Inflation Calculator
● In 1931 Babe Ruth earned $80,000 per year
while President Hoover earned $75,000.
“I had a better year.” Babe Ruth
How do those numbers compare to today’s salaries?
What do we need to take into consideration?
Inflation
What is inflation?
An increase in prices (on average)
What indicator of inflation have we already
discussed?
GDP Deflator
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Inflation Calculator
● Today the average baseball player earns
■ $ 3.4 Million per year
■ Alex Rodriguez earned $30 Million in 2013!
President Obama is paid $400,000
What is the largest grossing Hollywood Movie of all
time?
Gone with the Wind: $198 Million (1939) or
Avatar : $ 760 Million (2009)
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Inflation Calculator
Ford Model “T” in 1908: $850
Today Ford Fusion:
$28,000 Base 2013
Which was more expensive?
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More about Henry Ford and elasticity of demand
Due to improvements in the
manufacturing process the
cost of a Model T dropped.
In 1914: $300!
Ford’s market share rose from
9.4% to 48% of the car market
by 1914 and net income rose
from $3 Mil. to $ 25 Mil.
How would
you describe
the price
elasticity of
demand for
cars in 1910?
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How do we normally measure inflation?
● Calculate the Consumer Price Index (CPI)
● Pick a basket of Consumer Goods and track
those prices over time. Record the % change
in the basket
● Fix the Basket: Determine what goods are most
important to the typical consumer.
■ The Bureau of Labor Statistics (BLS) identifies a
market basket of goods and services the typical
consumer buys.
■ The BLS conducts monthly consumer surveys to set
the prices of those goods and services.
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Figure 1 The Typical Basket of Goods and
Services
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Measuring the Cost
of Living
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24
Figure 2 Two Measures of Inflation
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Living with Inflation
Is Inflation always BAD?
How can inflation hurt
people?
How can inflation benefit
people?
● Real Interest Rates vs.
Nominal Interest Rates
● Real Wages vs. Nominal
Wages
● Borrowing vs. Lending
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REAL WAGES VS. NOMINAL WAGES
Let’s assume inflation in 10% per year, what does that mean?
Prices of consumer goods are increasing by 10% each
year.
Let’s return to Babe Ruth’s $80,000 salary in 1931
What if Babe Ruth stayed earning the same salary each year
for the next 20 years.
How is inflation affecting Babe Ruth?
His NOMINAL Wages would stay the same at $80,000, but
his real wages are decreasing by 10% each year!
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How are you effected by Inflation??
● Rising Prices
■ Is that always a problem?
Are your wages keeping up with inflation?
If so, inflation isn’t really a problem.
If not, inflation is a problem.
For sellers, inflation causes their costs to increase
which forces them to always change the price of
their goods. Sometimes they can’t pass these extra
costs along to consumers, causing their business to
be less profitable.
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How are you effected by Inflation??
● Savings/Investments
■ Your investments must keep up with the rate of
inflation or you are losing money each year.
■ REAL Interest Rates vs. Nominal Interest Rates
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Let’s take another look at Nominal vs. Real GDP
NOMINAL
2003
2004
2005
2006
2007
2008
10,971.2
11,734.3
12,479.4
13,194.0
13,737.0
14,294.0
REAL
10,320.6
10,755.7
11,131.1
11,319.0
11,491.0
11,727.0
INFLATION
651
979
1348
1875
2246
2567
Nominal GDP = Real GDP + Inflation
We could also say that…
Real GDP = Nominal - Inflation
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Interest Rates
vs.
Inflation
If you were to invest $1000 for 1 year, what is the lowest
rate of interest you would need to receive to keep from
losing money?
This year’s expected rate of INFLATION
If inflation = 10%
You must receive $1100 one year from today, or you will
lose money on this investment.
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Real and Nominal Interest Rates
● The nominal interest rate is the interest rate
your investment earns
● The real interest rate is the nominal interest
rate that is corrected for the effects of inflation.
Real interest rate = Nominal interest rate –
Inflation rate
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RATE OF INFLATION VS. INTEREST RATES
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Figure 3 Real and Nominal Interest Rates
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How do Real and Nominal Interest Rates Effect
You?
● Let’s say you put your money in the bank and
earn a nominal interest rate of 2% per year.
● If Inflation was 4% over this time period, what
is your REAL rate of return on this investment?
● Real interest rate = Nominal interest rate –
Inflation
REAL = 2% -4% = -2% Not a good investment
IF inflation = 1%, then real interest
= 2% -1% = 1%
Savers need to beat inflation!!
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So how can you GAIN from inflation?
● WHAT if you borrowed $1,000 for one year.
● The bank charges a Nominal interest rate of
5%. (the rate you pay)
● During the year inflation was 10%.
Real interest rate = Nominal interest rate –
Inflation
= 5% - 10% = -5%
Is the real interest rate what you pay?
No, but if you earned at least the inflation rate
then your net cost was -5%.
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Another scenario
You buy a house right now for 200k
● If you pay a fixed rate of interest (say 4% per year for
30 years). The amount you pay is fixed, it doesn’t
change over time!
● Your home should appreciate in value by at least the
rate of inflation, because all prices are going up, real
estate as well!
● If your salary increases along with inflation and that is
greater than 4%, over time the cost of paying off your
loan will get lower and lower.
● BUT your income must increase by more than 4%
(Cost of living increases, raises, etc.)
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So, what does all this mean for you?
WAGES
You must earn wage increases at least as much as inflation
to keep your REAL wages from declining.
SAVING/INVESTING
Investors/Savers must earn a positive real rate of interest
Nominal rate > inflation
BORROWING
Lenders must earn a real rate of interest greater than zero,
Borrowers can benefit from inflation by borrowing at
FIXED rates, below the rate of inflation
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Congratulations!! You just bought a house!
Now, how are you going to pay for it?
House cost: $250,000
10% down payment = $25,000
$225,000 loan
The bank will lend you money in two different
ways:
Option A
Borrow @ 4.4 % FIXED RATE for 30 years
Option B
Borrow @ 3.4% ADJUSTABLE one time per
year – NO Cap
Which would you choose??
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It depends on your expectations about inflation and
your tolerance for risk!
If inflation is higher than 4.4% (say, 10%)
Real Interest rate = 4.4 % - 10% = -5.6%
How would you gain?
Your home might increase in value at 10%, while you only
pay 4.4%
What if inflation stayed below 4.4 %? (1.4%)
Real Interest rate = 4.4% - 1.4% = 3.4%
You would earn closer to 1.4% on your home value, while
paying 4.4% to own it!
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Who is helped and who is hurt by high inflation?
1.
Banks extend many fixed rate loans. H-G-U
1.
2.
Hurt, since they are only receiving money back at a fixed interest
A farmer buys machinery with a fixed rate loan to be repaid
over 10 years
1.
3.
2. Gain, since he earns more money and pays a fixed rate
Your family buys a new home with an adjustable rate
mortgage, the rate you pay adjusts with interest rates.
1.
4.
Hurt, since you will pay higher interest if inflation causes rates to rise
Your savings are in a savings account paying a fixed rate of
interest
1.
Hurt, since your receive only a fixed rate and interest rates and prices
of everything are rising.
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1.
A widow lives entirely on a fixed income from a pension the
woman receives from her former employer.
1.
2.
A retired couple lives entirely on income from a pension the
woman receives from her former employer.
1.
3.
Hurt, since prices are going up and the interest she receives is fixed.
Unclear, since we don’t know if the pension is INDEXED to inflation.
A retired man lives entirely on income from Social Security.
Unclear, since although SS is indexed to inflation we don’t know if it will
keep up with the man’s personal expenses.
4. The federal gov. has a $ 5 Billion debt.
1.
Unclear, since we don’t know if it’s borrowed at fixed rates or adjustable.
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Figure 1 The Typical Basket of Goods and
Services HOW IS THE CONSUMER PRICE
INDEX CALCULATED?
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How the Consumer Price Index Is
Calculated
● Fix the Basket: Determine what products are
most important to the typical consumer.
■ The Bureau of Labor Statistics (BLS) identifies a
market basket of goods and services the typical
consumer buys.
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How the Consumer Price Index Is
Calculated
● Find the Prices: Find the prices of each of the
goods and services in the basket for each point
in time.
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3 Steps to Calculate CPI for any year (x)
● Step 1 Calculate cost of basket for base year
● Cost of basket (base year) = Prices (base year) * Quantities (base year)
● Step 2 Calculate cost of basket in year x
● Cost of basket (yr X) = Prices(yr X) * Quantities (base year)
● Step 3 Calculate CPI yearX
CPI (yrX)= Basket (yrX)/Basket (base year)
● Reminder: To calculate the cost of each year’s basket, don’t
change the quantities, ONLY CHANGE THE PRICES!
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How the Consumer Price Index Is
Calculated
CPI (yr X) = Price of the Basket (yr X)
X 100
Price of the Basket (base year)
HISTORICAL CPI!
So, what is the value of
the CPI in the Base Year?
100
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Dollar Figures from Different Times
● Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2001:
CPI DEFLATOR
Salary2001
Price level in 2001
 Salary1931 
Price level in 1931
177
 $80,000 
15.2
CPI Deflator 2001
CPI Deflator 1931
 $931,579
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How the Consumer Price Index Is
Calculated
Compute the inflation rate: The inflation rate is
the percentage change in the CPI from the
preceding period.
● The Inflation Rate
■ The inflation rate is calculated as follows:
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year 2 =
 100
CPI in Year 1
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Table 1 Calculating the Consumer Price Index and
the Inflation Rate: An Example
Quantity Hot Dogs
4
3
2
The
quantity
stays the
same
each
year!
Quantity
Hamburger
1.Find the
prices
2
2
1
2. Calculate
the cost of the
original basket
in each year.
3. Divide each
basket into the
base year
basket to find
the CPI.
4. Calculate
change in
CPI to find
inflation
rate
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“Inflate or Deflate” Prices
You can put the price of any good from any year into
another year’s dollar value by calculating how much the
CPI grew or shrunk over that time period.
For instance:
Question: Has minimum wage kept up with inflation?
Minimum Wage in 1965 = $1.25/hr
CPI in 1965 = 31.5
CPI in 2013 = 233
$ 1.25 “inflated” to 2013 prices =
1.25 x 233/31.5 = $9.25
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Problems in Measuring the Cost of Living
● The CPI is an accurate measure of the selected
goods that make up the typical bundle, but it is
not a perfect measure of the cost of living.
Most problems with CPI result in
inflation being measured as too high!
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Problems in Measuring the Cost of Living
● Substitution bias
● Introduction of new goods
● Unmeasured quality changes
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Problems in Measuring the Cost of Living
● Substitution Bias
■ The basket does not change to reflect consumer
reaction to changes in relative prices.
♦ Consumers substitute toward goods that have become
relatively less expensive.
♦ The index overstates the increase in cost of living by not
considering consumer substitution.
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Problems in Measuring the Cost of Living
● Introduction of New Goods
■ The basket does not reflect the change in purchasing
power brought on by the introduction of new
products.
♦ New products result in greater variety, which in turn
makes each dollar more valuable.
♦ Consumers need fewer dollars to maintain any given
standard of living.
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Problems in Measuring the Cost of Living
● Unmeasured Quality Changes
■ If the quality of a good rises from one year to the
next, the value of a dollar rises, even if the price of
the good stays the same.
■ If the quality of a good falls from one year to the
next, the value of a dollar falls, even if the price of
the good stays the same.
■ The BLS tries to adjust the price for constant
quality, but such differences are hard to measure.
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The GDP Deflator versus the Consumer
Price Index
● The GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
● …the consumer price index reflects the prices
of all goods and services bought by consumers.
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