Inflation

Define Inflation / Deflation Inflation – a general increase in the price level Deflation – a general decrease in the price level Hyperinflation – extraordinarily high inflation (Germany 1923 – prices doubled roughly every 2 days)

Measuring Inflation Question: How do we measure inflation? Answer: With a price index!

Measuring Inflation Common Price Indexes CPI (Consumer Price Index) PPI (Producer Price Index) GDP Deflator Each focuses on a different part of the economy CPI uses a market basket typically faced by the household sector. PPI uses a market basket typically faced by the private sector (the Firms). CPI and PPI is tracked by the Bureau of Labor Statistics

Measuring Inflation

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Hornet’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Calculate Cost of the Basket for each year. Calculate the CPI for each year (using Year 1 as the base year) Calculate the Inflation Rate from Year 1 to Year 2. Calculate the Inflation Rate from Year 2 to Year 3.

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Bobcat’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Compute the Cost of the Basket: Cost in Year 1 = (3 × $10) + (4 × $12) = $78 Cost in Year 2 = (3 × $12) + (4 × $15) = $96 Cost in Year 3 = (3 × $14) + (4 × $18) = $114

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Bobcat’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Calculate the CPI for each year (using Year 1 as the base year): CPI in Year 1 = ($78/$78) × 100 = 1 × 100 = 100 CPI in Year 2 = ($96/$78) × 100 = 1.2308 × 100 = 123.08 CPI in Year 3 = ($114/$78) × 100 = 1.4615 × 100 = 146.15

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Bobcat’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Calculate the Inflation Rate from Year 1 to Year 2. Calculate the Inflation Rate from Year 2 to Year 3. Inflation rate for Year 2 = [(123.08 – 100)/100] × 100% = 23.08% Inflation rate for Year 3 = [(146.15 – 123.08)/123.08] × 100% = 18.74%

CPI, PPI & GDP Deflator History

Comparisons CPI vs. GDP Deflator CPI measures the prices of only the goods and services bought by the households GDP Deflator measures the prices of all goods and services produced Thus an increase in the price of goods bought by firms or the government would not show up in the CPI, but would increase the GDP Deflator GDP Deflator does only includes domestic goods GDP Deflator allows the market basket of goods to change over time

Comparisons The difference in each price index is usually not large. CPI usually overstates inflation Estimated to overstate inflation between 0.8 and 1.6 %... with 1.1% being a “best estimate” GDP Deflator tends to understate inflation

Biases in the CPI Substitution Bias Introduction of New Goods Prices go up, households substitute away from the higher priced goods Introduction of New Goods Effectively increases the purchasing power of the dollar. CPI does not account for this. Unmeasured Changes in Quality Not all price increases are due to cost of living increases

Nominal & Real Interest Rates We see inflation in interest rates as well. Real Interest Rate = Nominal Interest Rate – Inflation Rate What matters is the purchasing power of money.

Nominal & Real Interest Rates Real Interest Rate = Nominal Interest Rate – Inflation Rate Example: Sally deposits $1,000 into a bank account that pays an annual interest rate of 10%. A year later, she withdraws $1,100. (remember to focus on the purchasing power of the money) If there is zero inflation, her purchasing power has risen by 10%. If there is 10% inflation, her purchasing power has remained the same. If there is 12% inflation, her purchasing power has declined by about 2%.

Inflation Winners & Losers Borrowers vs. Lenders Expected Inflation vs. Unexpected Inflation Unexpected Inflation can transfer wealth from lenders to borrowers The payments on a 30 year fixed mortgage remain constant, but the value of the dollar decreases with inflation. The lenders in these cases receive less “real money.”

Biggest Movie Ever? What is the biggest movie ever? Star Wars (Episode 7) Box Office Receipts were roughly $936 million domestically. What if we adjust other movies for inflation? Nominal Records – Real Records