Inflation: Measuring the Cost of Living AP Macroeconomics

Most lattes she could buy Opportunity cost of 1 latte Money—money—money! Most gas she could buy Most lattes she could buy Opportunity cost of 1 latte 10 gallons 5 cups 2 gallons $20 allowance per week for gas ($2/gallon) and venti mochiaccino café lattes ($4/cup) 1 gallon of gas uses 10% of her income. 1 cup of latte uses 20% of her income. What happens if her income doubled and so did the price of gas and the price of a latte?

Most lattes she could buy Opportunity cost of 1 latte Money—money—money! Most gas she could buy Most lattes she could buy Opportunity cost of 1 latte 10 5 gallons 5 2.5 cups 2 gallons $20 allowance per week for gas ($2/gallon) and venti mochiaccino café lattes ($4/cup) 1 gallon of gas uses 10% 20% of her income. 1 cup of latte uses 20% 40% of her income. Now, what if the price of gas and café lattes doubles, while her income stays the same?

Inflation Rise in the general level of prices. Results in fewer goods and services being purchased Reduction of purchasing power of the dollar

Low Inflation AD increases Workers increase spending Workers hired Production expands Producers make high real profits Wages raise slower than prices

Unemployment increases Prices rise rapidly Real income decreases Fewer goods purchased Unemployment increases Economy suffers High Inflation

Grand Poobah for a Day 1950’s television game show “Queen for the Day” Contestants took turns describing their lives of tragedy, hardship, and sorrow Audience voted for the most deserving Winner crowned queen for the day Today you will play to become the “Grand Poobah for a Day”

Rules of the Game 12 students will compete Given a role card 60 seconds to “perform” role for class Class will score each contestant After all have presented we will determine the Grand Poobah for the day Any questions? Let’s begin!

Spectrum to analyze contestants Lucy Mayor Helga Mr. Class Priscilla Lawrence Bernie Elmer Peter Jerome Jerry Theresa Suffers most from inflation Benefits most from inflation Neutral (neither suffers nor benefits)

Anticipated & Unanticipated Inflation Unanticipated inflation hurts Fixed-income receivers Savers Creditors Unanticipated inflation helps Flexible-income receivers Debtors What about anticipated inflation?

Demand-Pull Inflation People are willing and able to buy more output than the economy can produce Excess demand bids up the prices of limited output “Too many dollars chasing too few goods” SRAS aPL AD1 AD rGDP

Cost-Push Inflation Supply-side cost shocks Wage-price spiral Increase in business tax

ECB’s Inflation Monster Watch for different types of inflation. What’s the deal with deflation?

Inflation Rate Percentage of the change in the price level from one period to the next. The inflation rate reflects how fast prices are changing.

Deflation A persistent fall in the average level of prices in the economy “Good” deflation: improvements in the supply side of the economy and/or increased productivity “Bad” deflation: the demand of the economy declines, includes a decrease in real output

Disinflation A falling rate of inflation

Economic Costs of Inflation Shoe-leather costs Menu costs Unit of account costs Activity 2.5

A Brain Break… You start with $1000 in investments that do the following: fall 50%, go up 80%, fall 50%, go up 80%, fall 50%, and up 80%. How much money have you made?

The Consumer Price Index The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by typical consumers. It’s a number used to reflect the changes in the prices. It includes the “C” of the GDP plus used goods purchased by families. The Bureau of Labor Statistics reports the CPI each month. 2

Uses for the CPI Policy Target: The goal is to have stable prices, which means low inflation. COLA: earn appropriate pay raises. Translate prices from nominal to real: we can compare apples to apples.

CPI since 1950

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How the Consumer Price Index Is Calculated Fix the Basket: Determine what prices are most important to the typical consumer. The Bureau of Labor Statistics (BLS) identifies a market basket of 400 goods and services the typical consumer buys. The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services. 4

What’s in the CPI’s Basket? 5% 5% Housing Food/Beverages Transportation Medical Care Apparel Recreation Other Education and communication 6% 5% 6% 40% 17% 16% 10

How the Consumer Price Index Is Calculated Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. 5

How the Consumer Price Index Is Calculated Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. 6

How the Consumer Price Index Is Calculated Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. Beige book for examples pp 558-559. December 1999 CPI 168.3 (68.3% higher than July 1983). December 1960 CPI was 29.8 (29.8% of the prices in 1983). 1983 CPI is 100. 7

How the Consumer Price Index Is Calculated CPI= 7

How the Consumer Price Index Is Calculated Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period. 8

The Inflation Rate The annual inflation rate is calculated as follows:

Basket of goods in 1998 costs $1,200. Calculating the Consumer Price Index and the Inflation Rate: An Example Base Year is 1998. Basket of goods in 1998 costs $1,200. The same basket in 2000 costs $1,236. CPI = ($1,236/$1,200) X 100 = 103. Prices increased 3 percent between 1998 and 2000. Your turn! Please complete activity 2-4. 9

CPI of selected years, 1960-2015 Year Consumer Price Index 1960 29.8 1965 31.8 1970 39.8 1975 55.5 1980 86.3 1985 109.3 1990 130.7 1995 152.4 2000 172.2 Year Consumer Price Index 2005 195.3 2010 218.1 2013 233.0 2015 237.6

Price Indexes for Selected Goods and Services Year Overall Food Shelter Transportation Medical Care Apparel 1950 24.1 25.4 NA 22.7 15.1 40.3 1955 26.8 27.8 25.8 18.2 42.9 1960 29.6 30.0 25.2 29.8 22.3 45.7 1965 31.5 32.2 27.0 31.4 24.6 47.3 1970 38.8 39.2 35.5 37.5 34.0 59.2 1975 53.8 59.8 48.8 50.1 47.5 72.5 1980 82.4 86.8 81.0 83.1 74.9 90.9 1982-1984 100.0 1985 107.6 105.6 109.8 106.4 113.5 105.0 1990 130.7 132.4 140.0 120.5 162.8 124.1 1994 148.2 144.3 160.5 134.3 211.0 133.4 2000 174.0 167.3 171.4 157.7 264.1 125.3 2004 187.4 187.9 191.0 164.8 311.6 121.2 2006 203.5 194.5 201.7 188.5 336.0 116.1 2009 212.7 218.6 217.4 169.6 373.2 122.5 2016 241.9 248.1 291.4 196.2 499.7 130.3

Problems in Measuring The Cost of Living The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. 12

Problems in Measuring The Cost of Living Substitution bias Introduction of new goods Unmeasured quality changes 13

Hyperinflation Hungary in 1946: $1 US = 3 x 1022 pengös Germany 1920s: price level rose 1,300,000,000,000x Nicaragua 2/86 to 3/1991: 11,895,866,143% Serbia 2/93 to 1/94: 156,312,790%

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