1. INFLATION AP Economics

2. Measuring Inflation Country and Time- Zimbabwe, 2008 Annual Inflation Rate- 79,600,000,000% Time for Prices to Double- 24.7 hours

3. What is Inflation? Inflation: The rising general level of prices Inflation reduces the “purchasing power” of money Examples: It takes $2 to buy what $1 bought in 1982. It takes $6 to buy what $1 bought in 1961 When inflation occurs, each dollar buys fewer goods than before.

4. INTRODUCTION TO INFLATION VIDEO http://www.econedlink.org/interactives/EconEdLink-interactive-tool- player.php?iid=205

5. Make a T-Chart Hurt by Inflation Helped by Inflation Lenders—People who lend money (at fixed interest rates) People with fixed incomes Savers Borrowers A business where the price of the product increases faster than the price of resources Cost of Living Adjustment (COLA) Some workers have salaries that mirror inflation. They negotiate wages that rise with inflation.

6. How is Inflation measured? Two ways: Price Indices Consumer Price Index Producer Price Index GDP deflator Inflation Rate

7. Consumer Price Index (CPI) Measures the typical consumer’s cost of living The basis of COLAS in many contracts & in Social Security Calculated using a “market basket” of 300 commonly purchased items.

8. Problems with CPI Substitution Bias When the economy goes south, consumers substitute goods. However, because the CPI is based on a fixed basket, it misses these changes. CPI overstates increases in the cost of living. Introduction of New Goods. New goods are introduced all the time, allowing consumers to find products that more closely meet their needs. Because of the competition, dollars become more valuable. Because the basket is set, new items are not added/counted for. CPI overstates increases in the cost of living. CPI misses changes in consumer preferences, leading to CPI being overstated.

9. Imported consumer goods: included in CPI excluded from GDP deflator Imported consumer goods: included in CPI excluded from GDP deflator Contrasting the CPI and GDP Deflator The basket:  CPI uses fixed basket  GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. The basket:  CPI uses fixed basket  GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. Capital goods:  excluded from CPI  included in GDP deflator (if produced domestically) Capital goods:  excluded from CPI  included in GDP deflator (if produced domestically)

10. Producer Price Index (PPI) Cost of a basket of goods & services bought by firms rather than consumers PPI is thought to be a good predictor of changes in CPI. Why? Firms eventually pass on their costs to consumers. 1. PPI increases (cost for producers) 2. Producers raise prices and the cost of goods increases 3. CPI increases (cost for consumers)

11. Inflation Formulas Price Index (PI) Formula: Inflation Rate Formula 100 x cost of basket in current year cost of basket in base year PI this year – PI last year PI last year Inflation rate x 100% =

12. ACTIVE LEARNING Calculate the CPI ACTIVE LEARNING 1 Calculate the CPI CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2010, the base year. A. Compute the CPI in 2011. B. What was the CPI inflation rate from 2011–2012? price of beef price of chicken 2010$4 2011$5 2012$9$6

13. ACTIVE LEARNING Answers ACTIVE LEARNING 1 Answers A. Compute the CPI in 2011: Cost of CPI basket in 2011 = ($5 x 10) + ($5 x 20) = $150 CPI in 2011 = 100 x ($150/$120) = 125 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2010, the base year. price of beef price of chicken 2010$4 2011$5 2012$9$6 100 x cost of basket in current year cost of basket in base year

14. ACTIVE LEARNING Answers ACTIVE LEARNING 1 Answers price of beef price of chicken 2010$4 2011$5 2012$9$6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2010, the base year. B. What was the inflation rate from 2011–2012? Cost of CPI basket in 2012 = ($9 x 10) + ($6 x 20) = $210 CPI in 2012 = 100 x ($210/$120) = 175 CPI inflation rate = (175 – 125)/125 = 40% CPI this year – CPI last year CPI last year Inflation rate x 100% =

15. ACTIVE LEARNING Substitution bias ACTIVE LEARNING 2 Substitution bias CPI basket: {10 beef, 20 chicken} 2010–11: Households bought CPI basket. 2012: Households bought {5 lbs beef, 25 lbs chicken}. beefchicken cost of CPI basket 2010$4 $120 2011$5 $150 2012$9$6$210 A. Compute cost of the 2012 household basket. B. Compute % increase in cost of household basket over 2011–12, compare to CPI inflation rate.

16. ACTIVE LEARNING Answers ACTIVE LEARNING 2 Answers A. Compute cost of the 2012 household basket. ($9 x 5) + ($6 x 25) = $195 CPI basket: {10 beef, 20 chicken} Household basket in 2012: {5 beef, 25 chicken} beefchicken cost of CPI basket 2010$4 $120 2011$5 $150 2012$9$6$210

17. ACTIVE LEARNING Answers ACTIVE LEARNING 2 Answers B. Compute % increase in cost of household basket over 2011–12, compare to CPI inflation rate. Rate of increase: ($195 – $150)/$150 = 30% CPI inflation rate from previous problem = 40% CPI basket: {10 beef, 20 chicken} Household basket in 2012: {5 beef, 25 chicken} beefchicken cost of CPI basket 2010$4 $120 2011$5 $150 2012$9$6$210

18. Review

19. Causes of Inflation 1. The Quantity Theory of Money The government prints too money. Keeps printing money to pay debts and ends up with hyperinflation. 2. Demand-Pull Inflation Too many dollars chasing too few goods. Demand pulls up prices  shortage drives up prices. 3. Cost-Push Inflation Wage Price Spiral Higher production costs increase prices.

20. A Perpetual Process: 1.Workers demand raises 2.Owners increase prices to pay for raises 3. High prices cause workers to demand higher raises 4. Owners increase prices to pay for higher raises 5. High prices cause workers to demand higher raises 6. Owners increase prices to pay for higher raises The Wage-Price Spiral

21. CARTOON VIDEO: WHY PLAY LEAP FROG? https://www.youtube.com/watch?v=dXgUGtwmyq8

22. Interest Rates 22

23. Interest Rates and Inflation What are interest rates? Why do lenders charge them? Who is willing to lend me $100 if I will pay a total interest rate of 100%? (I plan to pay you back in 2050) If the nominal interest rate is 10% and the inflation rate is 15%, how much is the REAL interest rate? Real Interest Rates- The percentage increase in purchasing power that a borrower pays. (adjusted for inflation) Real = nominal interest rate - expected inflation Nominal Interest Rates- the percentage increase in money that the borrower pays not adjusting for inflation. Nominal = Real interest rate + expected inflation

24. Nominal vs. Real Interest Rates Example #1: You lend out $100 with 20% interest. Inflation is 15%. A year later you get paid back $120. What is the nominal and what is the real interest rate? Nominal interest rate is 20%. Real interest rate was 5% In reality, you get paid back an amount with less purchasing power. Example #2: You lend out $100 with 10% interest. Prices are expected to increased 20%. In a year you get paid back $110. What is the nominal and what is the real interest rate? Nominal interest rate is 10%. Real rate was –10% In reality, you get paid back an amount with less purchasing power.

25. SUMMARY The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumer’s “basket” of goods & services. The CPI is used to make Cost of Living Adjustments and to correct economic variables for the effects of inflation. The real interest rate is corrected for inflation and is computed by subtracting the inflation rate from the nominal interest rate.