Inflation Chapter 6

Inflation Since 1900 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved –10 –

Creating a Price Index A price index is calculated by dividing the current price of a basket of goods by the price of the basket in a base year then multiplying by 100.

Creating a price index Basket of goodsPrices in base year Prices in current year Expenditure in base year Expenditure in current year 10 pairs of jeans $20/pair$25/pair$200$ flannel shirts$15/shirt$20/shirt$180$ lb of oranges $.80/lb$1.05/lb$80$ lb of apples$1.00/lb $80 Total Expenditures $540$675

Price Index Price of basket in current year/ Price of basket in base year x 100

Babe Ruth Salary in 1930: $80,000 “I had a better year than he did.” -- Babe Ruth when told his salary was higher than President Hoover’s

Mark McGwire Salary in 1998: $8.3 million How does it compare with Babe Ruth’s salary? The CPI for 1930 was and in 1998 it was (The base year was an average of the period )

Divide nominal amount by index 80,000/ ,042 8,300,000/1.64 5,060,980

The Consumer Price Index (CPI) The consumer price index (CPI) measures the prices of a fixed "basket" of consumer goods. It is weighted according to each component's share of an average consumer's expenditures.

Composition of CPI Recreation (5.9%) Food and beverage (16.4%) Apparel (4.2%) Transportation (16.6%) Medical care (6.0%) Housing (40.5%) Other (5.0%) Education and Communication (5.4%)

CPI and “True” Inflation Quality bias Substitution bias

Costs of Inflation “Noise” in price system Distortion in tax system (capital depreciation allowances don’t keep up) “Shoe leather” costs Unexpected redistribution of wealth Interference with long run planning

Hyperinflation Money as fuel. Germany,

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become 'profiteers,' who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth- getting degenerates into a gamble and a lottery. ---J.M. Keynes, 1919