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 What the state of Inflation/Deflation around 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

Consumer Price Index (CPI) [CPI measures cost of living relative to a base year[100] 364 items21,000 The CPI is a market basket of 364 items at 21,000 establishments91 cities establishments in 91 cities that the typical householder buys. It does not include exports because we do not buy exports but does include 55% of the CPI is services imports. About 55% of the CPI is services.

What is actually measured in this market basket?

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 =

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 hamburgers Step 2. Find the prices of each good in each year. YearPrice of Hot DogsPrice of Hamburgers 2001 $1$ $1$ $2 $ $2 $3 Step 3. Compute the basket cost for each year ($1 per hot dog x 4 = $4) + ($2 per hamburger x 2 = $4), so $ ($2 per hot dog x 4 = $8) + ($3 per hamburger x 2 = $6), so $ ($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 = (14/$8) x 100 = (14/$8) x 100 = 175 Step 5. Use the CPI to compute the inflation rate from previous year ( )/100 x 100 =75% 2002 (175/100 x 100 = 175%) or to get actual % ( )/100 x 100 =75%

(42%) buys the following quantities of these (42%) 18. Suppose that a typical consumer buys the following quantities of these three commodities in 2000 and 2001 three commodities in 2000 and CommodityQuantity2000 perUnit Price2001 perUnit Price CommodityQuantity2000 per Unit Price2001 per Unit Price Food5 units $6.00 $5.00 Clothing2 units $7.00 $9.00 Shelter3 units $12.00$19.00 concluded about the CPI for this individual from Which of the following can be concluded about the CPI for this individual from 2000 to 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) 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)] Year 2 [2001]: [5 food x $5 = $25; 2 clothing x $9 = $18; 3 shelters x $19 = $57, for value of $100. CPI =125 ($100/$80 x 100 = 125% for 2001) ] CPI increased by 25%. So, the 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 How could measuring the CPI be distorted? © ©1999 South-Western College Publishing

1962 Prices2006 Prices 1962 Prices v Prices Tuition at MIT - $1,500Tuition at MIT - $1,500 Starting salary - $6,000 [college graduate]Starting salary - $6,000 [college graduate] FICA of of $4,800 [$150 maximum]FICA of of $4,800 [$150 maximum] Top marginal tax rate of 91% of incomes over $200,000.Top marginal tax rate of 91% of incomes over $200,000. New house for $10-15,000 [2.5 times the income of a new college graduate]New house for $10-15,000 [2.5 times the income of a new college graduate] Coke - 10 centsCoke - 10 cents Movies -.50Movies Chevy - $1, Chevy - $1,500 Tuition at MIT - $32,300Tuition at MIT - $32,300 Starting salary - $44,000 [college [college graduate]Starting salary - $44,000 [college [college graduate] FICA of 7.65 of $94,600 [$7,237 maximum]FICA of 7.65 of $94,600 [$7,237 maximum] Top marginal tax rate of 35% of incomes over $326,450Top marginal tax rate of 35% of incomes over $326,450 New median house price is $218,000 [5 times the income of today’s college grads]New median house price is $218,000 [5 times the income of today’s college grads] Coke - 60 centsCoke - 60 cents Movies - $7Movies - $ Chevy - $23, Chevy - $23, Corvette $2, Corvette $58,000

Who is the Richest American Ever? Who is the Richest American Ever? John D. Rockefeller’s John D. Rockefeller’s [ ] wealth would be worth $200 billion $200 billion in today’s money, or 4 times that of Bill Gates. Dollar Figures From Different Times Babe Ruth$80,000in 1931 Babe Ruth made $80,000 in That would $1 million today be equivalent to $1 million today. [B arry Bonds gets $18 million a year] Herbert H oover’s salary P resident Herbert H oover’s salary in 1931 $ 75,000 was $ 75,000. That would be equivalent to $900,000 $900,000 today. George Bush is being $400,000 paid $400,000 a year. President Kennedy was paid $100,000 in 62 [$650,000 today ] not Although Rockefeller was worth $200 billion, he could not watch TV, play video games, surf the internet, or send 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 the richest American a century ago. $ 80, 000= $ 1 M

GDP Deflator – more broad GDP Deflator – more broad GDP Deflator GDP Deflator includes prices all goods that we produce for all goods that we produce: householders 1.What householders are buying businesses 2.What businesses are buying government 3.What the government is buying foreigners 4.What foreigners are buying does not include imports [does not include imports because we don’t produce imports]

GDP Deflator Compared to the CPI [CPI is normally higher.] GDP Deflator Compared to the CPI [CPI is normally higher.]

Who measures inflation? The Bureau of Labor Statistics © ©1999 South-Western College Publishing

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, don’t worry about it. You can always be President 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 = $2,000 Has 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.

YearPrice 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) , , , , ,150 Nominal GDP = Price of G&S x Quantity of G &S GDP Deflator = Current Price/Base Year Price Real GDP = Nominal GDP/GDP Deflator X 100

UnemploymentInflationGDP Real Growth Rate Good6% or less1% to 4%2.5% to 5% Worry6.5% to 8%5% to 8%1% to 2% Bad8.5% or more9% or more.5% or less What does all this mean??? Unemployment Rate 9.7 % Inflation Rate % Real GDP -6.0%

IT IS A MUST TO REMEMBER THIS FORMULA: Real = Nominal - Inflation GDP Interest rate GDP Interest rate

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