1 Frank & Bernanke 4th edition, 2009 Ch. 5: Inflation and the Price Level

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3 Who Is Making More? A 2008 graduate of Hiram College got a job that pays $40,000 per year. Thirty-four years ago (1974), her father started his career with a $8,000 job. Is she making five times as much as her father did?

4 Who Is Making More? In order to compare the incomes of two different periods we have to eliminate the effect of inflation. What happened to prices between 1974 and 2008? Let’s find out the Consumer Price Index (CPI).

5 Who Is Making More? According to Bureau of Labor Statistics (ftp://ftp.bls.gov/pub/special.requests/cpi/ cpiai.txt), CPI in 1974 was 49.3.ftp://ftp.bls.gov/pub/special.requests/cpi/ cpiai.txt CPI in 2008 was Base year was If the average price level in 1974 was lower than in 2008, our graduate must not have been five times better off.

6 Who Is Making More? In real terms: –She made (40,000/2.153) = $18, in 1983 dollars. –He made (8,000/.493) = $16, in 1983 dollars. How much was his pay in 2008 dollars? –His pay is (8,000)(2.153/.493) = $34,937.12

7 How To Calculate The CPI? Fix the basket a typical consumer will buy. Find the prices of the items for different years. Compute the basket’s cost for each year. Choose a base year. Calculate the cost of the basket for other years in terms of the base year. Calculate inflation rates.

8 The Consumer Price Index: Measuring the Price Level Constructing the CPI Constructing the CPI Bureau of Labor Statistics (BLS) Bureau of Labor Statistics (BLS) Pick a base year Pick a base year Conduct the consumer expenditure survey to determine the base-year basket of goods and services Conduct the consumer expenditure survey to determine the base-year basket of goods and services Measure the current prices of the base-year basket Measure the current prices of the base-year basket

9 CPI Calculation BASKET Beer20 Pizza10 DVD5 P (2000) $1.00 $2.00 $5.00 P (2010) $1.50 $2.50 $6.00 Value$65.00$85.00 CPI = 85/65 = 1.325

10 Problems With CPI Substitution bias. –Basket changes as a response to relative price changes do not get accounted. New products. –Basket changes are ignored. –Prices of new products fall before they are included in the new basket. Quality change. –If the same gadget has higher quality now than in the past but viewed as the same item, an increase in price is not inflationary.

11 Calculating Inflation Rates: YearCPI

12 Calculating Inflation Rates: YearCPI

13 Does the CPI Measure “True” Inflation? 1996 report by the Boskin Commission estimated that the CPI overstates inflation by as much as 1 to 2 percentage points a year report by the Boskin Commission estimated that the CPI overstates inflation by as much as 1 to 2 percentage points a year. Overstating Inflation Overstating Inflation Would unnecessarily increase government spending Would unnecessarily increase government spending Underestimate the improvements in the standard of living Underestimate the improvements in the standard of living

14 Adjusting for Inflation Real Wage Real Wage The wage paid to workers measured in terms of real purchasing power The wage paid to workers measured in terms of real purchasing power The real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period The real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period

15 Nominal and Real Wages for Production Workers’

16 GDP Deflator vs. CPI Space shuttle costs more to operate. –Deflator is up, CPI unchanged. Antiques cost more. –CPI is up, deflator unchanged. Porsche increases the price. –CPI is up, deflator unchanged. New homes cost more. –Both CPI and deflator up.

17 Indexation If payments are automatically corrected for inflation, they are said to be indexed. –COLA –Social Security –TIPS –Variable mortgage rates

18 Adjusting for Inflation Indexing to Maintain Buying Power Indexing to Maintain Buying Power An example: An example: Social Security PaymentInflation 2000$1,000/month = 20% 2005$1,200/month indexed to inflation

19 The Costs of Inflation: Not What You Think Observations Observations Changes in relative price do not necessarily imply a significant amount of inflation. Changes in relative price do not necessarily imply a significant amount of inflation. Inflation can be high without affecting relative prices. Inflation can be high without affecting relative prices.

20 The Costs of Inflation: Not What You Think Observations Observations To counteract relative price changes, government policy would have to affect the market for specific goods. To counteract relative price changes, government policy would have to affect the market for specific goods. To counteract inflation, the government must use monetary and fiscal policy. To counteract inflation, the government must use monetary and fiscal policy.

21 Costs of Inflation Shoe-leather costs Shoe-leather costs Economizing on cash Economizing on cash More frequent trips to the bank More frequent trips to the bank More bank employees More bank employees Efforts to avoid the erosion of purchasing power Efforts to avoid the erosion of purchasing power

22 Costs of Inflation Noise in the price system Noise in the price system Is it an increase in the demand for a product or is it a general increase in prices? Is it an increase in the demand for a product or is it a general increase in prices? Should the supplier increase output or not? Should the supplier increase output or not?

23 Costs of Inflation Distortions of the tax system Distortions of the tax system Depreciation allowance and the replacement cost Depreciation allowance and the replacement cost Bracket creep Bracket creep

24 Costs of Inflation Unexpected distribution of wealth Unexpected distribution of wealth Real wage down => workers lose, employers gain Real wage down => workers lose, employers gain Borrowers gain and creditors lose Borrowers gain and creditors lose

25 Costs of Inflation Interference with long-run planning Interference with long-run planning Increase uncertainty Increase uncertainty Impossible to predict the future Impossible to predict the future

26 Hyperinflation Inflation of 500 or more per cent per year. Inflation of 500 or more per cent per year. Germany in early twenties. Germany in early twenties. Latin America. Latin America. Zimbabwe: 150,000% in 2007! Zimbabwe: 150,000% in 2007!

27 Hyperinflation Economic Naturalist Economic Naturalist Fischer, Sahay, and Vegh examined 133 market economies Fischer, Sahay, and Vegh examined 133 market economies episodes of high inflation (100% +) in 25 countries 45 episodes of high inflation (100% +) in 25 countries Real GDP/person fell by an average of 1.6%/yr Real GDP/person fell by an average of 1.6%/yr Real consumption/ person fell by an average of 1.3%/yr Real consumption/ person fell by an average of 1.3%/yr Real investment/person fell by an average of 3.3%/yr Real investment/person fell by an average of 3.3%/yr "Modern Hyper- and High Inflations", Journal of Economic Literature. September 2002, Volume XL, Number 3,

Hyperinflation in Zimbabwe 28 /institute/annual/2011/annual11b.pdf

29 Real and Nominal Interest Rates If you lend someone $1000 for a year and ask for a 5% interest, you will get $1050 at the end of the year. If inflation during the year were 10%, the products you could buy with your $1000 at the beginning of the year now costs $1100. Are you better-off or worse-off?

30 Real and Nominal Interest Rates Lenders will always ask a higher interest rate than the expected inflation to earn income. Nominal interest rates are what the bank quotes, what the car dealer quotes. Real interest rates are nominal rates corrected for inflation. i = r + π

31 The Real Interest Rate in the United States,

32 Inflation and Interest Rates in the United States,

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