1. Measuring the Price Level and Inflation Chapter 9

2. Salary Comparisons $62,150 $48,200 $40,000 $61,000 San Diego, CA - $62,150 Austin, TX - $48,200 Hammond, LA - $40,00 Fort Lauderdale, FL - $61,000 $64,905 $42,514 $40,000 $60,762

3. $500 in 1988 has the same buying power as…

4. Inflation Inflation is a change in the general level of prices as measured by a price index such as the GDP deflator or the consumer price index. –Inflation is generally measured at an annual rate. –When inflation is high, the year-to-year changes in the inflation rate are nearly always highly variable, making them difficult to predict.

5. The Inflation Rate, 1956-2013 Between 1956 and 1965, the general price level increased at an average annual rate of only 1.6%. In contrast, the inflation rate averaged 9.2% from 1973 to 1981, reaching double-digits during several years. Since 1982, the average rate of inflation has been lower (2.9% from 1983-2013) and more stable. 19561960196519701975198019851990199520002005 -5% 5% 10% 15% 0% 1983-2013 average inflation rate = 2.9 % 1956-1965 average inflation rate = 1.6 % 1973-1981 average inflation rate = 9.2 % 2013

6. Price Indexes A price index measures the cost of purchasing a given market basket in a given year, where that cost is compared to an index of 100 for the selected base year. Two most commonly used price indexes:

7. Price Indexes

8. Consumer Price Index (CPI) For any period, measures the cost in that period of a standard basket of goods and services bought by the typical urban consumer, relative to the cost of the same basket of goods and services in a fixed year, called the base year. Measure of the overall level of prices

9. Price Indexes A price index measures the cost of purchasing a given market basket in a given year, where that cost is compared to an index of 100 for the selected base year. Step 1. Fix the Basket Step 2. Find the Prices Step 3. Complete the Basket’s Cost Step 4. Choose a Base Year and Compute the Price Index

10. Hypothetical Market Basket Used to Develop Consumer Price Index $1,350 $1,585

11. Price Index for 2006: Cost of Basket in 2006 x 100 Cost of Basket in 2005 Cost of Basket in 2005: $1,350 Cost of Basket in 2006: $1,585 To compute the price index for the current year, divide the total cost in the current year by the total cost of the same basket in the base year: Price Index for 2006: $1,585 x 100 $1,350 Price Index for 2006: 117

12. cost of basket PI 2005$1,350100 2006 1,585117 2007 1,652122 2008 1,782132 PI and the Inflation Rate: Inflation Rate 8.2% 4.3% 17% Inflation rate = Last year’s price index This year’s price index Last year’s price index - * 100

13. How the BLS constructs the CPI Published by the Bureau of Labor Statistics (BLS) Used to –track changes in the typical household’s cost of living –adjust many contracts for inflation –allow comparisons of dollar figures from different years Every month, collect data on prices of all items in the basket; compute cost of basket

14. The composition of the CPI’s “basket”

15. Inflation CPI –The CPI is a price index, or a measure of the average level of prices relative to prices in the base year. Rate of Inflation –The annual percentage rate of change in the price level, as measured, for example, by the CPI

16. Base Period 1982-84

17. Changes in the Price Level: 1900 – 2000

18. Adjusting for Inflation –Nominal Quantity A quantity that is measured in terms of its current dollar value –Real Quantity A quantity that is corrected for price changes. A “constant” dollar value

22. Adjusting for Inflation Real Wage –The wage paid to workers measured in terms of purchasing power –Finding real wages allows us to compare nominal wages over time by adjusting for the cost of living that changed over time.

23. Adjusting for Inflation Real Wages of U.S. Production Workers –An example: Nominal WagesCPI (1982 - 84 = 100)Real Wage 1970 $3.40 38.8 2004$15.68188.9

24. Nominal WagesCPI (1982 - 84 = 100)Real Wage in 1982 – 84 $ 1970$3.40 38.8 2004$15.68188.9 Nominal WagesCPI (1982 - 84 = 100)Real Wage in 2004 $ 1970$3.40 38.8 Nominal WagesCPI (1982 - 84 = 100)Real Wage in 1970 $ 2004$15.68188.9 $3.40 * (100/38.8) = $8.76 $15.68 * (100/188.9) = $8.30 $3.40 * (188.9/38.8) = $16.55 $15.68 * (38.8/188.9) = $3.22

26. Inflation and Interest Rates Nominal Interest Rate (market interest rate) –The annual percentage increase in the nominal value of a financial asset; the stated interest rate Real Interest Rate –The annual percentage increase in the purchasing power of a financial asset –The real interest rate on any asset equals the nominal interest rate on that asset minus the inflation rate

27. Example: Inflation and Interest Rates You have $500 and can spend it today on a ____________ or save it and earn 5% by saving the money for one year. In one year: –If you save you have earned: –With the original investment you will have ____. –Suppose you now go to purchase the same item and find the price is now $510. –Your real earnings from saving are:

28. Inflation and Interest Rates Inflation and the Real Interest Rate

29. –From lenders to borrowers You are lending $100 to your roommate for a year. You both agree that you should earn a 5% real rate of return for the year. If you make the loan in the base year, and you expect the inflation rate to be 4% over the year, what nominal rate of interest should you charge your roommate? 5% = Nominal Interest Rate - Inflation If you charge the interest rate you determined in part a, but the actual inflation rate was 6%, what was your real rate of return on the loan? Real interest rate = Nominal interest rate - Inflation

30. Inflation and Interest Rates Observations –Who benefits from unexpected inflation – borrowers or lenders?

31. Inflation and Interest Rates YearReal Interest = Nominal Interest - Inflation 19700.806.55.7 1975-3.35.89.1 1980-2.011.513.5 19853.97.53.6 19902.17.55.4 19952.75.52.8 20002.55.93.4 2004-1.31.42.7

32. Inflation and Interest Rates Fisher-Effect –The tendency for nominal interest rates to be high when inflation is high and low when inflation is low

33. Inflation and Interest Rates in the United States, 1960 - 2004

34. Unanticipated and Anticipated Inflation There are two different kinds of inflation: –Unanticipated inflation: An increase in the price level that comes as a surprise, at least for most individuals. –Anticipated inflation: A widely expected change in the price level.

35. Effects of Inflation High and variable rates of inflation are harmful for several reasons: –Because unanticipated inflation alters the outcomes of long-term projects like the purchase of a machine or operation of a business, it will both increase the risks and retard the level of such productive activities. –Inflation distorts the information delivered by prices. –People will respond to high and variable rates of inflation by spending less time producing and more time trying to protect their wealth and income from the uncertainty created by inflation.

36. Nearly all economists believe that rapid expansion in the money supply is the primary cause of inflation. What Causes Inflation?