•
Inflation refers to a situation in
which the economy’s overall
price level is rising.
•
The inflation rate is the
percentage change in the price
level from the previous period.
• Reducing the price also
reduces Income, how?
Explain
• Real wage= wage/price level
• Real income= income/price
level
• Shoe-leather cost- wear and
tear of running around trying to
spend extra money
• Menu cost- real costs of
changing listed price of items
on shelves
• Unit of account costs- arise
from the way inflation makes
money a less reliable unit of
measurement
http://www.youtube.com/watch?v=t_LWQQrpSc4
• Who is Hurt by Inflation?
• Fixed-Income Receivers
• Savers
• Creditors
• Who is Unaffected by Inflation?
• Flexible-Income Receivers
• Cost-of-Living Adjustments (COLAs)
• Debtors
• Government (as a big debtor)
benefits big time.
Real (irR %) and Nominal
Interest (irN %) Rates
• Nominal interest rate- ir actually paid for a
loan
• You borrowed $1,000 for one year.
• Nominal interest rate was 15%.
• During the year inflation was 10%.
Real interest rate = Nominal interest rate –
Inflation
% = irN % - π%
irR % = 15% - 10%
irR % = 5%
irR
Real Income [Nominal – Inflation = Real]
11%
=
+
5%
Nominal
Income
raise
Real
Income
6%
Inflation
Premium
Real Interest Rate
11%
=
+
5%
Nominal
Interest
Rate
Real
Interest
Rate
6%
Inflation
Premium
“Real Income” measures the amount of goods/services nominal income will buy.
[% change in real income = % change in nominal income - % change in PL.]
5%
10%
5%
Nominal income rose by 10%, PL increased by 4% - then real income rose by ___%.
6
15
Nominal income rose by 20%, PL increased by 5% - then real income rose by ___%.
“You will get a 10% raise”
Figuring Inflation
[Change/Original X 100 = inflation]
5.4
-3.3%
11
Consequences of
Inflation
• Shrinking Incomes-People who don’t
get raises at the same rate as
inflation are losing money each year.
• If inflation is 3% and raise is 2%,
they are actually making less
money because the dollar can’t buy
as much as it could before.
• Changes in Wealth-if inflation rise
dramatically people that had money
in the bank find that their savings are
not worth anything.
• Effect on Interest Rates- If a
bank loans out money and
anticipates that inflation will go
up they know money will be
worth less in the future so to
protect themselves they will
raise interest rates. They will
get more of the money back from
the loan because they know it
will be worth less in the future.
The Three Worst Inflations
Hungary
June 1945-June 1946
Yugoslavia
Jan. 1993 – Jan. 1994
Germany
July 1922 – Jan. 1924
Hyperinflation Examples
20-billion Mark Note issued in Oct, 1923
[Would buy 40% of a stamp in 1923]
[A stamp cost $50 billion] Milliard means “billion”
Disinflation
• Process of bringing down the
inflation rate
• Usually happens when inflation rate
climbs above 2% or 3%
• Temporarily depress the economy
which causes a recession and in
unemployment
Demand-Pull Inflation – increase in AD.
[“Too many dollars chasing too few goods”]
Originates from “buyers side of the market”.
D1 D2
S
P2
P1
“Demand-pull”
D S2
Cost-Push Inflation – 3 things may
cause “cost-push” inflation.
PL2
PL1
S1
“Cost-push”
1. Wage-push – strong labor unions
2. Profit-push – companies increase prices
when their costs increase.
3. Supply-side cost shocks – unanticipated
increase in raw materials such as oil.
“Wage-price”
Spiral
Demand-Pull and CostPush Inflation
• Demand pull-if consumers want more then
producers can produce that drives up prices.
Think of an Auction. If there is only one of
something and more people then one want it
that will drive up the price of that good.
(shortage)
• Cost-Push-The cost of goods are going up
because production cost go up. If workers are
not producing well then cost for things go up.
If a worker used to produce 10 cars an hour
and now only can produce 5 the avg cost of
each car goes up.
• Measures the cost of the market
basket of a typical urban family
• Uses the market basket of goodshypothetical set of consumer
purchases of goods and services
• Uses aggregate price level- overall
level of prices
• Family of 4, living in a city
What’s in the CPI’s Basket?
5%
6%
6% 5% 5%
Housing
Food/Beverages
40%
17%
Transportation
Medical Care
16%
Apparel
Recreation
Other
Education and
communication
How the Consumer Price Index Is
Calculated
•
Fix the Basket: Determine what
prices are most important to the
typical consumer.
u
u
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 weights for the prices
of those goods and services.
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.
•
Compute the Basket’s Cost: Use
the data on prices to calculate the
cost of the basket of goods and
services at different times.
The Consumer Price Index
When the CPI rises, the typical
family has to spend more dollars
to maintain the same standard of
living.
How the Consumer Price Index Is
Calculated
Choose a Base Year & Compute the
Index:
u
u
u
Designate one year as the base year,
making it the benchmark against which
other years are compared.
Compute the index by dividing the price
of the basket in one year by the price in
the base year and multiplying by 100.
Cost of market basket in yr1/ cost of market basket in
base yr X 100
How the Consumer Price Index Is
Calculated
•
Compute the inflation rate: The
inflation rate is the percentage
change in the price index 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 Year2 
CPI in Year 1
 100
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Step 1:Survey Consumers to Determine a Fixed
Basket of Goods
4 hot dogs, 2 hamburgers
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Step 2: Find the Price of Each Good in Each Year
Year
Price of
Hot dogs
Price of
Hamburgers
2001
$1
$2
2002
$2
$3
2003
$3
$4
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Step 3: Compute the Cost of the Basket of Goods in
Each Year
2001
($1 per hot dog x 4 hot dogs) + ($2 per hamburger x 2 hamburgers) = $8
2002
($2 per hot dog x 4 hot dogs) + ($3 per hamburger x 2 hamburgers) = $14
2003
($3 per hot dog x 4 hot dogs) + ($4 per hamburger x 2 hamburgers) = $20
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Step 4: Choose One Year as the Base Year (2001) and
Compute the Consumer Price Index in Each Year
2001
($8/$8) x 100 = 100
2002
($14/$8) x 100 = 175
2003
($20/$8) x 100 = 250
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Step 5: Use the Consumer Price Index to Compute the
Inflation Rate from Previous Year
2002
(175-100)/100 x 100 = 75%
2003
(250-175)175 x 100 = 43%
Calculating the Consumer Price Index and
the Inflation Rate: Another Example
•
•
•
•
•
Base Year is 1998.
Basket of goods in 1998 costs
$1,200.
The same basket in 2000 costs
$1,236.
CPI = ($1,236/$1,200) X 100 = 103.
Prices increased 3 percent between
1998 and 2000.
Other Price Indexes
u
u
u
The index for different regions within the
country.
The producer price index, which measures
the cost of a basket of goods and services
bought by firms rather than consumers
(steel, electricity, etc)
Early warning signal for inflation
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.
Substitution Bias
•
The basket does not change to
reflect consumer reaction to
changes in relative prices.
u
u
Consumers substitute toward goods
that have become relatively less
expensive.
The index overstates the increase in
cost of living by not considering
consumer substitution.
Introduction of New Goods
•
The basket does not reflect the
change in purchasing power brought
on by the introduction of new
products.
u
u
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.
Dollar Figures from
Different Times
• Do the following to convert dollar
values from year T into today’s dollars:
Amount in
 Amount in
today’s dollars
year T’s dollars
Price level today
Price level in year T
Indexation
When some dollar amount is
automatically corrected for
inflation by law or contract the
amount is said to be indexed for
inflation.
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.
The GDP Deflator versus the
Consumer Price Index
•
•
The consumer price index compares
the price of a fixed basket of goods and
services to the price of the basket in
the base year (only occasionally does
the BLS change the basket)...
…whereas the GDP deflator compares
the price of currently produced goods
and services to the price of the same
goods and services in the base year.
Fixed basket of goods: 100
heads of cauliflower, 50
bunches of broccoli, 500
carrots
• Year Cauliflower Broccoli
Carrots
• 2001 $2
$1.50
$0.10
• 2002 $3
$1.50 $0.20
• Compute CPI For 2001 and 2002
• Use the CPI to compute the inflation
rate from the previous year
Compute the cost of the basket of goods in
each year:
2001: (100 x $2) + (50 x $1.50) + (500 x
$.10) = $325
2002: (100 x $3) + (50 x $1.50) + (500 x
$.20) = $475
Choose one year as a base year (2001) and
compute the CPI in each year:
2001: $325/$325 x 100 = 100
2002: $475/$325 x 100 = 146
Use the CPI to compute the inflation rate
from the previous year:
2002: (146-100)/100 x 100% = 46%
A consumer in this economy buys only 2 goods–hot dogs & hamburgers.
Step 1. Fix the market basket. What percent of income is spent on each.
The consumer in this economy buys a basket of:
4 hot dogs and
2 hamburgers
Step 2. Find the prices of each good in each year.
Year
Price of Hot Dogs
Price of Hamburgers
2001
$1
$2
2002
$2
$3
Step 3. Compute the market basket cost for each year.
2001 ($1 per hot dog x 4 = $4) + ($2 per hamburger x 2 = $4), so $8
2002 ($2 per hot dog x 4 = $8) + ($3 per hamburger x 2 = $6), so $14
Step 4. Choose one year as a base year (2001) and compute the CPI
2001 ($8/$8) x 100 = 100
2002 (14/$8) x 100 = 175
Step 5. Use the CPI to compute the inflation rate from previous year
2002 (175/100 x 100 = 175%) or to get actual % (175-100)/100 x 100 =75%
Or, Change
$14-$8 ($6)
Original
$8
x 100 = 75%
(42%) 18. Suppose that a consumer buys the following quantities of
these three commodities in 2007 and 2008.
Commodity
Quantity 2007 per Unit Price
Food
Clothing
Shelter
5 units
2 units
3 units
$6.00
$7.00
$12.00
2008 per Unit Price
$5.00
$9.00
$19.00
Which of the following can be concluded about the CPI for this individual
from 2007 to 2008?
a. It remained unchanged.
c. it decreased by 20%
b. It decreased by 25%.
d. It increased by 20%
e. It increased by 25%.
(Answer)
Year 1 [2007]: [5 food x $6 = $30; 2 clothing x $7 = $14; 3 shelters x $12 = $36,
for dollar value [or basket cost] of $80. CPI = 100 ($80/$80 x 100 = 100 for 2007)
Year 2 [2008]: [5 food x $5 = $25; 2 clothing x $9 = $18; 3 shelters x $19 = $57,
for dollar value [basket cost ]of $100. CPI =125 ($100/$80 X 100 = 125)
or (125/100 x 100 = 125 for 2008)
Change
Original =
$100-$80 [$20]
$80
x 100 = 25%;
so the CPI for this individual is 25%.
[Change/Original X 100 = inflation]
So, 3.3% increase in Social
Security benefits for 2007
(2006-later year)
(2005-earlier year)
Current year’s index – last year’s index
199.1 – 192.7 [6.7]
C.P.I. = Last year’s index(2006-earlier year) x 100; 192.7
x100 = 3.3%
130.7-124.0(6.7)
116-120(-4)
124.0 x 100 = ____
-3.3%
5.4% 120 x 100 = ____
333-300(33)
11%
300 x 100 = ____
NS 50, 51, & 52
50.The CPI was 166.6 in 1999 and 172.2 in 2000.
Therefore, the rate of inflation for 2000 was
(2.7/3.4/4.2)%
[5.6/166.6 x 100 = 3.4%]
51. If the CPI falls from 160 to 149 in a particular
year, the economy has experienced (inflation/deflation)
of (5/4.9/6.9)%.
[-11/160 x 100 = -6.9%]
52. If CPI rises from 160.5 to 163.0 in a particular year,
the rate of inflation for that year is (1.6/2.0/4.0)%.
(42%) 18. Suppose that a consumer buys the following quantities of
these three commodities in 2007 and 2008.
Commodity
Quantity
2007 per Unit Price
Food
Clothing
Shelter
5 units
2 units
3 units
$6.00
$7.00
$12.00
2008 per Unit Price
$5.00
$9.00
$19.00
Which of the following can be concluded about the CPI for this individual
from 2007 to 2008?
a. It remained unchanged.
c. it decreased by 20%
b. It decreased by 25%.
d. It increased by 20%
e. It increased by 25%.
(Answer)
Year 1 [2007]: [5 food x $6 = $30; 2 clothing x $7 = $14; 3 shelters x $12 = $36,
for dollar value [or basket cost] of $80. CPI = 100 ($80/$80 x 100 = 100 for 2007)
Year 2 [2008]: [5 food x $5 = $25; 2 clothing x $9 = $18; 3 shelters x $19 = $57,
for dollar value [basket cost ]of $100. CPI =125 ($100/$80 X 100 = 125)
or (125/100 x 100 = 125 for 2008)
Change
Original =
$100-$80 [$20]
$80
x 100 = 25%;
so the CPI for this individual is 25%.
3. Gala Land produces 3 final goods: bread,
water, and fruit. The table [right] shows this
year’s output and price for each good.
(a) Calculate this year’s nominal GDP.
Answer to 3. (a): 400x$6=$2,400; 1,000x$2=$2,000;
and 800x$2 = $1,600 for a Nominal GDP of $6,000.
This Year’s Output
400 loaves of bread
1,000 gallons of water
800 pieces of fruit
This Year’s Price
$6 per loaf
$2 per gallon
$2 per piece
(b) Assume that in Gala Land the GDP deflator [GDP price index) is 100 in the
base year and 150 this year. Calculate the following.
(i) The inflation rate, expressed as a percent, between the base year & this year.
Answer to 3. (b) (i):
Change/Original x 100; therefore 50/100 x 100 = 50% inflation rate.
(ii) This year’s real GDP
Answer to 3. (b) (ii):
Nominal GDP/GDP deflator x 100 = Real GDP; $6,000/150 X 100 = Real GDP of $4,000.
(c) Since the base year, workers have received a 20% increase in their nominal wages.
If workers face the same inflation that you calculated in part (b)(i), what has
happened to their real wages? Explain.
Answer to 3. (c): Inflation between these years has increased 50%; wages have increased
only 20%; therefore workers real wages or real purchasing power has decreased.
(d) If the GDP deflator [inflation] in Gala Land increases unexpectedly, would a
borrower with a fixed-interest-rate loan be better off or worse off? Explain.
Answer to 3. (d): The borrower has borrowed “dear” money but is paying back “cheaper”
money. He is better off because he is paying back money that isn’t worth what it was when
he took out the loan.
•
•
•
•
•
•
•
Baseballs
Price
Quantity
2001
10
50
2002
15
30
2003
20
20
Nominal GDP for 2001, 2002, 2003?
•
Real GDP for 2001, 2002, 2003
•
Deflator for 2001, 2002, 2003
•
Quiz 2
Price
Basketballs
Quantity
10
100
20
80
60
70
Inflation rate according to Deflator 2001, 2002, 2003
•
If the Basket is 2 baseballs and three basketballs (assume 2001
is base year)
•
What is CPI For 2001
• What is CPI for 2002
•
What is CPI for 2003
•
Inflation Rate in 2001,2002, 2003?
•
•
•
•
•
•
•
•
•
•
Baseballs
Basketballs
Price
Quantity
Price
Quantity
2001
10
50
10
100
2002
15
30
20
80
2003
20
20
60
70
Nominal GDP for 2001, 2002, 2003?
2001=$1500 2002= $2050
2003=$4600
Real GDP for 2001, 2002, 2003
2001=$1500 2002=$1100
2003=$900
•
•
Deflator for 2001, 2002, 2003
2001=100 2002=186
2003=511
•
•
Inflation rate according to Deflator 2001, 2002, 2003
2001= 0% 2002= 86%
2003=174%
•
•
•
•
•
•
•
•
•
Quiz 2
If the Basket is 2 baseballs and three basketballs(2001 is baseyear)
What is CPI For 2001
= 100
What is CPI for 2002
=180
What is CPI for 2003
=440
Inflation Rate in 2001,2002, 2003?
2001= 0%
2002= 80%
2003=144%
•
Baseballs
Basketballs
•
Price
Quantity
Price
• 2001
10
10
• 2002
12
20
• 2003
15
30
• Nominal GDP for 2001, 2002, 2003?
5
7
8
Quantity
5
10
24
• Real GDP for 2001, 2002, 2003
•
•
•
Deflator for 2001, 2002, 2003
Inflation rate according to Deflator 2001, 2002, 2003
•
If the Basket is 2 baseballs and three basketballs(2001 is
baseyear)
What is CPI For 2001
•
What is CPI for 2002
•
What is CPI for 2003
•
Inflation Rate in 2001,2002, 2003?
•
Baseballs
Basketballs
•
Price
Quantity
Price
Quantity
• 2001
10
10
5
• 2002
12
20
7
• 2003
15
30
8
• Nominal GDP for 2001, 2002, 2003?
• 2001=125
2002=310
2003=642
• Real GDP for 2001, 2002, 2003
• 2001=125 2002=250 2003=420
• Deflator for 2001, 2002, 2003
• 2001=100
2002=124 2003=153
• Inflation rate according to Deflator 2001, 2002, 2003
• 2001=0%
2002=24% 2003=22%
•
If the Basket is 2 baseballs and three basketballs(2001
baseyear)
• What is CPI For 2001
• 100
• What is CPI for 2002
• 128
• What is CPI for 2003
• 154
• Inflation Rate in 2001,2002, 2003?
• 2001=0%
2002=28%
2003=19%
5
10
24
is
2 (c) Suppose that the nominal interest rate has been 6% with no expected inflation.
If inflation is now expected to be 2%, determine the value of each of the following.
(i) The new nominal interest rate
(ii) The new real interest rate
2(c)(i): The nominal interest rate is 8%.
[6% real + 2% expected inflation premium]
2(c)(ii): The new real interest rate would be 6%.
[8% new nominal in. rate – 2% anticipated inflation = 6% real I.R.]
6%
Real
Interest Rates