Inflation

What is Inflation?

• The general upward movement in the average level of prices of the goods and services in an economy

What is Deflation?

• The general decrease in the average level of prices of the goods and services in an economy

www.nationmaster.comeco_inf_200&int=-1

What the state of Inflation/Deflationaround the world?

How is Inflation measured? Consumer Price Index (CPI)?

A measure of the cost of a fixed “market basket” of consumer goods and services

©©1999 South-Western College Publishing

Refer to EconEd Link handout – Statistics CPI

www.bls.gov

www.bls.gov/news.release/cpi.t01.htm

Consumer Price Index (CPI)Consumer Price Index (CPI)

[CPI measures cost of living relative to a base year[100][CPI measures cost of living relative to a base year[100]

The CPI is a market basket of 364 items364 items at 21,00021,000establishmentsestablishments in 91 cities91 cities that the typical householder buys. It does not include exports because we do not buy exports but does include imports. About 55% of the CPI is services55% of the CPI is services.

What is actually measured in this market basket?

http://www.bls.gov/news.release/cpi.t02.htm

How is the CPI calculated?Value of the market basket

in the current period

x 100 = PRICE INDEX

Value of the market basket in

the base period

(See Handout)

CPI =

http://inflationdata.com/Inflation/Consumer_Price_Index/CurrentCPI.asp

Consumers in this economy buy only two goods–hot dogs & hamburgers.Step 1. Fix the basket. What percent of income is spent on each. Consumers in this economy buy a basket of:

4 hot dogs and 2 hamburgers4 hot dogs and 2 hamburgers

Step 2. Find the prices of each good in each year. YearYear Price of Hot DogsPrice of Hot Dogs Price of HamburgersPrice of Hamburgers 20012001 $1 $1 $2$2 20022002 $2 $2 $3$3

Step 3. Compute the basket cost for each year. 2001 ($1 per hot dog x 4 = $4) + ($2 per hamburger x 2 = $4), so $82001 ($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 $142002 ($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 = 1002001 ($8/$8) x 100 = 100 2002 (14/$8) x 100 = 1752002 (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%(175-100)/100 x 100 =75%

(42%)(42%) 18. Suppose that a typical consumer buys the following quantities of thesebuys the following quantities of these three commodities in 2000 and 2001three commodities in 2000 and 2001.

CommodityCommodity QuantityQuantity 2000 per2000 per Unit PriceUnit Price 2001 per2001 per Unit PriceUnit PriceFood 5 units $6.00 $5.00Clothing 2 units $7.00 $9.00Shelter 3 units $12.00 $19.00

Which of the following can be concluded about the CPI for this individual from concluded about the CPI for this individual from 2000 to 20012000 to 2001? 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)(Answer) Year 1 [2000]: [5 food x $6 = $30; 2 clothing x $7 = $14; 3 shelters x $12 = $36,Year 1 [2000]: [5 food x $6 = $30; 2 clothing x $7 = $14; 3 shelters x $12 = $36,for dollar value of $80. CPI = 100 ($80/$80 x 100 = 100 for 2000)]for dollar value of $80. CPI = 100 ($80/$80 x 100 = 100 for 2000)]

Year 2 [2001]: [5 food x $5 = $25; 2 clothing x $9 = $18; 3 shelters x $19 = $57, Year 2 [2001]: [5 food x $5 = $25; 2 clothing x $9 = $18; 3 shelters x $19 = $57, for value of $100. CPI for value of $100. CPI =125 ($100/$80 x 100 = 125% for 2001)=125 ($100/$80 x 100 = 125% for 2001)]]

So, the CPI increased by 25%CPI increased by 25%..

If the value of the CPI equals 120, what does this mean?

• The fixed market basket of goods costs 20% more than in the base period of time

Does the makeup of the CPI change?

As people’s tastes and preferences change, what goes into the basket will change

The price of G/S in the base year of 1984. How could measuring the CPI be distorted?

©©1999 South-Western College Publishing

1962 Prices1962 Prices v. 2006 Prices2006 Prices• Tuition at MIT - $1,500Tuition at MIT - $1,500• Starting salary - $6,000 Starting salary - $6,000

[college graduate][college graduate]• FICA of 3.125 of $4,800 FICA of 3.125 of $4,800

[$150 maximum][$150 maximum]• Top marginal tax rate of 91% of Top marginal tax rate of 91% of

incomes over $200,000.incomes over $200,000.• New house for $10-15,000 [2.5 New house for $10-15,000 [2.5

times the income of a new times the income of a new college graduate]college graduate]

• Coke - 10 centsCoke - 10 cents• Movies - .50 Movies - .50 • 1962 Chevy - $1,5001962 Chevy - $1,500

• Tuition at MIT - $32,300Tuition at MIT - $32,300• Starting salary - $44,000 [college Starting salary - $44,000 [college

[college graduate][college graduate]• FICA of 7.65 of $94,600 FICA of 7.65 of $94,600

[$7,237 maximum][$7,237 maximum]• Top marginal tax rate of 35% of Top marginal tax rate of 35% of

incomes over $326,450incomes over $326,450• New median house price is New median house price is

$218,000 [5 times the income of $218,000 [5 times the income of today’s college grads] today’s college grads]

• Coke - 60 centsCoke - 60 cents• Movies - $7Movies - $7• 2006 Chevy - $23,0002006 Chevy - $23,000

62 Corvette62 Corvette $2,995$2,9952006 Corvette2006 Corvette $58,000$58,000

Who is the Richest American Ever?Who is the Richest American Ever? John D. Rockefeller’sJohn D. Rockefeller’s [1839-1937] wealth would be worth $200 billion$200 billion in today’s money, or 4 times that of Bill Gates.

Dollar Figures From Different TimesDollar Figures From Different TimesBabe RuthBabe Ruth made $80,000$80,000 in 1931in 1931. That would be equivalent to $1 $1 millionmillion today today. [Barry Bonds gets $18 million a year] President Herbert HHerbert Hoover’soover’s salarysalary in 1931 was $$75,00075,000. That would be equivalent to $900,000$900,000 today. George Bush is being paid $400,000$400,000 a year. President Kennedy was paid $100,000 in 62 [$650,000 today]

Although Rockefeller was worth $200 billion, he could notnotwatch TV, play video games, surf the internet, or send email to his grandkids. For most of his life, he could not use AC, travel by car or plane, use a telephone to call friends, or take advantage of antibiotics to prolong & enhance life.

Perhaps the average American today is richer than Perhaps the average American today is richer than the richest American a century ago.the richest American a century ago.

$80,000=$1 M

GDP DeflatorGDP Deflator – more broad – more broad

GDP DeflatorGDP Deflator includes prices for all goods all goods thatthat we producewe produce:

1.What householdershouseholders are buying2.What businessesbusinesses are buying3.What the governmentgovernment is buying4.What foreignersforeigners are buying [does does not include importsnot include imports because we don’t produce imports]

GDP Deflator Compared to the GDP Deflator Compared to the CPICPI

[CPI is normally higher.][CPI is normally higher.]

Who measures inflation?

The Bureau ofLabor Statistics

©©1999 South-Western College Publishing

www.bls.gov

What are the effects of unexpected inflation?

• Inflation redistributes income– some people win – the ones getting the higher

prices (think oil/gas companies)– Some people lose – the ones paying the

higher prices (think YOU!)

Who wins and who loses from inflation?

• Debtors win– Borrowers pay back loans with inflated dollars

(dollars that are worth less)

• Creditors lose– Lenders are paid back with inflated dollars

(dollars that are worth less)

More winners and losers of inflation• Those on fixed incomes lose

– Income does not keep up with prices - standard of living goes down.

– Exception – if fixed income is INDEXED to inflation (CPI)

• Savers often lose– If prices rise faster than the rate of interest they are getting from

their savings (investment) then they lose purchasing power

• Government sometimes wins– Government wins – Biggest debtor in the World (Debtors WIN!)

– Government loses – surplus in savings, increase in salaries and other prices paid

• Menu costs of inflation– Individuals and business must allocate resources to keep up with

changing prices – increases transaction costs

• Inflation and uncertainty– Do I spend today, or save? Prices going up or not? What is happening to

my purchasing power? ARRRGGHH!

President Bush’s College Transcript

““So - - If you are having a hard time in economics,So - - If you are having a hard time in economics,don’t worry about it. You can always be Presidentdon’t worry about it. You can always be Presidentof the United States.”of the United States.”

The Inflation-GDP-Unemployment Connection

• GDP is calculated by taking the price of a good or service and multiplying it by the quantity of the good or service produced. – Example (assume a one product economy)

• Dry Erase Marker (sold this year)

– $1.00 (Price of one) X 1,000 produced this year

»GDP = $1,000

The Inflation-GDP-Unemployment Connection

• Let’s assume next year the price of Dry

• Erase Markers is $2.00 each and the economy still produces 1,000 markers.

$2.00 X 1,000

GDP = $2,000Has our GDP grown?

What caused GDP to rise? Is this good?

What should be our main concern?

The Inflation-GDP-Unemployment Connection

• Our main concern should be the growth of the production of goods and services (G/S). The implication is that with the growth of production of G/S more workers will be needed to produce the G/S, thereby putting people to work and getting closer to the Economic Goal of Full-employment.

The Inflation-GDP-Unemployment Connection

• Our example tells us that we only experienced a rise in price, not a rise in the quantity of the good produced.– We had inflation.

To see how we are doing from year to year in the production of G/S we need to factor out Inflation

The Inflation-GDP-Unemployment Connection

• Terms we need to know and understand:– Nominal GDP – the GDP calculated in any given year

using that particular years prices or price level. – Real GDP – the GDP calculated for a given year with

the change in price level (Inflation) factored out. Measures the production of G/S in terms of a base year price level

– GDP Deflator- calculates the change in price level for a particular year compared to an established base year price level.

Year Price of Goods and Services Produced

Quantity of Goods and Services Produced

Nominal GDP

(unadjusted for Price Change)

GDP

Deflator

Real GDP (adjusted for Price Change)

1999 .50 1,000

2000 .75 1,000

2001 .75 1,200

2002 1.00 1,100

2003 1.50 1,150

Nominal GDP = Price of G&S x Quantity of G &SGDP Deflator = Current Price/Base Year PriceReal GDP = Nominal GDP/GDP Deflator X 100

Unemployment Inflation GDP Real Growth

Rate

Good 6% or less 1% to 4% 2.5% to 5%

Worry 6.5% to 8% 5% to 8% 1% to 2%

Bad 8.5% or more 9% or more .5% or less

What does all this mean???

Unemployment Rate 9.7 % Inflation Rate -2.10% Real GDP -6.0%

IT IS A MUST TO REMEMBER THIS FORMULA:

• Real = Nominal - InflationGDP

Interest rate

GDPInterest rate

Increased