1. Microeconomics and Macroeconomics FCS 3450 Fall 2015 Unit 2

2. What is inflation? Prices rising and the purchasing power of the dollar declining Concept 5: Inflation

3. What is inflation rate? The percentage increase in prices over a period of time Examples The inflation rate for a group of products or services Medical care 2012-2013: 2.5% 1990-2013: 154.9% Food and beverages 2012-2013: 1.4% 1990-2013: 76.9% The inflation rate for all products and services 2012-2013: 1.5% 1990-2013: 75.6%

4. Relationship Between Inflation Rate and the Value of Your Dollar The higher the inflation rate, the less the value of your dollars over time. YearsAnnual Inflation Rate of 2% Annual Inflation Rate of 6% Annual inflation Rate of 15% 591 cents75 cents50 cents 1082 cents56 cents25 cents 4045 cents10 cents0.3 cents Value of $1 given specific inflation rates and years

5. Calculation of Purchasing power of a dollar after any given amount of years Y n = the purchasing power of one dollar after n years i a = annual inflation rate n = number of years Y n = ( 1 / 1+ia ) n

6. Inflation Examples At 2% annual inflation rate, how much will $1 be worth in 5 years? Y 5 = (1/(1+2%)) 5 =.91

8. Effects of Inflation Escalating inflation Prices rise at an increasing rate 3%, 4%, 5%, 6% Disinflation Prices rise at a decreasing rate. 6%, 5%, 4%, 3% Deflation Prices decline 2009

9. How do we know what the inflation rate is? Inflation rates are computed using Consumer Price Index (CPI) Bureau of Labor Statistics (BLS) collects monthly price data on over 100,000 items at 85 location from 19,000 retail establishments. The prices collected form the Consumer Price Index (CPI) The CPI is weighted by commodities’ relative importance in the average consumer’s budget

10. Consumer Price Index (CPI) Year191319601980199020002010201220132014 CPI9.929.682.4130.7172.2218.1229.5232.9236.4 For more information on CPI visit: http://www.bls.gov/cpi/home.htm

11. Comparing Inflation Rate from Year to Year i AB = inflation rate from year A to year B CPI A = CPI for year A CPI B = CPI for year B i AB = CPI B -1 CPI A

12. CPI Example The overall CPI in 1992 was 140.3. The overall CPI was 144.5 in 1993. What was the annual inflation rate from 1992 to 1993? i 1992-1993 = CPI 1993 -1 = 144.5 -1 = 0.03 =3% CPI 1992 140.3

13. Application of CPI CPI can be used to compare standard of living over time. Suppose that your income was $20,000 in 1992 (year A) and $25,000 in 1997 (year B), were you really better off in 1997 compared to 1992? There are three methods you can use to do this comparison:

14. Method 1-Converting today’s dollars into yesterday’s dollars Convert 1997 (Year B) income into 1992 (Year A) dollar value: Y 1997 – 1992 = Y 1997 x CPI 1992 = $25,000 x 140.3 = $21,854 CPI 1997 160.5 Since $21,854 > $20,000 you are better off in 1997.

15. Method 2-Converting yesterday’s dollars into today’s dollars Convert 1997 (Year B) income into 1992 (Year A) dollar value: Y 1992 – 1997 = Y 1992 x CPI 1997 = $20,000 x 160.5 = $22,880 CPI 1992 140.3 Since $22,880 < $25,000 you are better off in 1997.

16. Method 3-Compare percentage changes of income and price. Calculate inflation rate: I 1992 – 1997 = CPI 1997 -1 = 160.5 -1 = 14.4% CPI 1992 140.3 Calculate inflation rate: % change in income = $25,000 – 1 = 25% $20,000 Since income increased 25% and price increased 14.4%, you are better off in 1997

17. Concept 6: Interest Rate Why do interest rates exist? 1.Risk 2.Opportunity Cost 3.Inflation

18. Real and Nominal Interest Rates What is nominal interest rate? The rate we observe in the market. It compensates lenders for three things: 1.Risk 2.Opportunity cost 3.Future inflation What is real interest rate? Since being compensated for inflation is not a real gain for the lender, real interest rate only takes into consideration 1.Risk 2.Opportunity cost

19. The relationship between Real and Nominal Interest Rates nr = nominal interest rate (annual) rr = real interest rate (annual) i = inflation rate for the loan period (annual) nr = rr + i + (rr x i) Or rr = nr-i 1+i

20. Real and Nominal Interest Rate Example If you want to charge an 8% real interest rate, and the inflation rate is expected to be 10%, what is the nominal interest rate you should charge? nr = rr + i + (rr x i) = 8% + 10% + (8% x 10%) = 18% +.8% = 18.8%

21. Nominal vs Real Interest Rate Example (cont) Your savings account pays you an interest rate of 7%. The inflation rate is 5%. What is your real interest rate? rr = nr –i = 7% - 5% = 1.9048% 1 + i 1 + 5%

22. Concept 7: Uncertainty and Expectation What are the uncertainty we face that are important to consumer decision making? What do we do when we have to use future information? Expected value = Sum of (outcome i * probability of outcome i )

23. Example 1 of expectations OutcomeProbability Stay the same$25,00050% Increase30,00040% Decrease20,00010% Total 100% Expected salary next year: =$25,000 * 50% + $30,000 x 40% + $20,000 * 10% = 12,500 + 12,000 + 2,000 = $26,500