What about the other evil?

Inflation and Deflation

Inflation◦A sustained increase in the average of all

prices of goods and services in an economy

Deflation◦A sustained decrease in the average of all

prices of goods and services in an economy

Looking at the pastIn 1923, prices in Germany rose a trillion

times over.Prices in Russia, Bulgaria, and some other

nations have witnessed a tenfold increase in a year.

In the 1990’s the U.S. inflation rate rose between 1 and 4 percent a year.

Argentina 1975-91 Hyperinflation continued reaching a peak of 4,923.3 percent in December 1989 - government expenditure reached 35.6 percent of GDP and the fiscal deficit was 7.6 percent of GDP.

Inflation…is bad…is bad..is bad!

What is inflation?A continuing rise in the average level of

prices.(it costs more to purchase the typical “bundle” of goods and services that is produced or consumed or both.)

Bottom line: Too many $$$$ chasing too few goods.

World Look at current inflation

http://www.tradingeconomics.com/country-list/inflation-rate

The CPI is based on what it costs an average family to live.

Just think… Inflation enables us to live in more expensive neighborhoods without having to move

Inflation is bad… see???Shortened Time HorizonsDuring the German hyperinflation, workers

were paid two or three times a day so that they could buy goods in the morning before prices increased in the afternoon.

Speculation People may be encouraged to withhold

resources from the production process, hoping to sell them later at higher prices.

Bracket CreepUnder our progressive tax system, taxes go up

when prices rise.Savings, investment, and work effort decline.

Inflation discussionNotice we said an increase in the Average Level of prices. Not a change in any specific price…

Statisticians calculate the average then look for changes in the average. The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.4 percent in August, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The August level of 219.086 (1982-84=100) was 5.4 percent higher than in August 2007. A decline in average prices = deflation.

Relative price means an increase in the price of apples (relative to other fruits) apples cost more than pears.

Inflation does not make ALL persons worse off. .

Nominal Income vs. Real Income

What is the difference between nominal income and real income.

Nominal = income you receive in a particular period

Real income = what you can use for purchasing stuff.

***If your nominal income does not change and there is an increase in the average level of prices….. You cannot buy as much “stuff.”

If the number of dollars you receive every year is always the same, your nominal income doesn’t change- but your real income will rise or fall with price changes.

Another rule:

If you put your money into savings and keep it there rather than spending it, and inflation comes along…

your money in savings will not buy as much as it would prior to the wave of inflation that hit.

Uncertainty and Misconception

Money IllusionEven people whose nominal incomes keep up

with inflation often feel oppressed by rising prices.

They feel cheated when they discover that their higher nominal wages don’t buy additional goods.

UncertaintyOne of the most immediate consequences of

inflation is uncertainty.Uncertainties created by changing price levels

affect consumption and production decisions.

Inflation discussionUncertainty on the part of

the consumer in trying to outguess the price of goods and services.

If consumers or producers postpone or cancel their expenditure plans, the demand for g & s will fall. Eventually production falls, and unemployment occurs…

What Causes Inflation?

Nearly all economists believe that rapid expansion in the supply of money is the cause of inflation.

What happens if incomes go up to keep pace with inflation?

Bracket creep is the movement of taxpayers into higher tax brackets (rates) as nominal incomes grow.

Deflation DangersDeflation — a falling price level —

might not make people happy either.Deflation reverses the redistributions

caused by inflation. (Example: people today – upside down on their houses.)

Measuring Inflation

Measuring inflation serves two purposes:

◦Gauges the average rate of inflation.◦Identifies its principal victims.

Consumer Price Index (CPI)The CPI is the most common measure of

inflation.The consumer price index (CPI) is a

measure (index) of changes in the average price of consumer goods and services.

Macroeconomic Measures - Prices Price Level - A weighted average of the

prices of all goods and services. Price Index - A measure of the price level. Consumer Price Index (CPI) - A widely

cited index number for the price level; the weighted average of prices of a specific set of goods and services purchased by a typical household.

How to measure rate of inflation

Measuring the Rate of InflationMarket Basket

◦Representative bundle of goods and services

Base Year◦The point of reference for comparison of prices

in other years

Macroeconomic Measures - Prices

Base Year - The year chosen as a point of reference or basis of comparison for prices in other years; a benchmark year. (82-84)

Computing the Consumer Price Index

Consumer Price Index (CPI)

By observing the extent of price increases, we can calculate the inflation rate.

The inflation rate is the annual percentage rate of increase in the average price level.

Changes in Prices

In 2005 the CPI was 195.3; in 2006 the index was 201.6. What was the percentage change in prices from 2005-2006?

Click below for answer.

3.22 %

Here’s a little hint if you forget…C-L/L

Percentage change in prices = Current year - later year x100 later year

CPI determined

Calculates the inflation rate Market basket of goods

and services (same each year.)

Bureau of Labor Statistics determines cost in 85 cities by shopping 184 items.

19,000 stores visited and 60,000 landlords,renters and homeowners surveyed each month

Statistics released each month.(3.15- .7%)

Yearly average compiled.

CPI expressed in base year ’82-84

Constructing the CPI

The base period is the time period used for comparative analysis — the basis of indexing, for example, of price changes.

Shopping for CPI

CPI is constructed by identifying a typical bundle of goods that the average consumer buys. This bundle stays the same each year.

The base year is changed periodically. The base year used is ’82-’84 and prior to that it was ’63.The price level in the base period is designated as 100.

The market basket (bundle) can be changed if BLS research shows that the “average” consumer no longer is purchasing that good or service.

Each item in the bundle is weighted percent-wise in the market basket figures.

What is the difference?

So………if it cost you $225 in 2002 to buy the same bundle of goods that you bought in 1983, you would be paying 225% more for the same “stuff.”

Look at the inflationary costs of: cars, health care, housing, (house 4 bedrooms, 2 baths, in Highland Park in 1960 cost approximately $30,000.) (Today?????)

House in Plano, 1960. $40,000

Four Bedrooms, two bathrooms, often with a pool

CalculationsRate of Inflation = % of PI(price index)

from one year to the next.When prices are rising, on average, the price

index will rise. i = This year’s PI – Last year’s PI Last year’s PI x100

If price index this year was 220 compared to 200 last year, the inflation rate would equal 10%

220 – 200 200 x 100 = 10

Formula hint: c-l/l x 100 (current-last/last x 100)

Let’s try another calculation

In 2008 – CPI measured 215.3In 2004 – CPI measured 188.9What was the rate of inflation from 04 – 08?

Ans. 13.9

Is there a safety shield against inflation?Answer: not much!!!

But Congress has passed the Cost-of-living adjustment (COLA) provision for those receiving Social Security Checks.

Checks are indexed each January…in the amount equal to inflation the previous year.

If inflation was 3% then the checks are adjusted accordingly.

Unions also negotiate for this COLA in their pay proposals…

Bankers in business to make a profit.

Some bankers build in that same philosophy- Adjustable-rate mortgage (ARM) stipulates an interest rate that changes during the term of the loan.

Actually, banks build the inflation factor into all their loans…the number of points depends on many variables we will discuss later.

The real interest rate is the nominal interest rate minus the anticipated inflation rate.

Ways to measure inflation

Real-world price indexes

◦Consumer Price Index (CPI)

◦Producer Price Index (PPI)

◦GDP deflator

◦Personal Consumption Expenditure (PCE)

What is stagflation?High inflation and high

unemployment….A period during which an economy is

experiencing both substantial inflation and either declining or slow growth in output.

Economists used to say this would and could never happen… it did in the 80’s

Paul Volker entered the scene as Fed chairman and held court on monetary policy.. More of this story later…

CAUSES of inflation1. Demand pull (too much aggregate

demand and not enough aggregate supply.

Cost Push (production costs rise) supply decreases…

DD1

S

D

SS1

Explanations

Demand pull: Economy producing at capacityConsumers willing and able to buy more goodsCan buy goods because of accumulated

savings or easy access to credit (refinancing the house, second mortgages in Texas, low interest loans, credit card interest rates low, prime rate very low.)

Pull to have more goods and only limited amount of goods available… causes prices to rise!

Hence, a demand-driven rise in average prices or demand-pull

Explanations ContinuedCost Push:When producers have to pay more for inputs

(resources for production), the price of the good produced increases. ( also referred to as a supply shock.)

OPEC- prices of crude escalates any product dependent on crude (including heating costs, increases)

Explanation of Dollars in Cost-pushLabor has generally been the most

expensive of inputs for production up till now in our economy.

If wage rates are pushed upward…. The good or service would have an increase in price (longshoreman’s union, pilots,) Note that most of these are union connected. Tech industry workers took about a 50% cut to get jobs in 2002 as opposed to their salaries in 1999.

If the Fed releases too much money in the economy (continually pushing down interest rates, the value of that money is not as solid as if there were less circulating… more later on that)

Check the current inflation rate………..

http://inflationdata.com/inflation/

Bureau of Labor Statistics

Another way to measure U.S. economic healthProducer Price Index: The PPIs keep track of average prices received

by producers. October 20, 2005….PPI up highest in 15 years. 3 indices…crude materials, intermediate

goods, finished goods. Identified in monthly surveys just like CPI is. In SR, PPI increases before CPI (takes a little

while for the prices to be reflected in products we buy.

Is the Growth of GDP real or inflated?This is the real test!!!!!!! Was there actual increase in production

and services or did the prices just skew the GDP statistics when C+I+G was added?

Have to correct GDP for price changes so we can measure actual production.

CPI tells the consumer if they have to spend more dollars to get that loaf of bread… but other measures have to be evaluated.

Still another way to test the health of the U.S. economy

The GDP Deflator…. The broadest price index and covers all output including consumer goods, investment goods and government services. (C+I+G)

The GDP deflator isn’t a pure measure of price change. Its value reflects both price changes AND market responses to those price changes as reflected in new expenditure patterns.

The GDP deflator typically registers a lower inflation rate than CPI and the government watchdogs use this barometer more readily than current CPI

Year (base

Price of good Quantity GDP Real GDP

1 $10 100 $1,000 $1,000

2 $12 120 12x120 = $1,440

10 x 120 = $1,200

3 $14 140 14 x 140 = $1,960

10 x 140 = $1,400

Bottom LineCPI is designed to measure the impact of price changes on

the cost of a typical bundle of goods purchased by households(remember, market basket and only for urban purchasers.)

GDP deflator is a broader price index and is designed to measure the change in the average price of the market basket of goods included in GDP (in addition to consumer goods it includes capital goods, & g & s by government.)

CPI measures money income of consumers in relation to rising prices (only consumer goods.)

GDP deflator measures economy wide inflation- more g & s included in measurement.

Personal Consumption Expenditure PCE

More accurate than CPI Quantifies changing expenditure patterns

for consumers. Is a weighted measure Doesn’t always have same items calculated BEA uses continually updated surveys of

consumer purchases to determine index Federal Reserve uses this measure for their

predictions and assessments.

Historical Record Graph

20

16

12

8

4

0

4

8

12

1920 1930 1940 1950 1960 1970 1980 1990 2000

Inflation

B

A

Deflation

What really is the goal of fiscal and monetary planners?

The CPI’s market basket of goods and services was overhauled in 1998.

Price Stability….. Major changes in the general level of prices

indicate upsets in the economic system.

Prices act as allocators of economic goods, they are the mechanism that determines the answer to the three basic questions, What, How and For Whom.

Prices act as the basic force in a capitalistic economy

What does a pair of Nike shoes cost compared to a pair of Keds?