Turn & Talk: What’s this about?

Quick Definitions INFLATION an increase in the average level of prices, not a change in any specific price DEFLATION an decrease in the average level of prices, not a change in any specific price

Ch. 7: Inflation Unit 2, Days 5-7

INFLATION…CAUSES, EFFECTS & MEASUREMENT Ch. 7

INFLATION IS A TAX Effects of inflation redistribute wealth – Price Effects – Income Effects – Wealth Effects ALWAYS winners and losers

Price Effects Better to be a couch potato or a college student? Definition: Buyers are unequally affected by the changing prices of specific goods they purchase.

Income Effects Even if all prices rose at the same rate, inflation would still redistribute income. Redistributive effects originate both in expenditure and income patterns. LO2

Income Effects…Your 5% “Raise” NOMINAL INCOME Your income in today’s dollars (inflation is included) You receive a 5% raise  Nominal income is UP 5% REAL INCOME Your income adjusted for inflation (based on a based period) You receive a 5% raise during a period of 10% inflation  Real income is DOWN 5%

Wealth Effects Winners and losers from inflation depend on the form of wealth they own. You lose when inflation reduces the real value of wealth. LO2

The Real Story of Wealth LO2

Money Illusion The use of nominal dollars rather than real dollars to gauge changes in one’s income or wealth is called the money illusion. LO2

Macro Consequences of Inflation Uncertainty: hard to save, plan for the future (if money loses value) Speculation: decreases in output with focus on price changes – Hyperinflation (over 200%, 1yr) Bracket Creep: taxpayers pushed into higher tax levels because of nominal income changes

Protecting Against Inflation Cost of Living Adjustments (COLAs) Protect people on fixed incomes Adjust nominal incomes to rate of inflation Built into Social Security (to an extent), many contracts, pensions Adjustable Rate Mortgages (ARMs) Protect lenders Adjust mortgage rate to keep pace with inflation Use a real interest rate: nominal interest rate minus the anticipated inflation rate.

Inflation: Winners & Losers Does the person or group get HURT, GAIN from, or have UNCERTAIN consequences from inflation? WHY? 1.Banks extend many fixed rate loans. 2.A farmer buys machinery with a fixed rate loan to be repaid over 10 years. 3.Your family buys a new home with an adjustable rate mortgage. 4.Your savings from your summer job are in a savings account paying a fixed rate of interest. 5.A retired couple lives entirely on incomes from a pension a woman receives from her former employer. 6.A firm signs a contract to provide maintenance services at a fixed rate for the next five years. 7.The state government receives revenue mainly from a progressive income tax. 8.A local government receives revenue mainly from fixed rate license fees charged to local business.

POLITICAL CARTOONS IN ECONOMICS

#1 Law of Economics Economists Rarely Agree Econ=Material for Cartoonists

Cartoons Decoded…4 strategies – Labels: – Symbolism: – Analogy: – Irony: Make representations apparent Use simple objects for bigger ideas Compare a simple concept to a more complex one Highlight the difference between things as they are and things as they should be

Cartoon Poster Walk… Spend 2 minutes per cartoon – Identify Devices used (symbols, labels, analogy, irony) Cartoonist’s message – Add thoughts in group marker color to poster

Create Your Own Political Cartoon Your Task – with a partner, apply the knowledge learned about inflation to create a political cartoon depicting one of the following themes:  Wealth, price, or income effects  The money illusion  Be sure to explain what effect you chose and who the winners/losers are

Causes of Inflation (Supply & Demand) DEMAND PULL “Too much money chases too few goods” enabling producers to raise prices. COST PUSH Higher production costs put upward pressure on product prices.

The Goal: Price Stability Every U.S. president since Franklin Roosevelt has decreed price stability to be a foremost policy goal. – Full Employment & Balance Growth Act 1978 Est. Inflation Rate at <3% Trade off between inflation & unemployment LO3

The Historical Record In the long view of history, the U.S. has done a good job in maintaining price stability. Upon closer inspection, however, our inflation performance is very uneven.

Annual Inflation Rates

MEASURING INFLATION Unit 2, Day 6

How do we measure inflation? Price Level: relative size of prices at one point in time. Price Index: constructed to measure inflation – Most common  Consumer Price Index (CPI) Inflation is reported in terms of annual rates of change of the price level… Formula: Inflation Rate = Price Level 2 – Price Level 1 x 100 Price Level 1

Measuring Inflation 2012 Avg Consumer Price Index 2011 Avg Aug July Percent Change 0.12% Percent Change 2.06%

Price Indexes Consumer Price Index: changes in the average price of consumer goods and services. – Core Inflation Rate: CPI-food & energy (most volatile prices Producer Price Index: changes in price of crude, intermediate and finished goods for suppliers (increases usually precede CPI) GDP Deflator: index of changes in all G & S related to GDP, not a fixed basket (reflects both price changes and market responses)

Computing the CPI Est. Mkt. Basket BLS determines what Consumers are buying Establishes a base period (year to compare prices against) Set Item Weight BLS assigns a weight to items showing relative importance Big ticket items not always highest weight if less common Compare Prices Prices of weighted items are compared against base year Overall rate of inflation calculated by change in “basket’s” value

The Market Basket Transportation 18.0% Housing 32.7% Food 13.7% Clothing 4.1% Miscellaneous 9.5% Health care 5.7% Entertainment 5.1% Insurance and pensions 11.2% LO1

Real vs. Nominal GDP Nominal and Real GDP are connected by the GDP deflator:

Practice with Inflation! 1.If nominal GDP in 2005 was $10Trillion, what was real GDP? Real=Nominal/ (GDP Deflator/100) 2.If real income was 8 trillion in 2004, what was nominal income? Nominal=Real* (GDP Deflator/100) 3.According to the CPI, what was the inflation rate from 2004 to 2005? Inflation Rate= (2005 CPI-2004 CPI)/2004 CPI 4.According to the GDP deflator, what was the inflation rate from 2004 to 2005? Inflation Rate= (2005 df-2004 df)/2004 df 5.If the market basket in the base year cost $1,000, how much did that basket cost in 2006? 2006 basket=Base Year Basket*(2006 CPI/100) YearGDP Deflator CPI

Next Steps Use web quest to gather data on changes in inflation and unemployment Complete Unit 2 Study Guide for Monday