AP Macro/Economics 2301 © Robin Foster Consumer Price Index AP Macro/Economics 2301 © Robin Foster

Inflation or Deflation

Inflation……….Deflation….. Inflation=A rise in the general price level which causes each dollar to have less purchasing power. PL =% inflation $’s value Purchasing power Deflation=A fall in the general price level which causes each dollar to have more purchasing power. PL =% deflation $’s value Purchasing power

Deflation/disinflation In contrast, deflation occurs when prices are actually dropping. Disinflation is a decrease in the rate of inflation. This phase of the business cycle, in which retailers can no longer pass on higher prices to their customers, often occurs during a recession.

Demand Pull inflation Will continue as long as there is an excess in spending. Inflation diverts time and resources toward activities designed to hedge inflation. Businesses change direction. People and business put more $$ into savings. Too much $ chasing too few goods. Excess demand pulls prices upward based on limited output. Too many employed and leads to wage inflation.

Cost Push Inflation Automatically self- limiting; it will die by itself. Not enough supply of goods and services. Costs push prices upward. Total input cost units of output This gives per unit production costs. Reduces real output and redistributes a decreased level of real income.

Cost push inflation A major source of cost push inflation is a supply shock- abrupt increases in the cost of raw materials or energy inputs that drive up the per unit production costs and thus product prices Supply shocks: Natural disaster Political supply cuts, boycotts, OPEC Natural reduction in resources

Anticipated inflation We know inflation is coming in the future. Banks can charge an inflation premium-raise interest rates, by the amount of anticipated inflation. Variable rate mortgages protect from inflation.

Inflation helped or hurt: COLAS-cost of living adjustments Banks who loan at flexible i% People who borrow at fixed i% Hurt: People on fixed income People who loan at fixed i% People who borrow at flexible i% Usually savers with money in savings accounts.

Unanticipated inflation Inflation was not expected, therefore no one can prepare This type of inflation hurts: Fixed income receivers. Savers Creditors-lend “dear” money, pay back “cheap” money.

Unanticipated inflation Inflation was not expected, therefore no one can prepare This type of inflation helps: Flexible income receivers. Cost of living adjustments (COLAS) given to union workers. Debtors-borrow “dear”, pay back “cheap”.

Can you keep up with inflation? The inflation rate is important to know, as your pay, investments must keep up with or beat inflation. Real income=nominal-inflation Prices rise by 6%, Bob’s nominal income rises by 10%, his real income rises by 4%. If price levels rise by 6%, and his nominal income rises by 2%, his real income falls by 4%.

Consumer Price Index and the Cost of Living Consumer Price Index (CPI) BLS measures prices of a fixed market basket of 300 goods and services Typical urban consumer Market basket updated every 2 years Base years 1982-84=100 www.bls.gov

How do we measure inflation/deflation with a price index? Price x quantity= current market value of a production in a given year (GDPn). Create a market basket. Designate a base year. Create a price index. Calculate an inflation rate. Convert nominal to real GDP, Income, Interest, wages. A price index is a measure of the price of a specified collection of goods and services, called a “market basket”, in a given year as compared to the price of an identical (or highly similar) collection of goods and services in a reference year, called a “base year.”

Base or Reference Year What Does Reference Base Period Mean? A year in which the Consumer Price Index is equal to 100, a reference base period that serves as a benchmark for future periods. Currently, the reference base period is set between 1982 and 1984.

CPI Market Basket When conceptualizing a basket of goods, it is best to imagine a shopping basket. As the products in the basket increase or decrease in price, the overall value of the basket changes. The CPI compares the value of the basket each year and determines the level of inflation for that period. The contents of the basket are subject to change each year.

Producer Price Index Also known as wholesale price index. The PPI is the same as the CPI only for Producer goods, such as cost of steel, electricity, purchased by producers. The price increase in input materials, should In theory mirror increases in the CPI.

Calculating price level changes: Ms. Foster’s Market basket Prices in 2017** Quantity Prices in 2018 $.25 1 pencil $.40 $.75 I can of soda in teachers lounge $1.00 $. Did the quantity change? What did change?

Steps to calculate the CPI Base year:_________________ 2017 Price____x Quantity_____=_________ Price____x Quantiy______=________ total 2018 CPI=CPI basket current____ x100 CPI basket base_______ Inflation rate 2017 to 2018 CPI current-CPI previous x100 CPI previous

Calculating the CPI Cost of CPI basket at current period prices x 100 Cost of CPI basket at base period prices CPI Basket 2005 Item Quantity Price Total CPI basket Oranges 10 $1 each $10 Haircuts 5 $8 each $40 Total $50 CPI Basket 2008 Oranges 10 $2 each $20 Haircuts 5 $10 each $50 Total $70

Calculating the CPI Cost of CPI basket at current period prices x 100 Cost of CPI basket at base period prices CPI 2005=$50 x100=$100 $50 CPI 2008==$70 x100=$140 $100 spent in 2006 would cost you $140 in 2008.

GDP Deflator GDP Deflator=nominal GDP x 100 real GDP GDP Deflator is a measure of the inflation rate. This is different from the CPI inflation rate as the GDP deflator measures all goods and services included in the GDP. The GDP deflator is not subject to the bias of the CPI. The GDP price index is used to adjust the nominal GDP for inflation or deflation and thereby obtain real GDP. The deflator tends to underestimate inflation.

The CPI tends to overstate inflation due to bias: Substitution Bias-a price increase in one item leads to the substitution of a lower priced product. Ex oranges increase in price due to freeze, grapefruits are a substitute. Quality bias-over time technological advances increase the life and usefulness of products. Quality of tires. New product bias-new products are not introduced into the index until they become commonplace, so dramatic price decreases with new technology are not reflected. Outlet bias-wholesale clubs and online retailers are not well represented in the CPI.

Measuring Inflation The purpose of the CPI is to measure changes in the cost of living and value of money. The inflation rate which is he percentage change in the price level from one year to the next. Inflation rate= (CPI Current year-CPI Previous year) x 100 CPI in Previous year CPI 2008-140 CPI 2007-120 What is the inflation rate? 16.7%

Uses of the CPI Economic Indicator-The most commonly reported measure of consumer prices. Reference for escalation agreements-labor and other payment agreements indexed to inflation rely on the CPI. Deflator for economic series-when a series of data is to be adjusted so that it is reported in constant dollars, the CPI is used as the deflator.

Dollars and cents at different dates Current year=price previous year x (CPI current year) (CPI previous year) In 2007 the CPI was 207.2 In 1907 the CPI was 10.0 In 1907 the price of a stamp was $.02, convert to its 2007 equivalent. .02 x (207.2) = $.41 10.0 If a gallon of milk was $3.99 in 2007, what was the 1907 price?

Nominal and Real income Real income is nominal adjusted for inflation. Nominal income=real + inflation Prices rise by 6% and Bob’s nominal income rises by 10%, his real income will rise by 4%.

Nominal vs. real wage rates Wage rate in current year=nominal rage rate current year x 100 CPI Current year Nominal wage rate measured in current dollars Real wage rate measured in dollars of reference base year. In 2006, the average hourly wage rate for workers was $16.73 and the CPI was 201.6. What is their real wage rate? Real wage rate=$16.73 x 100 = $8.23 201.6

Calculating the Rate of change and real purchasing power Last year you earned $7 per hour in wages. This year you got a raise to $8 per hour. What was your pay increase? ($8-$7)/$7=14.29 nominal increase If the expected inflation rate was 4%, what is your real pay increase? 14.29%nom-4%inf=10.29% Yea!!!!

Nominal vs. real interest RAtes Real interest =nominal interest –inflation Real is the nominal interest rate adjusted for inflation. If the nominal interest rate is 5%, and the inflation rate is 3%. What is the real interest rate? 5%-3%=2%