollar terms.
• The real interest rate is the nominal interest rate minus
the rate of inflation.
• If inflation is higher than expected, borrowers gain at the
expense of lenders.
• If inflation is lower than expected, lenders gain at the
expense of borrowers.
• Unexpectedly high rates of inflation hurt lenders and
benefit borrowers.
• If inflation rate gets too high, the process of reducing
(disinflation) can be painful for the economy.
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Common Student difficulties
• Don’t assume that inflation hurts everyone in the economy, when it in
fact can serve as a distribution of income form those that are hurt, to
those that are hurt, to those that gain, from rising prices.
• The difference between nominal and real values is important, and not
always intuitive.
Hurt by Inflation
Helped by Inflation
• Lenders-People who
lend money (at fixed
interest rates)
• People with fixed
incomes
• Savers
• Borrowers-People
who borrow money
• A business where the
price of the product
increases faster than
the price of resources
Cost-of-Living-Adjustment (COLA)
Some works have salaries that mirror inflation.
They negotiated wages that rise with inflation
What are interest rates? Why do lenders charge them?
Who is willing to lend me $100 if I will pay a total
interest rate of 100%?
(I plan to pay you back in 2050)
If the nominal interest rate is 10% and the inflation rate is
15%, how much is the REAL interest rate?
Real Interest RatesThe percentage increase in purchasing power that a
borrower pays. (adjusted for inflation)
Real = nominal interest rate - expected inflation
Nominal Interest Ratesthe percentage increase in money that the borrower pays
not adjusting for inflation.
Nominal = Real interest rate + expected inflation
Nominal vs. Real Interest Rates
Example #1:
You lend out $100 with 20% interest. Inflation is 15%.
A year later you get paid back $120.
What is the nominal and what is the real interest rate?
Nominal interest rate is 20%. Real interest rate was 5%
In reality, you get paid back an amount with less
purchasing power.
Example #2:
You lend out $100 with 10% interest. Prices are expected
to increased 20%. In a year you get paid back $110.
What is the nominal and what is the real interest rate?
Nominal interest rate is 10%. Real rate was –10%
In reality, you get paid back an amount with less
purchasing power.
Inflation is Easy; Disinflation is Hard
•Disinflation is the
process of bringing the
inflation rate down.
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Israel’s Experience with Inflation
• In the mid-1980s, Israel experienced a “clean” inflation.
• But policy errors led to very high inflation.
• The shoe-leather costs of inflation were substantial. Israelis
spent a lot of time moving money in and out of bank accounts
that provided high enough interest rates to offset inflation.
• Businesses made efforts to minimize menu costs. For example,
restaurant menus often didn’t list prices.
• It was hard for Israelis to make decisions because prices
changed so much and so often.
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1. The rate of change of prices is important in the economy.
2. A high inflation rate imposes overall costs on the economy:
shoe-leather costs, menu costs, and unit-of-account costs.
3. Inflation does not, as many assume, make everyone poorer by
raising the level of prices because wages and incomes are
adjusted to take into account a rising price level, leaving real
wages and real income unaffected.
4. A higher-than-expected inflation rate is good for borrowers
and bad for lenders. A lower-than expected inflation rate is
good for lenders and bad for borrowers.
5. Disinflation is very costly, so policy makers try to prevent
inflation from becoming excessive in the first place.
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Price Level versus the Inflation Rate, 1969–2009….Notice how by 2009 costs of items are much higher
than the actual inflation rate thus reducing the purchasing power of the consumer.
Notice the “Stagflation Era” of the early 1980s.
How is Inflation measured? (Module 15)
The government tracks the prices of the same goods and
services each year.
• This “market basket” is made up of about 300
commonly purchased goods
• The Inflation Rate-% change in prices in 1 year
• Then compare changes in prices to a given base year
(usually 1982)
• Prices of subsequent years are then expressed as a
percentage of the base year
•
Examples:
•2005 inflation rate was 3.4%
•U.S. prices have increase 98.3% since 1982 (base year).
World Inflation Rates
Historic Inflation Rates
Price Indexes and
the Aggregate Price Level
• To determine the aggregate price level, we use a Market
Basket.
• A price index is the ratio of the current cost of that
market basket to the cost in a base year, multiplied by
100.
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The most commonly used method to determine inflation
for consumers is the Consumer Price Index
Here is how it works:
• The base year is given an index of 100
• To compare, each year is given an index # as well
CPI =
Price of market basket
Price of market
basket in base year
x 100
1997 Market Basket: Movie is $6 & Pizza is $14
Total = $20 (Index of Base Year = 100)
2009 Market Basket: Movie is $8 & Pizza is $17
Total = $25 (Index of 125)
•This means inflation increased 25% b/w ’97 & ‘09
•Items that cost $100 in ’97 cost $125 in ‘09
The CPI, 1913–2009
The Market Basket of Goods used to compute the Consumer Price Index in 2008.
Inflation Rate, CPI, and
other• Indexes
The inflation rate is the yearly percentage change in a
price index, typically based upon Consumer Price Index,
or CPI, the most common measure of the aggregate price
level.
• The CPI measures the cost of the market basket of a
typical urban American family.
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Table 15.1 Calculating the Cost of a Market Basket
Krugman and Wells: Macroeconomics, Second Edition in Modules
Copyright © 2012 by Worth Publishers
Example on the board
Figure 15.3 The CPI, the PPI, and the GDP Deflator
Krugman and Wells: Macroeconomics, Second Edition in Modules
Copyright © 2012 by Worth Publishers
Market Baskets and Price Indexes
Calculating GDP and Real GDP in a Simple Economy
Pre-frost
Post-frost
Price of orange
$0.20
$0.40
Price of grapefruit
0.60
1.00
Price of lemon
0.25
0.45
Cost of market basket
(200 × $0.20) +
(200 × $0.40) +
(200 oranges, 50 grapefruit,
(50 × $0.60) +
(50 × $1.00) +
100 lemons)
(100 × $0.25) =
$95.00
(100 × $0.45) = $175.00
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Other Price Measures
• A similar index to CPI for goods purchased by firms is the
producer price index.
• Economists also use the GDP deflator, which measures
the price level by calculating the ratio of nominal to real
GDP.
• The GDP deflator for a given year is 100 times the ratio of
nominal GDP to real GDP in that year.
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CPI vs. GDP Deflator
The GDP deflator measures the prices of all goods
produced, whereas the CPI measures prices of only the
goods and services bought by consumers.
An increase in the price of goods bought by firms or the government
will show up in the GDP deflator but not in the CPI.
The GDP deflator includes only those goods and services produced
domestically. Imported goods are not a part of GDP and
therefore don’t show up in the GDP deflator.
GDP
Deflator
=
Nominal GDP
Real GDP
x 100
If the nominal GDP in ’09 was 25 and the real GDP
(compared to a base year) was 20 how much is the
GDP Deflator?
Calculating GDP Deflator
GDP
Deflator
Nominal
GDP
=
=
Nominal GDP
Real GDP
x 100
(Deflator) x (Real GDP)
100
The CPI, the PPI, and
the GDP Deflator
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Indexing to the CPI
• The CPI has a direct and immediate impact on millions of
Americans.
• Many payments are tied, or “indexed,” to the CPI.
• Today, 48 million people receive checks from Social
Security. In addition, all Social Security payments are
adjusted each year to offset any increase in consumer
prices over the previous year.
• The CPI is used to calculate the official estimate of the
inflation rate used to adjust these payments yearly.
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1. To measure the aggregate price level, economists
calculate the cost of purchasing a market basket.
2. A price index is the ratio of the current cost of that
market basket to the cost in a selected base year,
multiplied by 100.
3. The inflation rate is the yearly percent change in a price
index, typically based on the consumer price index the
most common measure of the aggregate price level.
4. A similar index for goods and services purchased by firms
is the producer price index. Finally, economists also use
the GDP deflator, which measures the price level by
calculating the ratio of nominal to real GDP times 100.
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So What Do You Actually Understand?
• Modules 10-15 Review Questions
51. GDP is:
A) the monetary value of all goods and services (final,
intermediate, and non-market) produced in a given year.
B) total resource income less taxes, saving, and
spending on exports.
C) the economic value of all economic resources used
in the production of a year's output.
D) the market value of all final goods and services
produced within a nation in a specific year.
52. GDP can be calculated by summing:
A) consumption, investment, government purchases,
exports, and imports.
B) consumption, investment, government purchases,
and imports.
C) investment, government purchases, consumption,
and net exports.
D) consumption, investment, wages, and rents.
53. Net exports are negative when:
A) a nation's imports exceed its exports.
B) the economy's stock of capital goods is declining.
C) depreciation exceeds domestic investment.
D) a nation's exports exceed its imports.
E) the government increases trade barriers
54. Historically, real GDP has increased less rapidly than
nominal GDP because:
A) price indices have not reflected improvements in
product quality.
B) the general prices have increased.
C) technological progress has resulted in more efficient
production.
D) the general prices have declined.
E) nominal GDP is adjusted for inflation
55. Which of the following best measures a nation’s
standard of living:
A) unemployment rate.
B) nominal GDP.
C) total consumption and government spending
D) real GDP per capita.
E) inflation rate
56. The phase of the business cycle in which real GDP
declines for at least 2 quarters is called:
A) the peak.
B) a recovery.
C) a recession.
D) the trough.
E) a depression
57. Assuming the total population is 100 million, the
civilian labor force is 50 million, and 47 million workers
are employed, the unemployment rate:
A) is 3 percent.
B) is 6 percent.
C) is 7 percent.
D) is 9 percent.
E) cannot be determined because we do not know
how many workers are retired.
58. Which of the following is correct?
A) The unemployment rates of men and women
workers are roughly the same.
B) Unemployment rates for black and white workers
are approximately the same.
C) Teenagers experience approximately the same
unemployment rates as do adults.
D) Laborers are less vulnerable to unemployment than
are professional workers.
59. Kim quit her job as an insurance agent to return to
school full-time to earn an MBA degree. She is now done
with school and is searching for a position in management.
Kim is:
A)
cyclically unemployed. C) frictionally
unemployed.
B) The presence
structurally
D) not in the labor
60.
of unemployed.
“discouraged workers”:
force.
A) increases the size of the labor force, but does not
affect the unemployment rate.
B) reduces the size of the labor force, but does not
affect the unemployment rate.
C) may cause the official unemployment rate to
understate the amount of unemployment.
D) may cause the official unemployment rate to
overstate the amount of unemployment.
Answers
51.D
52.C
53.A
54.B
55.D
56.C
57.B
58.A
59.C
60.C
Sample Calculations
1. In an economy, Real GDP (base year = 1996) is $100
billion and the Nominal GDP is $150 billion. Calculate
the GDP deflator.
2. In an economy, Real GDP (base year = 1996) is $125
billion and the Nominal GDP is $150 billion. Calculate
the GDP deflator.
3. In an economy, Real GDP for year 2002 (base year =
1996) is $200 billion and the GDP deflator 2002 (base
year = 1996) is 120. Calculate the Nominal GDP for
2002.
4. In an economy, Nominal GDP for year 2005 (base year
= 1996) is $60 billion and the GDP deflator 2005 (base
year = 1996) is 120. Calculate the Real GDP for 2005.
Calculating CPI
Year
1
2
3
4
5
Units of Price
Output Per Unit
10
10
15
20
25
Nominal,
GDP
Real,
GDP
CPI/ GDP
Deflator
(Year 1 as
Base Year)
$4
5
6
8
4
Make year one the base year
CPI =
Price of market basket in
the particular year
x
100
Price of the same market
basket in base year
Inflation
Rate
Calculating CPI
Year
1
2
3
4
5
Units of Price
Output Per Unit
10
10
15
20
25
$4
5
6
8
4
Nominal,
GDP
Real,
GDP
CPI/ GDP
Deflator
(Year 1 as
Base Year)
$40
50
90
160
100
$40
40
60
80
100
100
125
150
200
100
Inflation
Rate
N/A
25%
20%
33.33%
-50%
Inflation Rate
% Change
in Prices
=
Year 2 - Year 1
Year 1
X 100
Practice
Year
1
2
3
4
5
Units of Price
Output Per Unit
5
10
20
40
50
$6
8
10
12
14
Nominal,
GDP
Real,
GDP
$30
80
200
480
700
$50
100
200
400
500
Consumer Price Index
(Year 3 as Base Year)
60
80
100
120
140
Make year three the base year
CPI =
Price of market basket in
the particular year
Price of the same market
basket in base year
x 100
Problems with using CPI as a Measurement
1. Substitution Bias- As prices increase for the fixed
market basket, consumers buy less of these products
and more substitutes that may not be part of the
market basket. (Result: CPI may be higher than what
consumers are really paying)
2. New Products- The CPI market basket may not include
the newest consumer products. (Result: CPI measures
prices but not the increase in choices)
3. Product Quality- The CPI ignores both improvements
and decline in product quality. (Result: CPI may
suggest that prices stay the same though the
economic well being has improved significantly)