1. MBMC Measuring the Price Level and Inflation

2. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 2 Introduction What Do You Think? Could you retire in thirty years if you have $100 million?

3. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 3 The Consumer Price Index: Measuring the Price Level Consumer Price Index (CPI) For any period, measures the cost in that period of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed year, called the base year

4. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 4 Monthly Household Budget of the Typical Family in 1995 (Base Year) Item Cost (in 1995) Rent, two-bedroom apartment$500 Hamburgers (60 at $2.00 each)120 Movie tickets (10 at $6.00 each) 60 Total expenditure$680 Constructing a Hypothetical CPI

5. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 5 Cost of Reproducing the 1995 (Base-Year) Basket of Goods and Services in Year 2000 Item Cost (in 1995) Rent, two-bedroom apartment$630$500 Hamburgers (60 at $2.00 each)150120 Movie tickets (10 at $6.00 each) 7060 Total expenditure$850$680 Cost (in 2000) Constructing a Hypothetical CPI

6. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 6 The Consumer Price Index: Measuring the Price Level Constructing the CPI Bureau of Labor Statistics (BLS)  Pick a base year  Conduct the consumer expenditure survey to determine the base-year basket of goods and services  Measure the current prices of the base-year basket

7. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 7 Cost of Reproducing the 1995 (Base-Year) Basket of Goods and Services in Year 2000 Item Cost (in 1995) Rent, two-bedroom apartment$630$500 Hamburgers (60 at $2.00 each)150120 Movie tickets (10 at $6.00 each) 7060 Total expenditure$850$680 Cost (in 2000) Constructing a Hypothetical CPI The CPI in year 2000 = $850/$680 = 1.25 Base year = 1.00 The cost of living increased by 25% from 1995 to 2000

8. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 8 The Consumer Price Index: Measuring the Price Level Constructing the CPI The CPI for a given period measures the cost of living for that period relative to the base year

9. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 9 The Consumer Price Index: Measuring the Price Level Constructing the CPI The CPI is a price index. Price Index A measure of the average price of a given class of goods or services relative to the price of the same goods and services in a base year

10. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 10 Inflation CPI Measures the average level of prices relative to prices in the base year Inflation Measures how fast the average price level is changing over time

11. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 11 Inflation Rate of Inflation The annual percentage rate of change in the price level

12. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 12 Calculating Inflation Rates: 1972 - 1976 YearCPI 19720.418 19730.444 19740.493 19750.538 19760.569

13. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 13 Calculating Inflation Rates: 1929 - 1933 YearCPI 19290.171 19300.167 19310.152 19320.137 19330.130

14. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 14 Inflation Deflation A situation in which the prices of most goods and services are falling over time so that inflation is negative

15. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 15 Adjusting for Inflation Deflating a Nominal Quantity Nominal Quantity  A quantity that is measured in terms of its current dollar value Real Quantity  A quantity that is measured in physical terms -- for example, in terms of quantities of goods and services

16. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 16 Adjusting for Inflation Deflating a Nominal Quantity Deflating (a nominal quantity)  A process of dividing a nominal quantity by a price index (such as the CPI) to express the quantity in real terms

17. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 17 Comparing the Real Values of a Family’s Income in 1995 and 2000 Year Real family income = Nominal family income/CPI 1995$20,0001.00$20,000/1.00 = $20,000 2000$22,0001.25$22,000/1.25 = $17,600 Nominal family income CPI

18. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 18 Adjusting for Inflation Example Home run hitters drive Cadillacs  1930 Babe Ruth’s salary was $80,000  1998 Mark McGwire’s salary was $8.3 million  CPI (1982 - 84 = 100) o1930 = 0.167 o1998 = 1.64 oBabe Ruth’s real salary = $80,000/0.167 = $479,000 oMark McGwire’s real salary = $8.3 million/1.64 = $5.06 million

19. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 19 Adjusting for Inflation Real Wage The wage paid to workers measured in terms of real purchasing power The real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period

20. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 20 Adjusting for Inflation Real Wages of U.S. Production Workers An example: Nominal WagesCPI (1982 - 84 = 100)Real Wage 1970$3.230.388$3.23/0.388 = $8.32 1990$10.011.307$10.01/1.307 = $7.66

21. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 21 Nominal and Real Wages for Production Workers’ 1960 - 2001

22. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 22 Adjusting for Inflation Indexing The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation

23. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 23 Adjusting for Inflation Indexing to Maintain Buying Power An example: Social Security PaymentInflation 2000$1,000/month2000 - 2005 = 20% 2005$1,200/month indexed to inflation

24. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 24 Adjusting for Inflation Example An indexed labor contract  Contract specifics o1st year wage = $12/hr oReal wage will rise 2 percent in the 2nd and 3rd year  CPI: Year 1 = 1.00; Year 2 = 1.05; Year 3 = 1.10  Year 2 wage = w 2 /1.05 = $12 x 1.02 = $12.24 oW 2 = $12.24 X 1.05 = $12.85  Year 3 wage = w 3 /1.10 = 12.24 x 1.02 = $12.48 oW 3 = $12.48 X 1.10 = $13.73

25. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 25 Adjusting for Inflation Economic Naturalist Every few years there is a well-publicized battle in Congress over whether the minimum wage should be raised. Why do these heated debates recur so regularly?

26. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 26 Does the CPI Measure “True” Inflation? 1996 report by the Boskin Commission estimated that the CPI overstates inflation by as much as 1 to 2 percentage points a year. Overstating Inflation Would unnecessarily increase government spending Underestimate the improvements in the standard of living

27. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 27 Does the CPI Measure “True” Inflation? Two Causes of the CPI Overestimation of Inflation Quality adjustment bias Substitution bias

28. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 28 Items Expenditure 1995 Prices 2000 Prices Does the CPI Measure “True” Inflation? Coffee (50 cups at $1/cup)$50$2/cup = $100 Tea (50 cups at $1/cup)$50$1/cup = $50 Scones (100 at $1 each)$100$1.50/cup = $150 Total$200$300 Substitution Bias -- An Example Assume 1995 CPI basket  Inflation: 1995 - 2000 = $300/$200 = 1.50 or 50%

29. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 29 Item (2000 w/substitution)Expenditure Does the CPI Measure “True” Inflation? Coffee (0 cups at $2/cup)$0.00 Tea (100 cups at $1/cup)100.00 Scones (100 at $1.50 each)150.00 Total$250.00 Substitution Bias -- An Example Assume 1995 CPI basket  Inflation: 1995 - 2000 w/substitution = $250/$200 = 25%

30. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 30 Does the CPI Measure “True” Inflation? Economic Naturalist Why is inflation in the health care sector apparently high?

31. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 31 The Costs of Inflation: Not What You Think Price Level A measure of the overall level of prices at a particular point in time as measured by a price index such as the CPI Relative Price The price of a specific good or service in comparison to the prices of other goods and services

32. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 32 The Costs of Inflation: Not What You Think Observations Changes in relative price do not necessarily imply a significant amount of inflation. Inflation can be high without affecting relative prices.

33. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 33 The Costs of Inflation: Not What You Think Observations To counteract relative price changes, government policy would have to affect the market for specific goods. To counteract inflation, the government must use monetary and fiscal policy.

34. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 34 CPI% change in oil pricesInflationRelative price of oil 20001.20 20011.32 20021.40 The Costs of Inflation: Not What You Think The Price Level, Relative Prices, and Inflation 8% (2000 - 2001)10%-2% 8% (2001 - 2002)6%+2%

35. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 35 The True Costs of Inflation “Shoe-Leather” Costs The use of resources to economize on holding cash during periods of high inflation

36. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 36 The True Costs of Inflation “Shoe-Leather Costs at Woodrow’s Hardware Need $5,000 cash/day May withdraw $25,000 on Monday or $5,000/day Cost of a withdraw = $4/trip

37. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 37 The True Costs of Inflation “Shoe-Leather Costs at Woodrow’s Hardware Zero inflation  Withdraw $25,000  Shoe-leather cost = $4/week

38. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 38 The True Costs of Inflation “Shoe-Leather Costs at Woodrow’s Hardware 10% inflation  Withdraws $25,000 oAverage cash holding/day = $15,000 oCost of holding cash = $15,000 x 10% = $1,500

39. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 39 The True Costs of Inflation “Shoe-Leather Costs at Woodrow’s Hardware 10% inflation  Withdraws $5,000 daily oAverage cash holding/day = $5,000 oCost of holding cash = $5,000 x 10% = $500 oShoe-leather cost = $4/trip x 200 trips (50 wks) = $800 oBenefit of $1,000 > cost of $800

40. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 40 The True Costs of Inflation “Noise” in the Price System Inflation obscures the information transmitted by prices and reduces the efficiency of the market system

41. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 41 The True Costs of Inflation Distortions of the Tax System Inflation, Indexation, and ---  Bracket creep  Capital depreciation allowance

42. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 42 The True Costs of Inflation Observation Inflation may distort the incentives provided by the tax system for people to work, save, and invest and reduce economic growth.

43. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 43 The True Costs of Inflation Unexpected Redistribution of Wealth From workers to employers if wages are not indexed to inflation From lenders to borrowers

44. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 44 The True Costs of Inflation Interference with Long-Run Planning Retirement planning Investment and business strategies

45. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 45 Hyperinflation Economic Naturalist How costly is high inflation?

46. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 46 Hyperinflation Economic Naturalist Fischer, Sahay, and Vegh examined 133 market economies 1960 - 96  45 episodes of high inflation (100% +) in 25 countries oReal GDP/person fell by an average of 1.6%/yr oReal consumption/ person fell by an average of 1.3%/yr oReal investment/person fell by an average of 3.3%/yr

47. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 47 Inflation and Interest Rates Nominal Interest Rate (market interest rate) The annual percentage increase in the nominal value of a financial asset

48. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 48 Inflation and Interest Rates 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

49. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 49 Inflation and Interest Rates Inflation and the Real Interest Rate

50. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 50 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 20002.24.72.5

51. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 51 The Real Interest Rate in the United States, 1960 - 2001

52. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 52 Inflation and Interest Rates Observations Unexpected inflation will benefit borrowers and hurt lenders Expected inflation may not hurt lenders if they can adjust the nominal interest rates

53. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 53 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

54. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Measuring the Price Level and Inflation Slide 54 Inflation and Interest Rates in the United States, 1960 - 2001

55. MBMC End of Chapter End of Chapter