INFLATION- THE CONSUMER PRICE INDEX AND THE COST OF LIVING Principles of Macroeconomics Lecture 5

What do you think?  1976: Starting salary for an economics professor was $15,000  2001: Starting salary for an econ. prof. was $55,000.  Considering the REALITY PRINCIPLE, who had a better life?

Reality Principle  What matters to people is the real value of money – its PURCHASING POWER – not the nominal or face value of money.

CPI:  Consumer Price Index  A price index that measures the cost of a fixed basket of goods chosen to represent the consumption pattern of individuals.  Tracks the cost of living over time.

What is in the “market basket”?  Food and Beverages  Housing  Apparel  Transportation  Medical Care  Recreation  Education  Other goods and services

Food and Beverages  Breakfast Cereal  Milk  Chicken  Wine  Coffee  Service meals  Snacks

Housing  Rent for primary residences  Owners equivalent rent  Fuel Oil (home heating)  Bedroom furniture

Apparel  Men’s shirts and sweaters  Women’s dresses  Jewellery

Transportation  New cars  Airline fares  Gasoline  Car insurance

Medical Care  Prescription drugs  Medical supplies  Doctor services  Eyeglasses  Eyeglass services  Hospital care

Recreation  Television  Pets  Pet products  Sports equipment  Admissions

Education and Communication  College Tuition  Postage  Telephone Services  Computer Software  Computer accessories

Other Goods and Services  Tobacco and smoking products  Haircuts  Other personal services  Funeral Expenses

CPI  Used by both government and the private sector to measure changes in prices facing consumers.

CPI versus GDP  CPI measures goods produced in prior years (older cars) as well as imported goods.  Chained GDP does not measure either of these. ONLY new goods and those produced in the country.

CPI vs GDP  Because consumers will cut back on goods that cost more – the CPI will tend to overstate true changes in cost of living.  If chicken goes up in price, we switch to hamburger.

CPI Problems  Does not “cut back” on higher priced goods like consumers do.  Would still count the same share of chicken as it did before the price index.

What Economists THINK  CPI may be overestimated by 0.5% to 1.5% each year.  BIG argument among the econ community.

Cost of Living Adjustments  Automatic increases in wages or other payments that are tied to a price index.  For Future Reference on contract negotiations: Called COLA.

COLA and CPI  As CPI goes up, our wages or Social Security makes adjustments to keep up with the cost of living.

INFLATION  Inflation Rate:  The percentage rate of change of the price level of the economy.

Calculating Inflation Rates  Inflation Rate = percentage rate of change of a price index.  See page 124 for more on how to calculate!

INFLATION – The trade-off with more employment.

Types of Inflation Demand-Pull Inflation Cost-Push Inflation Monetary Inflation Stagflation Hyperinflation

Demand-Pull Inflation When the demand for goods and services exceeds the production capacity. – Prices rising because of shortages.

Cost-Push Inflation Inflation can arise from changes in the costs of production of goods and services. – Increase in the price of raw materials – Increase in the price of labor – Increase in the cost of capital.

Cost-Push v. Demand Pull They push and pull prices up. – Labour contracts containing COLA clauses. C ost- O f- L iving A djustments.

Monetary Inflation Inflation caused by excessive growth in the money supply. – Value of money decreases if it isn’t that “rare.”

Rule for Monetary Inflation: VELOCITY Quantity Equation – M x V = T x P – Money supply times the velocity at which it changes hands equals the number of transactions times the average level of prices.

M x V = T x P Direct relationship between the money supply and the price level.

What happens when the quantity equation is “ off ” ? Hyperinflation Money supply increases much, much faster than an economy’s output of goods and services. – THINK RUSSIA in 1990s. – Zimbabwe in 2000s – Germany post WWI

Phillips Curve: The relationship between unemployment and inflation. INVERSE relationship. Unemployment goes UP, then inflation goes DOWN.

Stagflation: When things REALLY go wrong on the Phillips Curve Inflation and unemployment were at higher levels. – Combination of stagnation and inflation. – Both were increasing.

1970s: What caused Stagflation? Spending on the Vietnam War PLUS spending on domestic social programs. Inflationary expectations Rise in energy costs caused by OPEC Monopolistic pricing

What is wrong with Inflation? Inflation reduces REAL INCOME of those whose incomes do not rise as fast as the price level. Hurts: – People holding assets in MONEY – Lenders

Special Note: Phillips Curve International – Europe 1970s had higher inflation and unemployment. – Worse because: Labour union practices Tax structures Government economic policies

Consequences of INFLATION Income Effects: – Reduced purchasing power of the dollar – Reduced real income for fixed income receivers – Reduced real wealth of savings

Income Effects of Inflation (cont.) Benefits those whose incomes rise faster than the inflation rate. Benefits owners of real assets (real estate, precious metals (kinda!)) Benefits debtors

How Inflation effects Real Output Inflation initially stimulates output Near full employment, there arise bottlenecks in supplies Costs begin rising faster than prices Interest rates accelerate, discouraging new investment.

Helpful Reading Economics. Samuelson, & Nordhaus (2005) Ch