Copyright©2004 South-Western Inflation Calculator ●In 1931 Babe Ruth earned $80,000 per year while President Hoover earned $75,000. “I had a better year.” Babe Ruth How do those numbers compare to today’s salaries? What do we need to take into consideration? Inflation What is inflation? An increase in prices (on average) What indicator of inflation have we already discussed? GDP Deflator ●In 1931 Babe Ruth earned $80,000 per year while President Hoover earned $75,000. “I had a better year.” Babe Ruth How do those numbers compare to today’s salaries? What do we need to take into consideration? Inflation What is inflation? An increase in prices (on average) What indicator of inflation have we already discussed? GDP Deflator

Copyright©2004 South-Western Inflation Calculator ●Today the average baseball player earns ■$ 3.4 Million per year ■Alex Rodriguez earned $30 Million in 2013! President Obama is paid $400,000 What is the largest grossing Hollywood Movie of all time? Gone with the Wind: $198 Million (1939) or Avatar : $ 760 Million (2009) ●Today the average baseball player earns ■$ 3.4 Million per year ■Alex Rodriguez earned $30 Million in 2013! President Obama is paid $400,000 What is the largest grossing Hollywood Movie of all time? Gone with the Wind: $198 Million (1939) or Avatar : $ 760 Million (2009)

Copyright©2004 South-Western Ford Model “T” in 1908: $850 Today Ford Fusion: $28,000 Base 2013 Which was more expensive? Inflation Calculator

Copyright©2004 South-Western More about Henry Ford and elasticity of demand Due to improvements in the manufacturing process the cost of a Model T dropped. In 1914: $300! Ford’s market share rose from 9.4% to 48% of the car market by 1914 and net income rose from $3 Mil. to $ 25 Mil. How would you describe the price elasticity of demand for cars in 1910?

Copyright©2004 South-Western How do we normally measure inflation? ●Calculate the Consumer Price Index (CPI) ●Pick a basket of Consumer Goods and track those prices over time. Record the % change in the basket ●Fix the Basket: Determine what goods are most important to the typical consumer. ■The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. ■The BLS conducts monthly consumer surveys to set the prices of those goods and services. ●Calculate the Consumer Price Index (CPI) ●Pick a basket of Consumer Goods and track those prices over time. Record the % change in the basket ●Fix the Basket: Determine what goods are most important to the typical consumer. ■The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. ■The BLS conducts monthly consumer surveys to set the prices of those goods and services.

Copyright©2004 South-Western Figure 1 The Typical Basket of Goods and Services

Copyright©2004 South-Western 24 Measuring the Cost of Living

Copyright©2004 South-Western Figure 2 Two Measures of Inflation

Copyright©2004 South-Western Living with Inflation Is Inflation always BAD? How can inflation hurt people? ●Real Interest Rates vs. Nominal Interest Rates ●Real Wages vs. Nominal Wages How can inflation benefit people? ●Borrowing vs. Lending

Copyright©2004 South-Western Let’s return to Babe Ruth’s $80,000 salary in 1931 Let’s assume inflation in 10% per year, what does that mean? Prices of consumer goods are increasing by 10% each year. What if Babe Ruth stayed earning the same salary each year for the next 20 years. How is inflation affecting Babe Ruth? His NOMINAL Wages would stay the same at $80,000, but his real wages are decreasing by 10% each year! REAL WAGES VS. NOMINAL WAGES

Copyright©2004 South-Western How are you effected by Inflation?? ●Rising Prices ■Is that always a problem? Are your wages keeping up with inflation? If so, inflation isn’t really a problem. If not, inflation is a problem. For sellers, inflation causes their costs to increase which forces them to always change the price of their goods. Sometimes they can’t pass these extra costs along to consumers, causing their business to be less profitable. ●Rising Prices ■Is that always a problem? Are your wages keeping up with inflation? If so, inflation isn’t really a problem. If not, inflation is a problem. For sellers, inflation causes their costs to increase which forces them to always change the price of their goods. Sometimes they can’t pass these extra costs along to consumers, causing their business to be less profitable.

Copyright©2004 South-Western How are you effected by Inflation?? ●Savings/Investments ■Your investments must keep up with the rate of inflation or you are losing money each year. ■REAL Interest Rates vs. Nominal Interest Rates ●Savings/Investments ■Your investments must keep up with the rate of inflation or you are losing money each year. ■REAL Interest Rates vs. Nominal Interest Rates

Copyright©2004 South-Western Let’s take another look at Nominal vs. Real GDP NOMINALREALINFLATION Nominal GDP = Real GDP + Inflation We could also say that… Real GDP = Nominal - Inflation

Copyright©2004 South-Western If you were to invest $1000 for 1 year, what is the lowest rate of interest you would need to receive to keep from losing money? This year’s expected rate of INFLATION If inflation = 10% You must receive $1100 one year from today, or you will lose money on this investment. Interest Rates vs. Inflation

Copyright©2004 South-Western Real and Nominal Interest Rates ●The nominal interest rate is the interest rate your investment earns ●The real interest rate is the nominal interest rate that is corrected for the effects of inflation. ●The nominal interest rate is the interest rate your investment earns ●The real interest rate is the nominal interest rate that is corrected for the effects of inflation. Real interest rate = Nominal interest rate – Inflation rate

Copyright©2004 South-Western RATE OF INFLATION VS. INTEREST RATES

Copyright©2004 South-Western Figure 3 Real and Nominal Interest Rates

Copyright©2004 South-Western How do Real and Nominal Interest Rates Effect You? ●Let’s say you put your money in the bank and earn a nominal interest rate of 2% per year. ●If Inflation was 4% over this time period, what is your REAL rate of return on this investment? ●Real interest rate = Nominal interest rate – Inflation REAL = 2% -4% = -2% Not a good investment IF inflation = 1%, then real interest = 2% -1% = 1% Savers need to beat inflation!! ●Let’s say you put your money in the bank and earn a nominal interest rate of 2% per year. ●If Inflation was 4% over this time period, what is your REAL rate of return on this investment? ●Real interest rate = Nominal interest rate – Inflation REAL = 2% -4% = -2% Not a good investment IF inflation = 1%, then real interest = 2% -1% = 1% Savers need to beat inflation!!

Copyright©2004 South-Western So how can you GAIN from inflation? ●WHAT if you borrowed $1,000 for one year. ●The bank charges a Nominal interest rate of 5%. (the rate you pay) ●During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 5% - 10% = -5% Is the real interest rate what you pay? No, but if you earned at least the inflation rate then your net cost was -5%. ●WHAT if you borrowed $1,000 for one year. ●The bank charges a Nominal interest rate of 5%. (the rate you pay) ●During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 5% - 10% = -5% Is the real interest rate what you pay? No, but if you earned at least the inflation rate then your net cost was -5%.

Copyright©2004 South-Western Another scenario You buy a house right now for 200k ●If you pay a fixed rate of interest (say 4% per year for 30 years). The amount you pay is fixed, it doesn’t change over time! ●Your home should appreciate in value by at least the rate of inflation, because all prices are going up, real estate as well! ●If your salary increases along with inflation and that is greater than 4%, over time the cost of paying off your loan will get lower and lower. ●BUT your income must increase by more than 4% (Cost of living increases, raises, etc.) You buy a house right now for 200k ●If you pay a fixed rate of interest (say 4% per year for 30 years). The amount you pay is fixed, it doesn’t change over time! ●Your home should appreciate in value by at least the rate of inflation, because all prices are going up, real estate as well! ●If your salary increases along with inflation and that is greater than 4%, over time the cost of paying off your loan will get lower and lower. ●BUT your income must increase by more than 4% (Cost of living increases, raises, etc.)

Copyright©2004 South-Western So, what does all this mean for you? WAGES You must earn wage increases at least as much as inflation to keep your REAL wages from declining. SAVING/INVESTING Investors/Savers must earn a positive real rate of interest Nominal rate > inflation BORROWING Lenders must earn a real rate of interest greater than zero, Borrowers can benefit from inflation by borrowing at FIXED rates, below the rate of inflation

Copyright©2004 South-Western Congratulations!! You just bought a house! Now, how are you going to pay for it? House cost: $250,000 10% down payment = $25,000 $225,000 loan The bank will lend you money in two different ways: Option A 4.4 % FIXED RATE for 30 years Option B 3.4% ADJUSTABLE one time per year – NO Cap Which would you choose??

Copyright©2004 South-Western It depends on your expectations about inflation and your tolerance for risk! If inflation is higher than 4.4% (say, 10%) Real Interest rate = 4.4 % - 10% = -5.6% How would you gain? Your home might increase in value at 10%, while you only pay 4.4% What if inflation stayed below 4.4 %? (1.4%) Real Interest rate = 4.4% - 1.4% = 3.4% You would earn closer to 1.4% on your home value, while paying 4.4% to own it!

Copyright©2004 South-Western Who is helped and who is hurt by high inflation? 1.Banks extend many fixed rate loans. H-G-U 1.Hurt, since they are only receiving money back at a fixed interest 2.A farmer buys machinery with a fixed rate loan to be repaid over 10 years 1.2. Gain, since he earns more money and pays a fixed rate 3.Your family buys a new home with an adjustable rate mortgage, the rate you pay adjusts with interest rates. 1.Hurt, since you will pay higher interest if inflation causes rates to rise 4.Your savings are in a savings account paying a fixed rate of interest 1.Hurt, since your receive only a fixed rate and interest rates and prices of everything are rising. 1.Banks extend many fixed rate loans. H-G-U 1.Hurt, since they are only receiving money back at a fixed interest 2.A farmer buys machinery with a fixed rate loan to be repaid over 10 years 1.2. Gain, since he earns more money and pays a fixed rate 3.Your family buys a new home with an adjustable rate mortgage, the rate you pay adjusts with interest rates. 1.Hurt, since you will pay higher interest if inflation causes rates to rise 4.Your savings are in a savings account paying a fixed rate of interest 1.Hurt, since your receive only a fixed rate and interest rates and prices of everything are rising.

Copyright©2004 South-Western 1.A widow lives entirely on a fixed income from a pension the woman receives from her former employer. 1.Hurt, since prices are going up and the interest she receives is fixed. 2.A retired couple lives entirely on income from a pension the woman receives from her former employer. 1.Unclear, since we don’t know if the pension is INDEXED to inflation. 3.A retired man lives entirely on income from Social Security. Unclear, since although SS is indexed to inflation we don’t know if it will keep up with the man’s personal expenses. 4. The federal gov. has a $ 5 Billion debt. 1.Unclear, since we don’t know if it’s borrowed at fixed rates or adjustable. 1.A widow lives entirely on a fixed income from a pension the woman receives from her former employer. 1.Hurt, since prices are going up and the interest she receives is fixed. 2.A retired couple lives entirely on income from a pension the woman receives from her former employer. 1.Unclear, since we don’t know if the pension is INDEXED to inflation. 3.A retired man lives entirely on income from Social Security. Unclear, since although SS is indexed to inflation we don’t know if it will keep up with the man’s personal expenses. 4. The federal gov. has a $ 5 Billion debt. 1.Unclear, since we don’t know if it’s borrowed at fixed rates or adjustable.

Copyright©2004 South-Western Figure 1 The Typical Basket of Goods and Services HOW IS THE CONSUMER PRICE INDEX CALCULATED?

Copyright©2004 South-Western How the Consumer Price Index Is Calculated ●Fix the Basket: Determine what products are most important to the typical consumer. ■The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. ●Fix the Basket: Determine what products are most important to the typical consumer. ■The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys.

Copyright©2004 South-Western 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.

Copyright©2004 South-Western 3 Steps to Calculate CPI for any year (x) ●Step 1 Calculate cost of basket for base year ●Cost of basket (base year) = Prices (base year) * Quantities (base year) ●Step 2 Calculate cost of basket in year x ●Cost of basket (yr X) = Prices(yr X) * Quantities (base year) ●Step 3 Calculate CPI yearX  CPI (yrX)= Basket (yrX)/Basket (base year) ●Reminder: To calculate the cost of each year’s basket, don’t change the quantities, ONLY CHANGE THE PRICES! ●Step 1 Calculate cost of basket for base year ●Cost of basket (base year) = Prices (base year) * Quantities (base year) ●Step 2 Calculate cost of basket in year x ●Cost of basket (yr X) = Prices(yr X) * Quantities (base year) ●Step 3 Calculate CPI yearX  CPI (yrX)= Basket (yrX)/Basket (base year) ●Reminder: To calculate the cost of each year’s basket, don’t change the quantities, ONLY CHANGE THE PRICES!

Copyright©2004 South-Western How the Consumer Price Index Is Calculated CPI (yr X) = Price of the Basket (yr X) X 100 Price of the Basket (base year) HISTORICAL CPI!HISTORICAL CPI CPI (yr X) = Price of the Basket (yr X) X 100 Price of the Basket (base year) HISTORICAL CPI!HISTORICAL CPI So, what is the value of the CPI in the Base Year? 100

Copyright©2004 South-Western Dollar Figures from Different Times ●Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001: CPI DEFLATOR CPI Deflator 2001 CPI Deflator 1931

Copyright©2004 South-Western How the Consumer Price Index Is Calculated Compute the inflation rate: The inflation rate is the percentage change in the CPI from the preceding period. ●The Inflation Rate ■The inflation rate is calculated as follows: Compute the inflation rate: The inflation rate is the percentage change in the CPI from the preceding period. ●The Inflation Rate ■The inflation rate is calculated as follows:

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western The quantity stays the same each year! 1.Find the prices 2. Calculate the cost of the original basket in each year. 3. Divide each basket into the base year basket to find the CPI. 4. Calculate change in CPI to find inflation rate Quantity Hot Dogs Quantity Hamburger 2 1

Copyright©2004 South-Western “Inflate or Deflate” Prices You can put the price of any good from any year into another year’s dollar value by calculating how much the CPI grew or shrunk over that time period. For instance: Question: Has minimum wage kept up with inflation? Minimum Wage in 1965 = $1.25/hr CPI in 1965 = 31.5 CPI in 2013 = 233 $ 1.25 “inflated” to 2013 prices = 1.25 x 233/31.5 = $9.25

Copyright©2004 South-Western 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. Most problems with CPI result in inflation being measured as too high!

Copyright©2004 South-Western Problems in Measuring the Cost of Living ●Substitution bias ●Introduction of new goods ●Unmeasured quality changes ●Substitution bias ●Introduction of new goods ●Unmeasured quality changes

Copyright©2004 South-Western Problems in Measuring the Cost of Living ●Substitution Bias ■The basket does not change to reflect consumer reaction to changes in relative prices. ♦Consumers substitute toward goods that have become relatively less expensive. ♦The index overstates the increase in cost of living by not considering consumer substitution. ●Substitution Bias ■The basket does not change to reflect consumer reaction to changes in relative prices. ♦Consumers substitute toward goods that have become relatively less expensive. ♦The index overstates the increase in cost of living by not considering consumer substitution.

Copyright©2004 South-Western Problems in Measuring the Cost of Living ●Introduction of New Goods ■The basket does not reflect the change in purchasing power brought on by the introduction of new products. ♦New products result in greater variety, which in turn makes each dollar more valuable. ♦Consumers need fewer dollars to maintain any given standard of living. ●Introduction of New Goods ■The basket does not reflect the change in purchasing power brought on by the introduction of new products. ♦New products result in greater variety, which in turn makes each dollar more valuable. ♦Consumers need fewer dollars to maintain any given standard of living.

Copyright©2004 South-Western Problems in Measuring the Cost of Living ●Unmeasured Quality Changes ■If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. ■If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. ■The BLS tries to adjust the price for constant quality, but such differences are hard to measure. ●Unmeasured Quality Changes ■If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. ■If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. ■The BLS tries to adjust the price for constant quality, but such differences are hard to measure.

Copyright©2004 South-Western The GDP Deflator versus the Consumer Price Index ●The GDP deflator reflects the prices of all goods and services produced domestically, whereas... ●…the consumer price index reflects the prices of all goods and services bought by consumers. ●The GDP deflator reflects the prices of all goods and services produced domestically, whereas... ●…the consumer price index reflects the prices of all goods and services bought by consumers.