11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 6: Ch. 6: Measuring the Price Level and Inflation

22

Who Is Making More?

• A 2001 graduate of Hiram College got a job that pays $30,000 per year.

• Thirty years ago, her father started his career with a $7,500 job.

• Is she making four times as much as her father did?

33

Who Is Making More?

• In order to compare the incomes of two different periods we have to eliminate the effect of inflation.

• What happened to prices between 1969 and 2001?

• Let’s find out the Consumer Price Index (CPI).

44

Who Is Making More?

• According to Bureau of Labor Statistics (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), CPI in 1969 was 36.7.

• CPI in 2001 was 177.5. Base year was 1982-84.

• If the average price level in 1969 was lower than in 2001, our graduate must not have been four times better off.

55

Who Is Making More?

• In real terms:– She made (30,000/1.775) = $16,901.41 in

1983 dollars.– He made (7,500/.367) = $20,436 in 1983

dollars.

• How much was his pay in 2001 dollars?– His pay is (7,500)(1.775/.367) =

$36273.84.

66

How To Calculate The CPI?

• Fix the basket a typical consumer will buy.

• Find the prices of the items for different years.

• Compute the basket’s cost for each year.

• Choose a base year.

• Calculate the cost of the basket for other years in terms of the base year.

• Calculate inflation rates.

77

CPI Calculation

Consumer Basket is 2 Pizzas and 10 SodasYear Pizza Price Soda Price Pizza Spending Soda Spending Total Spending CPI (base=1999) Inflation

1996 $10.00 $0.75 $20.00 $7.50 $27.50 82.091997 $10.50 $0.85 $21.00 $8.50 $29.50 88.06 7.27%1998 $10.75 $1.00 $21.50 $10.00 $31.50 94.03 6.78%1999 $11.50 $1.05 $23.00 $10.50 $33.50 100.00 6.35%

88

The Consumer Price Index: The Consumer Price Index: Measuring the Price LevelMeasuring the Price Level

Constructing the CPIConstructing the CPI Bureau of Labor Statistics (BLS)Bureau of Labor Statistics (BLS)

Pick a base yearPick a base year Conduct the Conduct the consumer expenditure surveyconsumer expenditure survey to determine to determine

the base-year basket of goods and servicesthe base-year basket of goods and services Measure the current prices of the base-year basketMeasure the current prices of the base-year basket

yearbase in services and goods of basket year-base of Cost

yearcurrent in services and goods of basket year-base of Cost CPI

99

Problems With CPI•Substitution bias.

–Basket changes as a response to relative price changes do not get accounted.

•New products.

–Basket changes are ignored.

–Prices of new products fall before they are included in the new basket.

•Quality change.

–If the same gadget has higher quality now than in the past but viewed as the same item, an increase in price is not inflationary.

1010

Calculating InflationCalculating InflationRates: 1972 - 1976Rates: 1972 - 1976

Year CPI

1972 0.418

1973 0.444

1974 0.493

1975 0.538

1976 0.569

6.2% 100 x 0.062 0.418

0.418 - 0.444 '73 - 1972 :rate Inflation

11.0% 100 x 0.110 0.444

0.444 - 0.493 '74 - 1973 :rate Inflation

1111

Calculating InflationCalculating InflationRates: 1929 - 1933Rates: 1929 - 1933Year CPI

1929 0.171

1930 0.167

1931 0.152

1932 0.137

1933 0.130

2.3%- 100 x 0.023- 0.171

0.171 - 0.167 '30 - 1929 :rate Inflation

9.0%- 100 x 0.090- 0.167

0.167 - 0.152 '31 - 1930 :rate Inflation

1212

Median Household IncomeMedian Household Income

According to the US Census Bureau, According to the US Census Bureau, nominal income for a family of four was nominal income for a family of four was $24,332 in 1980. In 1997, it was $24,332 in 1980. In 1997, it was $53,350.$53,350.

CPI in 1980 was 82.4; in 1997, 160.5.CPI in 1980 was 82.4; in 1997, 160.5.What happened to median real income?What happened to median real income?How would you change your answer if How would you change your answer if

Boskin Commission is right?Boskin Commission is right?

1313

Does the CPI MeasureDoes the CPI Measure“True” Inflation?“True” Inflation?

1996 report by the Boskin Commission 1996 report by the Boskin Commission estimated that the CPI overstates inflation by estimated that the CPI overstates inflation by as much as 1 to 2 percentage points a year.as much as 1 to 2 percentage points a year.

Overstating InflationOverstating Inflation Would unnecessarily increase government Would unnecessarily increase government

spendingspending Underestimate the improvements in the standard Underestimate the improvements in the standard

of livingof living

1414

Real Median Household IncomeReal Median Household Income

Years Nominal Income CPI Real Income Growth Rate1980 $24,332.00 82.4 $29,529.131985 $32,777.00 107.6 $30,461.90 3.16%1990 $41,451.00 130.7 $31,714.61 4.11%1997 $53,350.00 160.5 $33,239.88 4.81%

1515Source: http://www.levy.org/modules/pubslib/files/wp407.pdf

1616

1717http://www.census.gov/acs/www/Products/Profiles/Chg/2003/ACS/Tabular/010/01000US3.htm

1818

http://factfinder.census.gov/servlet/STTable?_bm=y&-geo_id=01000US&qr_name=ACS_2005_EST_G00_S1901&-ds_name=ACS_2005_EST_G00_

1919

Adjusting for InflationAdjusting for Inflation

Real WageReal WageThe wage paid to workers measured in The wage paid to workers measured in

terms of real purchasing powerterms of real purchasing powerThe real wage for any given period is The real wage for any given period is

calculated by dividing the nominal (dollar) calculated by dividing the nominal (dollar) wage by the CPI for that periodwage by the CPI for that period

2020

Adjusting for InflationAdjusting for Inflation

Real WageReal WageThe wage paid to workers measured in The wage paid to workers measured in

terms of real purchasing powerterms of real purchasing powerThe real wage for any given period is The real wage for any given period is

calculated by dividing the nominal (dollar) calculated by dividing the nominal (dollar) wage by the CPI for that periodwage by the CPI for that period

2121

Nominal and Real Wages for Nominal and Real Wages for Production Workers’ 1960 - 2001Production Workers’ 1960 - 2001

2222

GDP Deflator vs. CPI• Space shuttle costs more to operate.

– Deflator is up, CPI unchanged.

• Antiques cost more.– CPI is up, deflator unchanged.

• Porsche increases the price.– CPI is up, deflator unchanged.

• New homes cost more.– Both CPI and deflator up.

2323

Indexation

• If payments are automatically corrected for inflation, they are said to be indexed.– COLA– Social Security– TIPS– Variable mortgage rates

2424

Adjusting for InflationAdjusting for Inflation

Indexing to Maintain Buying PowerIndexing to Maintain Buying PowerAn example:An example:

Social Security Payment Inflation

2000 $1,000/month 2000 - 2005 = 20%

2005 $1,200/month indexed to inflation

2525

The Costs of Inflation:The Costs of Inflation:Not What You ThinkNot What You Think

ObservationsObservationsChanges in relative price do not Changes in relative price do not

necessarily imply a significant necessarily imply a significant amount of inflation.amount of inflation.

Inflation can be high without Inflation can be high without affecting relative prices.affecting relative prices.

2626

The Costs of Inflation:The Costs of Inflation:Not What You ThinkNot What You Think

ObservationsObservationsTo counteract relative price changes, To counteract relative price changes,

government policy would have to affect the government policy would have to affect the market for specific goods.market for specific goods.

To counteract inflation, the government To counteract inflation, the government must use monetary and fiscal policy.must use monetary and fiscal policy.

2727

Costs of InflationCosts of Inflation

Shoe-leather costsShoe-leather costsEconomizing on cashEconomizing on cashMore frequent trips to the bankMore frequent trips to the bankMore bank employeesMore bank employeesEfforts to avoid the erosion of purchasing Efforts to avoid the erosion of purchasing

powerpower

2828

Costs of InflationCosts of Inflation

Noise in the price systemNoise in the price system Is it an increase in the demand for a product Is it an increase in the demand for a product

or is it a general increase in prices?or is it a general increase in prices?Should the supplier increase output or not?Should the supplier increase output or not?

2929

Costs of InflationCosts of Inflation

Distortions of the tax systemDistortions of the tax systemDepreciation allowance and the replacement Depreciation allowance and the replacement

costcostBracket creepBracket creep

3030

Costs of InflationCosts of Inflation

Unexpected distribution of wealthUnexpected distribution of wealthReal wage down => workers lose, employers Real wage down => workers lose, employers

gaingainBorrowers gain and creditors loseBorrowers gain and creditors lose

3131

Costs of InflationCosts of Inflation

Interference with long-run planningInterference with long-run planning Increase uncertaintyIncrease uncertainty Impossible to predict the futureImpossible to predict the future

3232

HyperinflationHyperinflation

Inflation of 500 or more per cent per Inflation of 500 or more per cent per year.year.

Germany in early twenties.Germany in early twenties.Argentina and currency board.Argentina and currency board.

3333

HyperinflationHyperinflation

Economic NaturalistEconomic NaturalistFischer, Sahay, and Vegh examined 133 Fischer, Sahay, and Vegh examined 133

market economies 1960 - 96market economies 1960 - 9645 episodes of high inflation (100% +) in 25 45 episodes of high inflation (100% +) in 25

countriescountries Real GDP/person fell by an average of 1.6%/yrReal GDP/person fell by an average of 1.6%/yr Real consumption/ person fell by an average of Real consumption/ person fell by an average of

1.3%/yr1.3%/yr Real investment/person fell by an average of 3.3%/yrReal investment/person fell by an average of 3.3%/yr

"Modern Hyper- and High Inflations", Journal of Economic Literature. September 2002, Volume XL, Number 3, 837-880.

3434

Real and Nominal Interest Rates

• If you lend someone $1000 for a year and ask for a 5% interest, you will get $1050 at the end of the year.

• If inflation during the year were 10%, the products you could buy with your $1000 at the beginning of the year now costs $1100.

• Are you better-off or worse-off?

3535

Real and Nominal Interest Rates• Lenders will always ask a higher interest

rate than the expected inflation to earn income.

• Nominal interest rates are what the bank quotes, what the car dealer quotes.

• Real interest rates are nominal rates corrected for inflation.

• i = r + π

3636

The Real Interest Rate in the The Real Interest Rate in the United States, 1960 - 2001United States, 1960 - 2001

3737

Inflation and Interest Rates in Inflation and Interest Rates in the United States, 1960 - 2001the United States, 1960 - 2001