1. Introduction to Economics: Social Issues and Economic Thinking Wendy A. Stock PowerPoint Prepared by Z. Pan CHAPTER 7 INFLATION AND THE MEASUREMENT OF PRICES Copyright © 2013 John Wiley & Sons, Inc. / Photo Credit: public domain image from wikipedia: http:en.wikipedia.org/wiki/File: Mugabecloseup20008.jpg

2.  Explain the difference between the face value of money and the purchasing power of money  Describe inflation and calculate inflation across time periods  Describe the winners and losers from inflation  Distinguish the sources of inflation  Illustrate the difference between real and nominal values Copyright © 2013 John Wiley & Sons, Inc. 2 AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:

3.  Inflation is the rise in the general level of prices in an economy.  Zimbabwe’s hyperinflation  Inflation rate 11.2 million percent per year  prices doubled every 25 hours! Copyright © 2013 John Wiley & Sons, Inc. 3 INFLATION

4.  The Face Value of Money is determined by governments and printed on currency.  The Purchasing Power of Money reflects the amount of goods and services that a given unit of money could be used to acquire. Copyright © 2013 John Wiley & Sons, Inc. 4 THE VALUE AND USES OF MONEY

5. Three Roles of Money:  Medium of Exchange – Money can be used as a means of payment for goods and services or repayment of debt.  Unit of Account – Money provides a common measure of the worth of goods or services.  Store of Value – Money can be saved and used to purchase goods and services at a future time. Copyright © 2013 John Wiley & Sons, Inc. 5 DEFINITION OF MONEY

6.  Commodity Money has value for its own sake, in addition to its value as money.  e.g. gold, silver, shells, stones, decorated belts, cigarettes, and alcohol  Fiat Money has value because of government law or regulation.  e.g. Federal Reserve Notes, most paper money Copyright © 2013 John Wiley & Sons, Inc. 6 EVOLUTION OF MONEY

7.  Price Index - A measure of the average prices of a given set of goods or services across time.  Consumer Price Index (CPI) is the ratio of the cost of the market basket in one year over the cost of the market basket in the base year multiplied by 100.  A Market Basket is a fixed set of goods or services whose prices are tracked across time. Copyright © 2013 John Wiley & Sons, Inc. 7 MEASURING PRICES AND INFLATION

8. Copyright © 2013 John Wiley & Sons, Inc. 8 MEASURING PRICES AND INFLATION

9. Three Steps: 1)Finding the prices in the market basket 2)Computing the cost of the market basket in each year 3)Calculating CPI by taking the ratio Copyright © 2013 John Wiley & Sons, Inc. 9 CALCULATING CPI: AN EXAMPLE

10. Copyright © 2013 John Wiley & Sons, Inc. 10 CALCULATING CPI: AN EXAMPLE

11. Copyright © 2013 John Wiley & Sons, Inc. 11 U.S. CONSUMER PRICE INDEX

12. Copyright © 2013 John Wiley & Sons, Inc. 12 INFLATION RATE

13. Copyright © 2013 John Wiley & Sons, Inc. 13 CALCULATING INFLATION RATE – AN EXAMPLE

14. Copyright © 2013 John Wiley & Sons, Inc. 14 U.S. INFLATION RATE (1950-2010)

15. Disinflation is a period of positive but falling inflation. Disinflation indicates a slowing of the rate of price increase in the economy. Deflation is negative inflation. Deflation indicates a period of declining prices of goods and services. Copyright © 2013 John Wiley & Sons, Inc. 15 DEFLATION AND DISINFLATION

16. Copyright © 2013 John Wiley & Sons, Inc. 16 WORLD INFLATION COMPARISON

17.  Government printing too much money  Demand Pull Inflation  Cost Push Inflation Copyright © 2013 John Wiley & Sons, Inc. 17 SOURCES OF INFLATION

18. Demand-pull Inflation arises from increases in aggregate demand. Copyright © 2013 John Wiley & Sons, Inc. 18 SOURCES OF INFLATION

19. Cost-push Inflation arises from decreases in aggregate supply. Copyright © 2013 John Wiley & Sons, Inc. 19 SOURCES OF INFLATION

20.  Nominal Values are values that have not been adjusted for inflation.  Real Values are values that have been adjusted for inflation. Copyright © 2013 John Wiley & Sons, Inc. 20 MEASURING NOMINAL AND REAL VALUES

21. Copyright © 2013 John Wiley & Sons, Inc. 21 MEASURING NOMINAL AND REAL VALUES An Example: 1960: CPI = 29.6 Your grandma's starting salary as a school teacher = $6,500 2010: CPI = 220.2 Your starting salary as a school teacher = $45,000 Will you make more than she did in real earnings?

22. Copyright © 2013 John Wiley & Sons, Inc. 22 MEASURING NOMINAL AND REAL VALUES  First, convert all nominal values into real values in base year (base year = 1982 – 84) Real value in base year = (nominal value in current year/CPI in current year) x 100  Then, compare

23. Copyright © 2013 John Wiley & Sons, Inc. 23 MEASURING NOMINAL AND REAL VALUES 1960: CPI = 29.6 Your grandma's starting salary as school teacher = $6,500 2010: CPI = 220.2 Your starting salary as a school teacher = $45,000 Grandma’s real salary = ($6,500/29.6) x 100 = $21,959 in 1982–84 dollars. Your real salary = ($45,000/220.2) x 100 = $20,436 in 1982–84 dollars.

24. QUESTIONS/DISCUSSIONS Copyright © 2013 John Wiley & Sons, Inc. 24 During 2011, many citizens in the Middle East called for governmental reform. In some countries, oil production was reduced in the face of protests. Use an AD/AS diagram to illustrate the potential impact of these outcomes on inflation in the United States.

25. Copyright © 2013 John Wiley & Sons, Inc. 25 KEY CONCEPTS Inflation Face value of money Purchasing power of money Medium of exchange Unit of account Store of value Commodity money Fiat money Price index Market basket