1. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 0 Measuring the Price Level and Inflation

2. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 1 Value of Money  Value of money depends upon  the prices of goods and services  Rapid and ongoing increases in the prices of most goods and services  can radically reduce the buying power of a given amount of money

3. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 2 Problems of Inflation  Makes comparisons of economic conditions over time difficult  Creates uncertainty about the future  How much should I save for retirement?  Imposes many costs on an economy

4. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 3 Measuring Inflation  Consumer Price Index, CPI  It measures, for any time period, the cost of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed year  The fixed year is called the base year  It uses a constant basket of goods and services  It is collected by the BLS

5. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 4 CPI  Measures changes in prices of a typical market basket  Is used to eliminate the effects of inflation from economic data

6. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 5 Inflation  Rate of inflation  The annual percentage rate of change in the price level, as measured, for example, by the CPI  A measure of how fast the average price level is changing over time

7. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 6 Deflation  Deflation  A situation in which the prices of most goods and services are falling over time so that inflation is negative

8. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 7 Adjusting for Inflation  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  Deflating  The process of dividing a nominal quantity by a price index to express the quantity in real terms

9. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 8 Real Wage  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 wage by the CPI for that period

10. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 9 Fig. 7.1 Nominal and Real Wages for Production Workers, 1960-1999

11. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 10 Indexing  Indexing  The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index  Prevents the purchasing power of the nominal quantity from being eroded by inflation (e.g., a Social Security payment)

12. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 11 Accuracy of CPI  Changes in the CPI are important  Directly impacts government budgets  Study shows CPI overstates inflation between 1 - 2% a year  Costing federal government billions of dollars more than necessary every year  Underestimating of true living standard

13. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 12 Reasons for Overstatement of Inflation  Quality adjustment bias: statistics do not account for the fact that  The quality of goods and services change over time  New goods appear  Substitution bias  CPI uses a fixed market basket  Consumers seek out cheaper substitutes when prices rise

14. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 13 Price Level vs. Relative Price  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  If the price of oil decreases by 10% and all other prices decrease by 3%, then the relative price of oil decreases (i.e. oil is cheaper relatively)  Serious misunderstanding by the public  The remedies are different

15. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 14 Costs of Inflation  Reduces efficiency of the economy  “Shoe-leather” costs  More frequent trips to the bank  Inflation raises the cost of holding cash  “Noise” in the price system  Difficult to interpret information conveyed by prices  Relative price change or inflation?  Distortions of the tax system  Many provisions in the tax codes are not indexed  Causes bracket creep  Causes paying more than initially intended

16. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 15 Costs of Inflation  Reduces efficiency of the economy  Unexpected redistribution of wealth  Inflation higher than expected  Under contracts, wage earners are hurt to the benefit of employers  Hurts creditors to the benefit of debtors  Interference with long-run planning  Difficult to forecast prices over long periods

17. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 16 Hyperinflation  Hyperinflation  A situation in which the inflation rate is “extremely” high  Experienced by  Several Latin American countries  Israel  Transition economies like Russia  Confederacy of U.S. 1861-1865  Magnifies the costs of inflation

18. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 17 Real Interest Rate  Real interest rate (i.e., real rate of return)  The annual percentage increase in the purchasing power of a financial asset  Equals the nominal interest rate on that asset minus the inflation rate  Financial investors and lenders do best when the real (not the nominal) interest rate is high  Increasing purchasing power

19. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 18 Nominal Interest Rate  Nominal interest rate (i.e., the market interest rate)  The annual percentage increase in the nominal value of a financial asset

20. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 19 Real vs. Nominal  r = real interest rate  i = nominal, market, interest rate   = inflation rate

21. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 20 Fig. 7.2 The Real Interest Rate in the United States, 1960-1999

22. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 21 Lenders vs. Borrowers  Unexpected inflation  Hurt creditors, aids borrowers  reduces the value of the dollars with which the debts are repaid  For a given nominal interest rate, the higher the inflation rate (higher than expected), the lower the real interest rate the lender receives

23. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 22 Inflation and Interest Rates  Economists have noticed that  During periods of high inflation  Interest rates are high as well  During periods of low inflation  Interest rates are low as well

24. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 23 Fig. 7.3 Inflation and Interest Rates in the United State, 1960-1998

25. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 7 - 24 Fisher Effect  Fisher effect  The tendency for nominal interest rates to be high when inflation is high and low when inflation is low  If inflation has been high recently  Lenders anticipate that it will continue to be high  Lenders raise the nominal interest rate so that the real rate of return is not affected