1. Copyright©2004 South-Western Mods 14-15 Measuring the Cost of Living

2. Copyright©2004 South-Western Measuring Price Levels Seeing what happens with price levels in the economy at large is another measure of Macroeconomic functioning Price level can be measured, and inflation tracked InflationInflation refers to a situation in which the economy’s overall price level is rising. inflation rateThe inflation rate is the percentage change in the price level from the previous period.

3. Copyright©2004 South-Western THE COSTS OF INFLATION Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy because inflation also raises nominal incomes. So, if the level of prices rises AND your income rises at the same pace—there is no problem. **************************** In this case, the LEVEL OF PRICES does not matter!!!

4. Copyright©2004 South-Western A girl, her car, and her coffee v.1.0 $20 wkly income Gas—$2.00 /gal Coffee—$4.00/cup 1 gallon gas uses up 10% income 1 cup coffee uses up 20% income What happens if income doubles and so do prices??? Most gas possibleMost coffee possible To buy 1 more coffee, she gives up: 10 gallons gas5 cups coffee2 gallons gas

5. Copyright©2004 South-Western THE COSTS OF INFLATION However…. Sometimes, wages do not keep pace with inflation. OR… Sometimes, prices go up unexpectedly. SO… you can suffer from the ill-effects of inflation. *********************** In these cases, the RATE OF CHANGE OF PRICES matters!!!

6. Copyright©2004 South-Western A girl, her car, and her coffee v.2.0 What happens if prices double and income stays the same??? $20 wkly income—income stays the same Gas—$4.00 /gal—doubles in price Coffee—$8.00/cup—doubles in price 1 gallon gas uses up 20% income 1 cup coffee uses up 40% income Most gas possibleMost coffee possible To buy 1 more coffee, she gives up: 5 gallons gas2.5 cups coffee2 gallons gas

7. Copyright©2004 South-Western Inflation Info Inflation: Historical Aspects Over the past 60 years, prices have risen on average about 5 percent per year, in the U.S. In the 1970s prices rose by 7% per year. During the 1990s, prices rose at an average rate of just 2% per year.

8. Copyright©2004 South-Western Inflation Info Hyperinflation is an extraordinarily high rate of inflation. Germany in the 1920s Zimbabwe (2010)

9. Copyright©2004 South-Western Zimbabwe Hyperinflation Zimbabwe's Annual Inflation Rate is now 516 Quintillion % By Luke Burgess Wealth Daily—Tuesday, December 2nd, 2008 Hyperinflation has Zimbabwe in the throes of a financial crisis that makes the one we're dealing with look like a walk in the park. The monthly inflation rate in Zimbabwe is currently running at 13.2 billion per cent, and could reach an all-time world record within weeks. The latest figures put Zimbabwe's annual inflation rate at 516 quintillion per cent. That's 516 followed by 18 zeros. Consumer prices on everything from gasoline to glue are doubling on average every 1.3 days.

10. Copyright©2004 South-Western Zimbabwe Inflation Photos

11. Copyright©2004 South-Western INFLATION HISTORY Highest Monthly Inflation Rates in History Country Month with highest inflation rate Highest monthly inflation rate Equivalent daily inflation rate Time required for prices to double HungaryJuly 19461.30 x 10 16 %195%15.6 hours Zimbabwe Mid-November 2008 (latest measurable) 79,600,000,000%98.0%24.7 hours YugoslaviaJanuary 1994313,000,000%64.6%1.4 days GermanyOctober 192329,500%20.9%3.7 days GreeceNovember 194411,300%17.1%4.5 days ChinaMay 19494,210%13.4%5.6 days

12. Copyright©2004 South-Western Concerns about Deflation DeflationDeflation is a general drop in the overall price level of a nation You would think that would be a good thing; you know, Demand curve—lower price = higher quantity demanded but… When prices are falling, people put off buying things, to try to get the lowest price... so… Overall, business falls—and a recession occurs.

13. Copyright©2004 South-Western MEASURING INFLATION: THE CONSUMER PRICE INDEX The Consumer Price Index (CPI) is a measure of the overall cost (prices) of the goods and services bought by a typical consumer. It is used to measure inflation, and is used to calculate the Inflation Rate The Bureau of Labor Statistics (bls.gov) reports the CPI each month. It is used to monitor changes in the cost of living over time.

14. Copyright©2004 South-Western How the Consumer Price Index Is Calculated 1.Fix the Basket: Determine what prices are most important to the typical consumer. The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer (a family of four)buys.

15. FYI: What’s in the CPI’s Basket? 16% Food and beverages 17% Transportation Medical care 6% Recreation 6% Apparel 4% Other goods and services 4% 41% Housing 6% Education and communication Copyright©2004 South-Western

16. How the Consumer Price Index Is Calculated 2.Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. The BLS surveys thousands of businesses each month to collect data on 80,000 items

17. Copyright©2004 South-Western How the Consumer Price Index Is Calculated 3.Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. Add up the cost of each good multiplied by the number of each good

18. Copyright©2004 South-Western How the Consumer Price Index Is Calculated 4.Choose a Base Year Designate one year as the base year, making it the benchmark against which other years are compared. First CPI base year was 1947 Then, 1957…1967…1982-84 The base year today is still 1982-84

19. Copyright©2004 South-Western How the Consumer Price Index Is Calculated 5.Compute the Index: 5.Compute the Index:. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. Formula for CPI calculation: Price of Basket in current year Price of Basket in base year The base year CPI is, then, always 100—and goes up from there! x 100

20. Copyright©2004 South-Western How the Inflation Rate (% change) Is Calculated 6.Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

21. Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

22. Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

23. Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

24. Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western Formula for CPI calculation: Price of Basket in current year Price of Basket in base year x 100

25. Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

26. How the Consumer Price Index Is Calculated—and then the Inflation Rate Calculating the Consumer Price Index and the Inflation Rate: Another Example Base Year is 2002. Basket of goods in 2002 costs $1,200. The same basket in 2004 costs $1,236. CPI = ($1,236/$1,200)  100 = 103. Inflation Rate = 103-100/100 x 100 = 3% Prices increased 3 % between 2002 and 2004.

27. Copyright©2004 South-Western THE CONSUMER PRICE INDEX When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

28. 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.

29. Copyright©2004 South-Western Problems in Measuring the Cost of Living Substitution bias Introduction of new goods

30. 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.

31. 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.

32. Copyright©2004 South-Western Problems in Measuring the Cost of Living The substitution bias, and the introduction of new goods cause the CPI to OVERSTATE the true cost of living. General consensus: The CPI overstates inflation by about 1% point per year. However, the BLS has recently worked to correct these problems: example: adjusted the market basket of goods in 2009-2010 The issue is important because many government programs use the CPI to adjust for changes in transfer payment and other benefit programs.

33. Copyright©2004 South-Western Using the CPI for Indexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. The adjustment is called a COLA—Cost of Living Adjustment

34. Copyright©2004 South-Western CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times because just using dollar figures from different points in time do not represent a valid comparison of purchasing power.

35. Copyright©2004 South-Western Comparing Dollar Figures from Different Times Formula for Comparing Dollar Figures Across Time: = What item should cost in today’s $$

36. Copyright©2004 South-Western Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2014: Salary 2016 = Salary 1931 x Price level (CPI) for 2016 Price level (CPI) in 1931 =$80,000 x 236.9 15.2 =$1,246,842 If only inflation is at work, this is what Babe Ruth would be earning today. Why are BB players earning much more than this???? Comparing Dollar Figures from Different Times

37. Copyright©2004 South-Western Comparing Dollar Figures from Different Times

38. Copyright©2004 South-Western Old/New CPI Worksheet Westegg calculator: http://www.westegg.com/inflation/ Comparing Dollar Figures from Different Times

39. Copyright©2004 South-Western Another useful measure: The GDP Deflator The GDP deflator is not really a price index, but is used in the same way—to give us information on the extent of price changes in the economy It is calculated as follows:

40. Copyright©2004 South-Western Another useful measure: The GDP Deflator Because calculating Nominal GDP is based on current prices, and calculating Real GDP is based on using base year prices, the figure you obtain for the GDP Deflator shows the effect of price increases on your real GDP. If your Nominal is 1500 and your Real is 650, the GDP Deflator is 230. That means that price increases are accounting for about 2 1/3 the increase in nominal GDP.

41. Copyright©2004 South-Western The GDP Deflator versus the Consumer Price Index A difference between the two measures is: 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.

42. Copyright©2004 South-Western The GDP Deflator versus the Consumer Price Index The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)... …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. So…the GDP Deflator has a broader base of goods reflected in it.

43. Two Measures of Inflation: CPI and GDP Deflator 1965 Percent per Year 15 CPI GDP deflator 10 5 0 1970197519801985199020001995 Copyright©2004 South-Western

44. Other Price Indices The BLS calculates other price indices: The index for different regions within the country. The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. www.bls.gov

45. Copyright©2004 South-Western The Coincidence of Inflation Measures

46. Copyright©2004 South-Western IMPACTS OF INFLATION Shoeleather costs Menu costs Unit of account costs Those helped/those hurt

47. Copyright©2004 South-Western Shoe leather Costs Shoe leather costs is an allusion to the wear and tear caused by the extra running around that takes place when people are trying to avoid holding money or the increased costs of transactions caused by inflation.

48. Copyright©2004 South-Western Remember “A girl, her car, and her coffee v.2.0”????? What happens if prices double and income stays the same??? $20 wkly income—income stays the same Gas—$4.00 /gal—doubles in price Coffee—$8.00/cup—doubles in price 1 gallon gas uses up 20% income 1 cup coffee uses up 40% income Most gas possibleMost coffee possible To buy 1 more coffee, she gives up: 5 gallons gas2.5 cups coffee2 gallons gas

49. Copyright©2004 South-Western Shoe leather costs for our girl She would look for less expensive substitutes Drive around looking for cheaper gas Drive around—maybe walk around!!—looking for cheaper coffee Try to spend her $20 quicker b/c it is becoming worth “less”

50. Copyright©2004 South-Western Menu Costs and Unit of Account Costs Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices. This is a resource-consuming process that takes away from other productive activities. Unit of Account costs are the costs arising from the way inflation makes money a less reliable unit of measurement

51. Copyright©2004 South-Western Unit of Account Costs Example You own a house worth $100,000 Property tax is 1% of its value Each year, you pay $1000 property tax Over 2-3 years, real estate goes up in value— WAY UP!!! Now, your house is worth $200,000 on paper (in value, if you sold) It still is the same house!! It’s not a better house!! Your property tax is now $2000!!!

52. Copyright©2004 South-Western Inflation Rates and Real and Nominal Values Inflation Rates are important for interpreting values of several other measures. GDP Remember—we would adjust for the effect of rising prices by figuring REAL GDP, rather than NOMINAL GDP INTEREST RATES on loans or savings/investments also need adjusting WAGE RATES also need adjusting for the effects of inflation

53. Copyright©2004 South-Western Real and Nominal Interest Rates The Nominal INTEREST RATE is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays. The Real INTEREST RATE is the nominal interest rate that is corrected for the effects of inflation. Formula is: nominal interest rate - inflation rate = real interest rate

54. Copyright©2004 South-Western How Interest Works You lend a friend $100—he will pay you back in 1 year Why charge interest? You won’t have the money to buy things with, so you should get something for that service and your sacrifice (real interest rate) When he pays you back, inflation will have occurred, and so you won’t have the full value of the $100. Interest would help make up for it. (expected inflation rate) Nominal interest rate =Real interest rate + Inflation Rate So…you and your friend agree that inflation will probably be 5% this coming year, and that a fair “rent” of your money is 3% interest, for a total of 8% NOMINAL interest rate What could be the results??

55. Copyright©2004 South-Western Interest Rate Scenarios You expected 5% inflation and there was 5% inflation. When your friend paid you back $108, that gave you the equivalent of keeping your money even with inflation ($5) and then $3 for the use of it You expected 5% inflation, and there was only 1%. You came out ahead of inflation. You expected 5% inflation, and there was 8% inflation. You came out behind in this scenario (Borrowers benefit, Lenders lose!!)

56. Copyright©2004 South-Western The Nominal Interest Rate and the Inflation Rate Copyright © 2004 South-Western Percent (per year) 196019651970197519801985199019952000 0 3 6 9 12 15 Inflation Nominal interest rate

57. Copyright©2004 South-Western Real and Nominal Wage Rates The Nominal WAGE RATE is the wage rate you earn, not corrected for inflation. It is the wage or salary on paper that you are paid. The Real WAGE RATE is the nominal wage rate corrected for the effects of inflation. Formula is: nominal wage rate - inflation rate = real wage rate

58. Copyright©2004 South-Western Real and Nominal Wage Rates You earn $10.00 per hour (MA min 2016) During the year inflation is 10%. Nominal wage rate – Inflation rate = Real wage rate $10.00-1.00=$9.00

59. Copyright©2004 South-Western Those Helped/Those Hurt… A particular problem with Inflation is that some people are hurt by it, and some are helped by it—especially when it is unexpected!! Those helped: Those who can increase incomes Borrowers Government Those hurt: Fixed income Lenders Savers Remember: Borrowers Benefit; Lenders Lose