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# Topic 03 inflation

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### Topic 03 inflation

1. 1. Topic 03Inflation and the Price Level 12-1
2. 2. Learning Objectives1. Explain how the Consumer Price Index is constructed and use it to calculate the inflation rate2. Show how the CPI is used to adjust economic data to eliminate the effects of inflation3. Discuss the two most important biases in the CPI4. Distinguish between inflation and relative price changes to find the true cost of inflation5. Summarize the connections among inflation, nominal interest rates, and real interest rates 12-2
3. 3. Keeping up with Grandpa• Prices of goods change over time – Adjust values, incomes, or spending for change in prices – Constant purchasing power• Baseball salaries – Babe Ruth earned \$80,000 in 1930 – Barry Bonds earned \$10.3 million in 2001• Inflation increases uncertainty when planning for the future• Consider costs of inflation 12-3
4. 4. Measuring the Price Level• The Consumer Price Index (CPI) is a measure of the cost of living during a particular period• The CPI measures – The cost of a standard basket of goods and services in a given year – relative to the cost of the same basket of goods and services in the base year• 2005 is the base year for the CPI – Base year changes periodically 12-4
5. 5. Calculating the CPI2005 Spending Monthly Cost in 2005Rent (2 bedroom apartment) \$500Hamburgers (60 at \$2 each) 120Movie tickets (10 at \$6 each) 60Monthly expenditures \$6802011 Spending Monthly Cost in 2011Rent (2 bedroom apartment) \$630Hamburgers (60 at \$2.50 each) 150Movie tickets (10 at \$7 each) 70Monthly expenditures \$850 12-5
6. 6. Calculating the CPI• CPI is the ratio of the cost of the basket of goods in the current year to the cost in the base year – Base year cost \$680 – 2011 cost \$850 CPI = (850 / 680) (100) = 1.25• Cost of living in 2011 is 25% higher than in 2005 – CPI for the base year is always 1 – CPI for a given period is the cost of living in that period relative to what it was in the base year – BEA uses CPI as a percentage – the ratio times 100 12-6
7. 7. Cost of Living CPI = 1050 / 850 = 1.312005 Spending Monthly Cost in 2005Rent (2 bedroom apartment) \$500Hamburgers (60 at \$2 each) 120Movie tickets (10 at \$6 each) 60Sweaters (4 at \$30) 120Monthly expenditures \$8002011 Spending Monthly Cost in 2011Rent (2 bedroom apartment) \$630Hamburgers (60 at \$2.50 each) 150Movie tickets (10 at \$7 each) 70Sweaters (4 at \$50) 200Monthly expenditures \$1,050 12-7
8. 8. Price Index• A price index measures the average price of a given class of goods and services relative to the price of the same goods and services in a base year• CPI measures the change in consumer prices• Other indices – Core inflation is CPI without energy and food – Producer price index – Import / export price index 12-8
9. 9. Inflation• The rate of inflation is the Year CPI Inflation 2005 1.95 annual percentage change 2006 2.02 3.6% in the price level 2007 2.07 2.5%• Inflation in 2006 2008 2.15 3.9% (2.02 – 1.95) / 1.95 2009 2.15 0% = 0.036 = 3.6% Year00 CPI Inflation• The Great Depression 1929 0.171 – Period of falling output 1930 0.167 –2.3% and prices 1931 0.152 –9.0% – When inflation rates are 1932 0.137 –9.9% negative there is deflation 1933 0.130 –5.1% 12-9
10. 10. US Inflation Rates 12-10
11. 11. Adjusting for Inflation• A nominal quantity is measured in terms of its current dollar value• A real quantity is measured in physical terms – Quantities of goods and services• To compare values over time, use real quantities – Deflating a nominal quantity converts it to a real quantity • Divide a nominal quantity by its price index to express the quantity in real terms 12-11
12. 12. Family Income in 2005 and 2011• Can a family buy more with \$20,000 in income in 2005 or with \$22,000 in 2011? – 2005 is the base year for the CPI – Deflate nominal income in both years to get real income – Compare real income – \$20,000 in 2005 has the greater purchasing powerYear Nominal Income CPI Real Income2005 \$20,000 1.00 \$20,000/1.00 = \$20,0002011 \$22,000 1.25 \$22,000/1.25 = \$17,600 12-12
13. 13. Baseball Stars• Compare Babe Ruths salary with Barry Bonds – Requires a CPI series that includes 1930 • CPI using 1982 – 1984 as base year – Bonds had higher real salary• Does not convey information about relative incomes – 1930 was Great Depression – Multi-million dollar salaries common for sports stars in 2001Player Year Nominal Salary CPI Real SalaryBabe Ruth 1930 \$80,000 0.167 \$479,042Barry Bonds 2001 \$10,300,000 1.780 \$5,786,517 12-13
14. 14. Real Wages• The real wage is the wage paid to the worker measured in terms of purchasing power – The real wage for any given period is calculated by dividing the nominal wage by the CPI for that period• US production worker wages – CPI uses 1982 – 1984 as base year – Real wages were higher in 1970Year Average Wage CPI Real Average Wage1970 \$3.40 0.39 \$3.40 / 0.39 = \$8.722009 \$18.60 2.15 \$15.68 / 2.15 = \$8.65 12-14
15. 15. Production Workers’ Wages, 1960 - 2009 12-15
16. 16. Indexing• Indexing increases a nominal quantity each period by the percentage increase in a specified price index – Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation• Indexing automatically adjusts certain values, such as Social Security payments, by the amount of inflation – If prices increase 3% in a given year, the Social Security recipients receive 3% more • No action by Congress required – Indexing is sometimes included in labor contracts 12-16
17. 17. Adjusting for Inflation• An indexed labor contract – First year wage is \$12 per hour • Real wages rise by 2% per year for next 2 years – Relevant price index is 1.00 in first year, 1.05 in the second, and 1.10 in the third• Nominal wage is real wage times the price index Year Real Wage Price Index Nominal Wage 1 \$12.00 1.00 \$12.00 2 \$12.24 1.05 \$12.85 3 \$12.48 1.10 \$13.73 12-17
18. 18. Minimum Wage• Congress sets the national minimum wage in nominal terms – Publicized debate results in periodic increases • Indexing would be simpler and less controversial • Politicians appear to benefit from the debate• Minimum wage increased 15 times between 1970 and 2008 – Real minimum wage has decreased by about one- third in that period 12-18
19. 19. CPI and Inflation• CPI and other indexes influence policy decisions and wage increases• 1996 report said CPI overstates inflation by 1 to 2 percentage points a year – Unnecessarily increases government spending – Underestimates increase in the standard of living • Suppose CPI indicates 3% inflation when cost of living actually increases 2% – Real income increases 1%• Changes to calculations made since report to improve the quality of the CPI calculations 12-19
20. 20. CPI Quality Adjustment Bias• One important bias in the CPI is its measurement of price changes but not quality changes – PC with 20% more memory has 20% higher price • Not the same PC as the one with less memory – If no adjustment is made for quality, PCs contribution to the CPI will be 20%• Adjusting for quality is difficult – Large numbers of goods – Subjective differences• Incorporating new goods is difficult – No base year price for this years new goods 12-20
21. 21. CPI Biases• CPI uses a fixed basket of goods and services – When the price of a good increases, consumers buy less and substitute other goods – Failing to account for substitution overstates inflation• Example: base year cost of market basket Item 2005 price 2005 Spending Coffee (50 cups) \$1.00 \$50.00 Tea (50 cups) \$1.00 \$50.00 Scones (100) \$1.00 \$100.00 Total \$200.00 12-21
22. 22. CPI Substitution Bias• In 2011, coffee and scones are more expensive – Buying exactly the same basket of goods costs \$300, compared to \$200 in 2005 – CPI = 300 / 200 = 1.50Item 2011 price 2011 SpendingCoffee (50 cups) \$2.00 \$100.00Tea (50 cups) \$1.00 \$50.00Scones (100) \$1.50 \$150.00Total \$300.00 12-22
23. 23. CPI Substitution Bias• Actually, consumer substitutes tea for coffee – Scone purchases constant• True CPI for consumer is 250 / 200 = 1.25• CPI estimate of 1.50 is 20% higher than the consumers experience Item 2011 price 2011 Spending Coffee (00 cups) \$2.00 \$0.00 Tea (100 cups) \$1.00 \$100.00 Scones (100) \$1.50 \$150.00 Total \$250.00 12-23
24. 24. Relative Prices• The price level is a measure of the overall level of prices at a particular point in time – Measured by a price index such as the CPI• The relative price of a specific good is a comparison of its price to the prices of other goods and services – Calculated as a ratio• Suppose we have a one-time doubling of the gas price – Overall price level and inflation increase by a small amount – The increase in the relative price of gasoline is large 12-24
25. 25. Relative Prices• Relative prices can change markedly without corresponding changes in inflation• Summer prices 12-25
26. 26. Inflation and Relative Prices Oil Price Relative PriceYear CPI Inflation Change of Oil2008 1.202009 1.32 10% 8% -2%2010 1.40 6% 8% 2% 12-26
27. 27. Noisy Prices• Prices transmit information about – The cost of production and – The value buyers place on buying an additional unit• Inflation creates static in the communication – Buyers and sellers cant easily tell whether • The relative price of this good is increasing OR • Inflation is increasing the price of this good and all others – Deciding these issues requires market participants gather information – at a cost – Response to changing prices is tentative and slow 12-27
28. 28. Indexing Avoids Distortions• Income taxes have been indexed to avoid bracket creep – Bracket creep occurs when a household is moved into a higher tax bracket due to increases in nominal but not real income • Higher tax brackets have a higher tax rate• Indexing income taxes matches tax rates to the real income level – Suppose the tax rate on \$50,000 is 25% in 2000 – CPI is 1 for 2000, 1.25 for 2005 – Nominal income of \$62,500 is taxed 25% in 2005 12-28
29. 29. Distortions Caused by Taxes• Not all taxes are indexed• Capital depreciation allowance encourages purchase of capital goods – Allows firms to deduct a share of the purchase price as a business expense – Machine cost is \$1,000 and its useful life is 10 years • Capital depreciation allowance of \$100 per year • \$100 in year 1 is worth more than \$100 in year 10 because of inflation• In times of high inflation, investment in plant and equipment decreases 12-29
30. 30. Distortions Caused by Taxes• US tax system is complex – Taxes are collected at the federal, state, and city levels – Conflicting incentives• Taxes that are not indexed distort the tax incentives for people to work, save, and invest – Lower savings and investment means lower economic growth – a real cost of inflation 12-30
31. 31. Inflation Increases the Cost of Cash• If there is no inflation, cash holds its value over time – Some cash will be held for convenience• When inflation is high, cash loses value over time• Manage cash balances to limit losses – More frequent, smaller withdrawals cost consumers and businesses time, travel – a real cost of inflation – Banks process more transactions, increasing costs – another real cost of inflation – Costs of managing cash holding are called "shoe leather" costs, referring to the cost of frequent trips to the bank 12-31
32. 32. Unexpected Redistribution of Wealth• Unexpected inflation redistributes wealth• Suppose workers salaries are not indexed and inflation is higher than anticipated – Salaries lose purchasing power – Employers gain at the expense of workers• Similarly, unexpectedly high inflation benefits borrowers at the expense of lenders – Borrowers repay with dollars worth less than anticipated• Unexpected inflation confuses incentives 12-32
33. 33. Long-Run Planning• Some decisions have a long time horizon – Erratic inflation makes planning risky• Retirement planning requires an estimated cost for your desired life-style – Save too little and you live less well in the future – Save too much and you live less well now• Given the costs of inflation, most economists agree that low and stable inflation promotes a healthy economy 12-33
34. 34. Hyperinflation• Hyperinflation is an extremely high rate of inflation – In 1923, German employers paid workers twice a day – Magnifies the costs of inflation – Minimize your cash holding• A study of market economies, 1960 – 1996 showed 45 episodes of high inflation (100+%) in 25 countries – Real GDP/person fell by an average of 1.6% per year – Real consumption/ person fell by an average of 1.3% per year – Real investment per person fell by an average of 3.3% per year 12-34
35. 35. Inflation and Interest Rates• Unanticipated inflation helps borrowers and hurts lenders• The real interest rate is the annual percentage increase in the purchasing power of financial assets – Real interest rate = nominal interest rate – inflation r=i-π• The nominal interest rate is the annual percentage increase in the dollar value of an asset – Nominal interest rates are the most commonly stated rates 12-35
36. 36. Inflation and Interest Rates• Nominal interest rates and inflation vary Interest Inflation Year • Nominal interest rate range Rate (%) Rate (%) is 1.4% to 11.5% 1970 6.5% 5.7% • Inflation rate range is 2.7% 1975 5.8 9.1 to 13.5% 1980 11.5 13.5– Real interest rate is nominal 1985 7.5 3.6 interest rate minus inflation 1990 7.5 5.4 • Real interest rate was 1995 5.5 2.8 highest in 1985, 3.9% • Real interest rate was 2000 5.9 3.4 lowest in 1975, – 3.3% 2005 3.2 3.4 12-36
37. 37. US Real Interest Rates, 1960 - 2009 12-37
38. 38. Inflation and Interest Rates• Unexpected inflation benefits borrowers and hurts lenders – For a given nominal interest rate, the higher the inflation rate, the lower the real interest rate• Expected inflation may not hurt lenders if they can adjust the nominal interest rates – Inflation-protected bonds pay a real rate of interest plus the inflation rate• The Fisher effect is the tendency for nominal interest rates to be high when inflation is high and low when inflation is low 12-38
39. 39. US Inflation and Interest Rates, 1960 - 2009 12-39
40. 40. Inflation and Price Levels 12-40
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