1. Chapter 8
8.1

2. Macroeconomic Performance
Since each economy has several different markets usually people will focus on the macroeconomic aggregates. (total unemployment)
Two really important indicators in recent economics are inflation and unemployment.

3. Importance of Information
There is not one source of information for the economy.
The information comes from multiple sources like the IMF, World Bank and United Nations.
This is why it is important to be up to date with data because it is always changing.

4. Real and Nominal Measurements
Nominal value: the value of an economic variable based on current prices, taking no account of changing prices through time.
Real value: the value of an economic variable taking account of changing prices through time.

5. Example
Suppose last year you bought a tub of ice cream for 100 baht, but inflation has been 10%, so this year you have to pay 110 baht. Your REAL consumption has not changed, but your spending has increased.
Real consumption has not changed at all, although nominal value has increased to 110 baht.

6. Index Numbers
Index numbers are a device for comparing the value of a variable in one period of time or location with base observation. (Example the retail price index measures the average level of prices relative to a base period)
Cost of living represents the households cost of goods over time relative to the base year.

7. Inflation vs Price Level
The phenomenon of inflation refers to a continual rise of the price-level. When inflation occurs, the purchasing power of a unit of money (the dollar in the United States) is declining. The inflation rate is calculated by comparing the price level in one time period to the price level of a previous period.

8. Measuring the Price Level
8.2

9. The Consumer Price Index
The price level is the “average” level of prices and is measured by using a price index.
The consumer price index, or CPI, measures the average level of the prices of goods and services consumed by an urban family.

10. The Consumer Price Index
Constructing the CPI
Constructing the CPI involves three stages:
Selecting the CPI basket
Conducting a monthly price survey
Using the prices and the basket to calculate the CPI

11. The Consumer Price Index
Housing is the largest component.
Transportation and food and beverages are the next largest components.
The remaining components account for only 26 percent of the basket.

12. The Consumer Price Index
The CPI basket is based on a Consumer Expenditure Survey.
The current CPI is based on a survey, although the reference base period is still
Every month, BLS employees check the prices of 80,000 goods and services in 30 metropolitan areas.
The CPI is calculated using the prices and the contents of the basket.

13. The Consumer Price Index
For a simple economy that consumes only oranges and haircuts, we can calculate the CPI.
The CPI basket is 10 oranges and 5 haircuts.
Item
Quantity
Price
Cost of CPI basket
Oranges 10
$1.00
$10
Haircuts 5
$8.00
$40
Cost of CPI basket at base period prices
$50

14. The Consumer Price Index
This table shows the prices in the base period.
The cost of the CPI basket in the base period was $50.
Item
Quantity
Price
Cost of CPI basket
Oranges 10
$1.00
$10
Haircuts 5
$8.00
$40
Cost of CPI basket at base period prices
$50

15. The Consumer Price Index
This table shows the prices in the current period.
The cost of the CPI basket in the current period is $70.
Item
Quantity
Price
Cost of CPI basket
Oranges 10
$2.00
$20
Haircuts 5
$10.00
$50
Cost of CPI basket at base period prices
$70

16. The Consumer Price Index
The CPI is calculated using the formula:
CPI = (Cost of basket in current period/Cost of basket in base period)  100.
Using the numbers for the simple example, the CPI is
CPI = ($70/$50)  100 = 140.
The CPI is 40 percent higher in the current period than in the base period.

17. The Consumer Price Index
Measuring Inflation
The main purpose of the CPI is to measure inflation.
The inflation rate is the percentage change in the price level from one year to the next.
The inflation formula is:
Inflation rate = [(CPI this year – CPI last year)/CPI last year]  100.

18. The Consumer Price Index
Figure 6.13 shows the CPI and the inflation rate, 1973–2003.

19. The Consumer Price Index
The Biased CPI
The CPI may overstate the true inflation for four reasons
New goods bias
Quality change bias
Commodity substitution bias
Outlet substitution bias.

20. The Consumer Price Index
The Biased CPI
New goods bias New goods that were not available in the base year appear and, if they are more expensive than the goods they replace, the price level may be biased higher.
Similarly, if they are cheaper than the goods they replace, but not yet in the CPI basket, they bias the CPI upward.
Quality change bias Quality improvements generally are neglected, so quality improvements that lead to price hikes are considered purely inflationary.

21. The Consumer Price Index
The Biased CPI
Commodity substitution bias The market basket of goods used in calculating the CPI is fixed and does not take into account consumers’ substitutions away from goods whose relative prices increase.
Outlet substitution bias As the structure of retailing changes, people switch to buying from cheaper sources, but the CPI, as measured, does not take account of this outlet substitution.

22. The Consumer Price Index
The Biased CPI
A Congressional Advisory Commission estimated that the CPI overstates inflation by 1.1 percentage points a year.
The bias in the CPI distorts private contracts, increases government outlays (close to a third of government outlays are linked to the CPI), and biases estimates of real earnings.
To reduce the bias in the CPI, the BLS will undertake consumer expenditure surveys more frequently and revise the CPI basket every two years.

23. Retail Price Index
CPI and RPI are nearly calculated the same. Both want to measure price levels at a certain time.
RPIX does not take into account household goods and excludes retired people and the super rich.

24. RPIX, RPI and CPI
The RPI (Retail price index) includes mortgage interest payments. Thus changes in the interest rates effect the RPI. If interest rates are cut, it will reduce mortgage interest payments. Thus the RPI will fall but not the CPI.
The RPI also includes council tax and some other housing costs not included in CPI
The CPI includes some financial services not included in the RPI
The CPI is based on a wider sample of the population for working out weights.
RPIX is the same as RPI minus mortgage interest payments.
RPIX is closer to CPI but not exactly same.

25. The Experience of Inflation
8.3

26. Zimbabwe inflation hits 231 million per cent
What is inflation?
Inflation is a general and sustained rise in the level of prices of goods and services
i.e. prices of the vast majority of goods and services keep on rising
9 October 2008
Zimbabwe inflation hits 231 million per cent
A loaf of bread, which cost Z$500 at the beginning of August, now costs between Z$7,000 and Z$10,000
Some countries have experienced hyperinflation in the past: runaway inflation during which prices rise at phenomenal rates and money becomes almost worthless

27. How to measure inflation
There are many millions of different goods and services exchanged in an economy, so most countries track the prices of a selection of goods and services to construct a price index
Year 0 (base year)
Identify the basket of goods and services purchased by the ‘typical’ family
Monitor the ‘average’ price of each item in the basket at a sample of different retail outlets
Monitor how much the ‘typical’ family spends on each item in the basket
Weight the average price of each item by the proportion of household expenditure spent on it
Add up all the weighted average prices
Set the total weighted average price of the basket equal to 100
Year 1 onwards
Repeat the monitoring of household spending patterns and prices
Compare the total weighted average price of the basket to base year to calculate the change in the price index

28. Calculating a consumer price index
Price of basket was $25 in base year, so annual inflation has been 8%, i.e.
Note: The basket of goods and services bought and the weights applied to each item in the basket may change from year to year as products and spending patterns change

29. Uses of price indices As an economic indicator
A consumer or retail price index is a widely used measure of price inflation and therefore a measure of changes in the cost of living
As a price deflator
Rising prices reduce the purchasing power of wages, profits, pensions, savings, tax revenues, and a host of other economic variables of importance to different groups of people and decision makers. A price index is therefore used to calculate changes in their real values over time
For indexation
Indexation involves increasing certain payments and values, such as state pensions and income tax thresholds, by the annual rate of increase in price inflation in order to keep their real value constant

30. The costs of inflation
Low and stable price inflation can be beneficial for an economy:
It encourages consumers to buy goods and services sooner rather than later
It reduces the real cost of loan repayments (think nominal and real values)
But high or rising inflation can be bad for an economy:
Inflation erodes the value or purchasing power of money. People, especially those on low and fixed incomes, cannot buy as much as they did before with their incomes. Demand for many products will fall if real incomes continue to be squeezed
It increases the costs of production and reduces profits margins
It reduces the price competitiveness of exports
It creates economic uncertainty. Consumers, firms and governments will be uncertain about their future costs and the impact rising inflation could have on their incomes and revenues. Firms may cut their investment and consumers their spending
Stagflation: an economic situation when unemployment and inflation are both high and/or rising

31. What is deflation?
Japanese inflation, 1970–2010 (% annual change in CPI)
Disinflation refers to a slowdown in the rate at which prices are rising in general
but
deflation involves a continuous decline in the general level of prices in an economy

32. So what’s so bad about falling prices?
Increasing supply, competition, productivity and technological advance are good things for an economy and consumers, and have reduced the prices of many products over time, such as mobile phones, televisions, cars, holidays and clothing, in many countries
However, when falling product prices become widespread and prolonged due to a slump in aggregate demand, the result is malign deflation
In addition, the real cost of borrowing and public spending rises. Firms cut investment and the government must cut spending or raise taxes.
Eventually the economy goes into a deep recession as demand, output, the demand for labour, and incomes continue to fall. Many firms may go out of business because they are unable to make any profit no matter how much they cut their prices.

33. 8.4

34. Theory of Money Money Stock: the quantity of money in the economy.
Velocity of circulation: the rate at which money changes hands: the volume of transactions divided by the money stock.

35. Supply Shock
A supply shock is an event that suddenly increases or decreases the supply of a commodity or service, or of commodities and services in general. This sudden change affects the equilibrium price of the good or service or the economy's general price level.

36. Demand-pull or cost-push inflation?
A demand-pull inflation is caused by aggregate demand rising faster than the aggregate supply of goods and services
A cost-push inflation is caused by rising wages and other production costs. Firms will raise their prices to cover these additional costs
A rise in import prices may cause an imported inflation. Import prices may rise following a fall in the exchange rate of the importing country

37. What causes inflation?
Economists today tend to agree that the main cause of inflation is ‘too much money chasing too few goods’
i.e. if the money supply increases at a faster rate than the aggregate supply of goods and services then the general level of prices will rise
The money supply may expand to meet demand and cost pressures ►

38. Consequences of Inflation
8.5

39. Consequences of Inflation
Many governments have set their central banks a target for a low but positive rate of inflation. They believe that persistently high inflation can have damaging economic and social consequences.

40. Consequences of Inflation
Income redistribution: One risk of higher inflation is that it has a regressive effect on lower-income families and older people in society. This happen when prices for food and domestic utilities such as water and heating rises at a rapid rate
Falling real incomes: With millions of people facing a cut in their wages or at best a pay freeze, rising inflation leads to a fall in real incomes.

41. Consequences of Inflation
Negative real interest rates: If interest rates on savings accounts are lower than the rate of inflation, then people who rely on interest from their savings will be poorer. Real interest rates for millions of savers in the UK and many other countries have been negative for at least four years

42. Consequences of Inflation
Cost of borrowing: High inflation may also lead to higher borrowing costs for businesses and people needing loans and mortgages as financial markets protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt. There is also pressure on the government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.

43. Consequences of Inflation
Risks of wage inflation: High inflation can lead to an increase in pay claims as people look to protect their real incomes. This can lead to a rise in unit labour costs and lower profits for businesses

44. Consequences of Inflation
Business competitiveness: If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. Eventually this may show through in reduced export orders, lower profits and fewer jobs, and also in a worsening of a country’s trade balance. A fall in exports can trigger negative multiplier and accelerator effects on national income and employment.

45. Consequences of Inflation
Business uncertainty: High and volatile inflation is not good for business confidence partly because they cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending.