1. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 1 CHAPTER 7 Inflation

2. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 2 Learning Objectives 1.Describe inflation rates in the U.S. and other countries. 2.Discuss the cost of inflation that cause low inflation to be a macroeconomic goal. 3.Compute, interpret, and use a price index to compute a real value. 1.Describe inflation rates in the U.S. and other countries. 2.Discuss the cost of inflation that cause low inflation to be a macroeconomic goal. 3.Compute, interpret, and use a price index to compute a real value.

3. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 3 Learning Objectives 4.Identify problems with price indexes and efforts to improve them. 5.(E&A) Explain how people respond to inflation, and how that affects its measurement. 4.Identify problems with price indexes and efforts to improve them. 5.(E&A) Explain how people respond to inflation, and how that affects its measurement.

4. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 4 7.1 THE GOAL OF LOW INFLATION  Alongwith economic growth and high employment, low inflation is the third fundamental goal of the economy.  Along with economic growth and high employment, low inflation is the third fundamental goal of the economy.  Inflation is a persistent increase in the price level.  The price level refers to the prices of goods and services, when considered in the aggregate.  Alongwith economic growth and high employment, low inflation is the third fundamental goal of the economy.  Along with economic growth and high employment, low inflation is the third fundamental goal of the economy.  Inflation is a persistent increase in the price level.  The price level refers to the prices of goods and services, when considered in the aggregate.

5. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 5 The inflation rate is the annual percentage increase in the price level.The inflation rate is the annual percentage increase in the price level. In the U.S., as long as the inflation rate from year to year stays at around 3% per year, Americans are satisfied that the goal of low inflation has been accomplished.In the U.S., as long as the inflation rate from year to year stays at around 3% per year, Americans are satisfied that the goal of low inflation has been accomplished. If the inflation rate is above 3%, people expect the government to take action to “fight” inflation.If the inflation rate is above 3%, people expect the government to take action to “fight” inflation. The inflation rate is the annual percentage increase in the price level.The inflation rate is the annual percentage increase in the price level. In the U.S., as long as the inflation rate from year to year stays at around 3% per year, Americans are satisfied that the goal of low inflation has been accomplished.In the U.S., as long as the inflation rate from year to year stays at around 3% per year, Americans are satisfied that the goal of low inflation has been accomplished. If the inflation rate is above 3%, people expect the government to take action to “fight” inflation.If the inflation rate is above 3%, people expect the government to take action to “fight” inflation. The Goal of Low Inflation

6. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 6 The U.S. Inflation Rate Selected Years Year Inflation Rate 19452.3 19468.3 194714.4 19488.1 1949-1.2 19501.3

7. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 7Year Inflation Rate 1955-.4 19601.7 19651.6 19705.7 19759.1 198013.5 The U.S. Inflation Rate Selected Years

8. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 8Year Inflation Rate 19853.6 19905.4 19914.2 19923.0 19933.0 19942.6 20021.6 20032.1 The U.S. Inflation Rate Selected Years

9. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 9 Inflation – A World-Wide Phenomenon  The CIA estimates that the average inflation in the world in 2002 was 3.3%.  Most of these severely high rates occurred in developing countries.  The developing countries inflation rates ranged between 5% and 60% as compared to the range in developed countries which was between 1% and 3%.  Political instability can result from severe inflation  The CIA estimates that the average inflation in the world in 2002 was 3.3%.  Most of these severely high rates occurred in developing countries.  The developing countries inflation rates ranged between 5% and 60% as compared to the range in developed countries which was between 1% and 3%.  Political instability can result from severe inflation

10. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 10 Country - Year 2003 Inflation Rate Ecuador12.5 Zimbabwe134.5 Yugoslavia (Slovakia & Montenegro) 19 Ukraine-1.2 Russia15 Venezuela31.2 Mexico6.4 Brazil8.3 China-.08 Inflation Rates in Selected Countries

11. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 11 Country - Year 2003 Inflation Rate Bolivia2 U.S.1.6 U.K.2.1 Germany1.3 Japan-0.99 Argentina-0.9 Inflation Rates in Selected Countries

12. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 12 Deflation and Disinflation  When the inflation rate is negative, deflation is said to occur.  This would happen if the price level declined from one year to the next.  Deflation is not an economic goal.  Historically, widespread falling prices and poor economic performance seem to go hand in hand.  Disinflation means that the rate of inflation declines, and is different than both inflation, and deflation.  When the inflation rate is negative, deflation is said to occur.  This would happen if the price level declined from one year to the next.  Deflation is not an economic goal.  Historically, widespread falling prices and poor economic performance seem to go hand in hand.  Disinflation means that the rate of inflation declines, and is different than both inflation, and deflation.

13. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 13 7.2 THE HARM FROM INFLATION oEnergy and food prices are subject to wide fluctuations caused by temporary shifts in their supply. oExcluding food and energy prices from the computation of the inflation rate reveals what is termed core inflation. oEnergy and food prices are subject to wide fluctuations caused by temporary shifts in their supply. oExcluding food and energy prices from the computation of the inflation rate reveals what is termed core inflation.

14. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 14 The Core Rate of Inflation

15. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 15 Inflation hurts those on fixed incomes. Inflation hurts lenders. Inflation increases the opportunity cost of search time for cheaper substitute goods. Inflation hurts those on fixed incomes. Inflation hurts lenders. Inflation increases the opportunity cost of search time for cheaper substitute goods. Inflation motivates businesses to offer new products. Inflation might motivate business to trim the amount of product rather than raise its price. Inflation motivates businesses to offer new products. Inflation might motivate business to trim the amount of product rather than raise its price. The Harm from Inflation

16. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 16 Anticipated and Unanticipated Inflation Anticipated inflation is expected by the public. In theory, everyone is able to defend themselves against losses imposed by anticipated inflation. Unanticipated inflation is inflation that catches the public by surprise. Borrower’s gain by unanticipated inflation, while lenders lose. Anticipated inflation is expected by the public. In theory, everyone is able to defend themselves against losses imposed by anticipated inflation. Unanticipated inflation is inflation that catches the public by surprise. Borrower’s gain by unanticipated inflation, while lenders lose.

17. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 17 Indexing to Offset Inflation’s Effects  Indexing is a solution to offset the problems created by unanticipated inflation.  Automatically adjusting the terms of an agreement to account for inflation is referred to as indexing.  Indexing is a solution to offset the problems created by unanticipated inflation.  Automatically adjusting the terms of an agreement to account for inflation is referred to as indexing.

18. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 18 7.3 MEASURING INFLATION  A price index measures the average level of prices in the economy.  There are several price indexes.  The consumer price index.  The producer price index.  The GDP chain-type price index  The GDP deflator.  A price index measures the average level of prices in the economy.  There are several price indexes.  The consumer price index.  The producer price index.  The GDP chain-type price index  The GDP deflator.

19. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 19 The CPI measures prices of typical purchases made by consumers living in urban areas. The CPI measures prices of typical purchases made by consumers living in urban areas. The base period used in the CPI is an arbitrary selected initial time period against which other time periods are compared. The base period used in the CPI is an arbitrary selected initial time period against which other time periods are compared. The base period index number always equals 100. The base period index number always equals 100. The CPI measures prices of typical purchases made by consumers living in urban areas. The CPI measures prices of typical purchases made by consumers living in urban areas. The base period used in the CPI is an arbitrary selected initial time period against which other time periods are compared. The base period used in the CPI is an arbitrary selected initial time period against which other time periods are compared. The base period index number always equals 100. The base period index number always equals 100. Measuring Inflation – The Consumer Price Index

20. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 20 Measuring Inflation – The Consumer Price Index Inflation Rate = [change in price index / initial price index] [change in price index / initial price index] multiplied by 100 The Inflation rate is calculated by taking the percentage change in the CPI as follows:

21. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 21 The collection of goods and services used in the calculation of the CPI is called the market basket. The market basket represents a sampling of the items that consumers buy that make up a significant portion of their budget. There are 200 specific items that make up the CPI. Each item is assigned a weight that reflects its importance in the consumers’ budgets. The collection of goods and services used in the calculation of the CPI is called the market basket. The market basket represents a sampling of the items that consumers buy that make up a significant portion of their budget. There are 200 specific items that make up the CPI. Each item is assigned a weight that reflects its importance in the consumers’ budgets. Measuring Inflation – The Consumer Price Index

22. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 22 CPI Market Basket Expenditure Categories Expenditure Category Weight (in %) Food and beverages 15.7 Housing40.9 Apparel4.4 Transportation17.1 Medical care 5.8 Recreation6.0 Education and communication 5.8 Other goods and services 4.3 Total100.0

23. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 23 The Consumer Price Index, Selected Years Averages to 100, base period value.

24. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 24 Computing a Price Index  The CPI measure the increase in the price of the market basket between the current year and the base period.  The simplified formula for the CPI is:  The CPI measure the increase in the price of the market basket between the current year and the base period.  The simplified formula for the CPI is: Cost of market basket at current prices Cost at market basket at base period prices X 100

25. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 25 Nominal Versus Real Values oA nominal interest rate is the payment from a borrower to a lender, expressed in percentage terms. oA real interest rate measure the percentage payment in terms of purchasing power. oA nominal interest rate is the payment from a borrower to a lender, expressed in percentage terms. oA real interest rate measure the percentage payment in terms of purchasing power. Real interest rate = nominal interest rate – inflation rate

26. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 26 Price Indexes for Other Purposes The Producer Price Index (PPI) focuses on the prices received by U.S. producers, as measured by the revenue they receive.The Producer Price Index (PPI) focuses on the prices received by U.S. producers, as measured by the revenue they receive. The prices in the PPI are those received by producers no matter who makes the initial purchase, whether it be another firm or consumer.The prices in the PPI are those received by producers no matter who makes the initial purchase, whether it be another firm or consumer. The Producer Price Index (PPI) focuses on the prices received by U.S. producers, as measured by the revenue they receive.The Producer Price Index (PPI) focuses on the prices received by U.S. producers, as measured by the revenue they receive. The prices in the PPI are those received by producers no matter who makes the initial purchase, whether it be another firm or consumer.The prices in the PPI are those received by producers no matter who makes the initial purchase, whether it be another firm or consumer.

27. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 27 Price Indexes for Other Purposes The GDP chain-type price index is computed in a manner similar to the GDP deflator.The GDP chain-type price index is computed in a manner similar to the GDP deflator. The difference is that the real chained GDP is used in the calculation.The difference is that the real chained GDP is used in the calculation. The GDP chain-type price index is computed in a manner similar to the GDP deflator.The GDP chain-type price index is computed in a manner similar to the GDP deflator. The difference is that the real chained GDP is used in the calculation.The difference is that the real chained GDP is used in the calculation. GDP chain-type = nominal GDP/real chained GDP

28. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 28 Price Indexes for Other Purposes The term chain weight comes about because the GDP chain-type price index links quantities (weights) in two successive years.The term chain weight comes about because the GDP chain-type price index links quantities (weights) in two successive years. It then moves forward a year and does that link again, and so forth.It then moves forward a year and does that link again, and so forth. This continuous linking, for two years at a time forms a chain, hence the name.This continuous linking, for two years at a time forms a chain, hence the name. The term chain weight comes about because the GDP chain-type price index links quantities (weights) in two successive years.The term chain weight comes about because the GDP chain-type price index links quantities (weights) in two successive years. It then moves forward a year and does that link again, and so forth.It then moves forward a year and does that link again, and so forth. This continuous linking, for two years at a time forms a chain, hence the name.This continuous linking, for two years at a time forms a chain, hence the name.

29. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 29 Price Indexes for Other Purposes  The GDP deflator is a type of price index called an implicit price deflator.  An implicit price deflator takes current quantities and calculates what they would have cost at prices prevailing during the base period.  The GDP deflator is a type of price index called an implicit price deflator.  An implicit price deflator takes current quantities and calculates what they would have cost at prices prevailing during the base period. GDP deflator = Value of current quantities at current period prices Value of current quantities at base period prices

30. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 30 Recent Changes to the CPI  Prior to 1999, the CPI was calculated using fixed-weights throughout the market basket.  Fixed-weights do not take into account that people change their consumption patterns when prices rise.  When the price level rises people substitute relatively cheaper goods for goods that have become relatively more expensive.  Prior to 1999, the CPI was calculated using fixed-weights throughout the market basket.  Fixed-weights do not take into account that people change their consumption patterns when prices rise.  When the price level rises people substitute relatively cheaper goods for goods that have become relatively more expensive.

31. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 31 Recent Changes to the CPI  The inaccuracy in the CPI cause by using fixed weights is termed the substitution bias.  The substitution bias causes inflation to be overstated.  A new CPI was established in 2002 called the Chained weight CPI (C-CPI).  The inaccuracy in the CPI cause by using fixed weights is termed the substitution bias.  The substitution bias causes inflation to be overstated.  A new CPI was established in 2002 called the Chained weight CPI (C-CPI).

32. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 32 7.4 EXPLORE & APPLY Adjusting to Price Changes  The CPI is used in three ways.  As an economic indicator.  To convert nominal values to real values.  To adjust selected monetary payments upward as prices increase.  Hyperinflation is inflation that is out of control.  The CPI is used in three ways.  As an economic indicator.  To convert nominal values to real values.  To adjust selected monetary payments upward as prices increase.  Hyperinflation is inflation that is out of control.

33. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 33  The rule of 72 is used to compute the approximate time it takes for a rate to double.  To compute how long it would take for an inflation rate to double the equation would be… 72/the inflation rate  The rule of 72 is used to compute the approximate time it takes for a rate to double.  To compute how long it would take for an inflation rate to double the equation would be… 72/the inflation rate How the CPI Measures the Price Level

34. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 34 Annual Inflation Rate Estimated # of Years for Price Level to double 1%72 2%36 4%18 8%9 10%7.2 16%4.5 How the CPI Measures the Price Level

35. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 35 Key Terms inflation inflation rate indexing Consumer Price Index Producer Price Index inflation inflation rate indexing Consumer Price Index Producer Price Index GDP chain-type index GDP deflator nominal value real value

36. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 36 Test Yourself 1.Which of the following best fits the definition of inflation? a.A one-time increase in a few prices. b.A one-time increase in many prices. c.A sustained increase in a few prices. d.A sustained increase in many prices. 1.Which of the following best fits the definition of inflation? a.A one-time increase in a few prices. b.A one-time increase in many prices. c.A sustained increase in a few prices. d.A sustained increase in many prices.

37. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 37 Test Yourself 2. The core inflation rate excludes a.energy prices. b.the price of medical care. c.food prices. d.both food and energy prices. 2. The core inflation rate excludes a.energy prices. b.the price of medical care. c.food prices. d.both food and energy prices.

38. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 38 Test Yourself 3.The goods and services included in the computation of the CPI are referred to as the _____________________. a.base year. b.fixed weights. c.market basket. d.price level. 3.The goods and services included in the computation of the CPI are referred to as the _____________________. a.base year. b.fixed weights. c.market basket. d.price level.

39. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 39 Test Yourself 4.How is inflation computed? a.The inflation rate equals the value of a price index. b.The inflation rate equals the value of a price index. c.By the following computation: (change in price index/initial value of price index multiplied by 100). d.By the following computation: change in price index multiplied by the initial value of price index. 4.How is inflation computed? a.The inflation rate equals the value of a price index. b.The inflation rate equals the value of a price index. c.By the following computation: (change in price index/initial value of price index multiplied by 100). d.By the following computation: change in price index multiplied by the initial value of price index.

40. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 40 Test Yourself 5.When the real value of GDP is computed by the government a.the CPI is used. b.the PPI is used. c.The GDP deflator or the chained-type price index is used. d.no price index is necessary because the real and nominal values of GDP are always identical. 5.When the real value of GDP is computed by the government a.the CPI is used. b.the PPI is used. c.The GDP deflator or the chained-type price index is used. d.no price index is necessary because the real and nominal values of GDP are always identical.

41. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 41 Test Yourself 6.The substitution bias causes the CPI to? a.overstate the effects of inflation. b.understate the effects of inflation. c.more accurately reflect the effects of inflation. d.be nearly useless as a measure of inflation. 6.The substitution bias causes the CPI to? a.overstate the effects of inflation. b.understate the effects of inflation. c.more accurately reflect the effects of inflation. d.be nearly useless as a measure of inflation.

42. © 2005 Prentice Hall Publishing ECONOMICS: Explore & Apply, Enhanced Edition Ayers/Collinge 42 The End! Next Chapter 8 A Framework for Macroeconomic Analysis