03 inflation

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03 inflation

  1. 1. Chapter 17 Inflation • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing 1
  2. 2. In this chapter, you will learn to solve these economic puzzles: Can a person’s income Can an interestrate Does inflation harm ofWhat is even though he or the inflation fall be negative? rate everyone equally? your college education? she received a raise? 2
  3. 3. What is Inflation?An increase in the general (average) price level of goods and services in the economy 3
  4. 4. What is Deflation?A decrease in the general (average) price level of goods and services in the economy 4
  5. 5. What is the most widely reportedmeasure of Inflation?The Consumer Price Index 5
  6. 6. What is theConsumer Price Index?The CPI is an index that measures changes in the average prices of consumer goods and services 6
  7. 7. Who reports the CPI?The Bureau of Labor Statistics (BLS) of the Department of Labor 7
  8. 8. How is the CPI calculated?Price collectors contact retail stores, homeowners, and tenants in selected cities in the U.S. monthly 8
  9. 9. Which goods and servicesare included in the CPI?The BLS records average prices for a “market basket” of different items purchased by the typical urban family 9
  10. 10. Composition of the CPIFood and Beverages 16.3%Housing 39.6%Apparel and Upkeep 4.9%Transportation 17.6%Medical Care 5.6%Recreation 6.1%Education & Communication 5.6%All other goods & services 6.9% 10
  11. 11. Does the makeup of the CPI change?As people’s tastes and preferences change, some of the goods and services that go into the basket change 11
  12. 12. How is the CPI computed?Current year prices are compared to prices of a similar basket of goods and services in a base year 12
  13. 13. What is a Base Year?A year chosen as a reference point for comparison with some earlier or later year 13
  14. 14. Why is the CPI always100 in the Base Year? The numerator and the denominator of the CPI formula are the same in the base year 14
  15. 15. *CYP = cost of the market basket of products at current-year prices*BYP = cost of the market basket of products at base-year prices CYP X 100 CPI = BYP 15
  16. 16. How is theInflation Rate computed?The annual inflation rate is computed as the percentage change in the official CPI from one year to the next 16
  17. 17. *ARI = Annual rate of inflation*CPIY = Consumer price index in given year*CPIPY = Consumer price index in previous year CPI - CPIPYX 100ARI = CPIPY 17
  18. 18. 20 The U.S. Inflation Rate 1929 - 19981612 8 4 0 -4 -8-12 1930 40 50 60 70 80 90 00 18
  19. 19. What is Disinflation? A reduction in the rate of inflation 19
  20. 20. What are someCriticisms of the CPI?• It can overstate or understate the impact of inflation for certain groups• Does not measure quality• Substitutes are ignored 20
  21. 21. What does Inflation do to People’s Income?A general rise in prices will shrink people’s income 21
  22. 22. What isNominal Income?The actual number of dollars received over a period of time 22
  23. 23. What is Real Income?The actual number of dollars received (nominal income) adjusted for changes in the CPI 23
  24. 24. *RI = Real income*NI = Nominal income*CPI = CPI as a decimal or CPI ÷ 100 NI RI = CPI 24
  25. 25. % ∆ in real % ∆ in _ % ∆ in income = nominal CPI income 25
  26. 26. What is Wealth?The value of the stock of assets owned at some point in time 26
  27. 27. How is Wealthaffected by Inflation?Inflation can benefit holders of wealth because the value of their assets tends to increase as prices rise 27
  28. 28. What will cause yourReal Income to decline? The rate of inflation is greater than your rate of income 28
  29. 29. How does Inflation affectBorrowers and Savers? They can win or lose depending on the rate of inflation 29
  30. 30. What is the Interest Rate?Interest per year as a percentage of the amount loaned or lent 30
  31. 31. What is theNominal Interest Rate?The actual rate of interest earned over a period of time 31
  32. 32. What is the Real Interest Rate?The nominal rate of interest minus the inflation rate 32
  33. 33. What are the two basic types of Inflation? Demand-pull Cost-push 33
  34. 34. What isDemand-pull Inflation? A rise in the general price level resulting from an excess of total spending (demand) 34
  35. 35. When does Demand-pull Inflation occur? When the economy is operating at or near full employment 35
  36. 36. What isCost-push Inflation?A rise in the general price level resulting from an increase in the cost of production 36
  37. 37. What can cause Cost- push Inflation?Cost increases for labor, raw materials, construction, equipment, borrowing etc. 37
  38. 38. Do people’s Expectations affect Inflation?Yes, expectations can influence both demand-pull and cost-push inflation 38
  39. 39. What is Hyperinflation? An extremely rapid rise in the general price level 39
  40. 40. What is a Wage-price Spiral?A situation that occurs when increases in nominal wage rates are passed on in higher prices, which, in turn, result in even higher nominal wages and prices 40
  41. 41. How does the U.S.inflation rate compare with other countries? It is lower than some and higher than others 41
  42. 42. 84.6% 59.1%57.6% 36.1% 1.6% 1.0% 0.7%Turkey Romania Indonesia Ecuador U.S. Germany France 42
  43. 43. Key Concepts 43
  44. 44. Key Concepts• What is Inflation?• What is the Consumer Price Index?• Which goods and services are included in the CP• How is the CPI computed?• What is a Base Year?• How is the Inflation Rate computed?• What is Disinflation? 44
  45. 45. Key Concepts cont.• What does Inflation do to People’s Income?• What is Nominal Income?• What is Real Income?• What is Wealth?• How is Wealth affected by Inflation?• How does Inflation affect Borrowers and Saver• What are the two basic types of Inflation? 45
  46. 46. Key Concepts cont.• What is Demand-pull Inflation?• What is Cost-push Inflation?• Do people’s Expectations affect Inflation?• What is Hyperinflation?• How does the U.S. inflation rate compare with 46
  47. 47. Summary 47
  48. 48. Inflation is an increase in thegeneral (average) price level ofgoods and services in the economy. 48
  49. 49. The consumer price index (CPI) isthe most widely known price-levelindex. It measures the cost ofpurchasing a market basket of goodsand services by a typical householdduring a time period relative to the costof the same bundle during a base year.The annual rate of inflation iscomputed using the following formula: 49
  50. 50. *ARI = Annual rate of inflation*CPIY = Consumer price index in given year*CPIPY = Consumer price index in previous year CPI - CPIPYX 100ARI = CPIPY 50
  51. 51. Deflation is a decrease in thegeneral level of prices. During theearly years of the Great Depression,there was deflation, and the CPIdeclined at about a double digit rate. 51
  52. 52. Disinflation is a reduction inthe inflation rate. Between 1980 and1986, there was disinflation. Thisdoes not mean that prices werefalling, but only that the inflationrate fell. 52
  53. 53. The inflation rate is criticizedbecause (1) it is not representative,(2) it incorrectly adjusts for qualitychanges, and (3) it ignores therelationship between price changesand the importance of items in themarket basket. 53
  54. 54. Nominal income is incomemeasured in actual money amounts.Measuring your purchasing powerrequires converting nominal incomeinto real income, which is nominalincome adjusted for inflation. 54
  55. 55. The real interest rate is thenominal interest rate adjusted forinflation. If real interest rates arenegative, lenders incur losses. 55
  56. 56. % ∆ in real % ∆ in _ % ∆ in income = nominal CPI income 56
  57. 57. Demand-pull inflation is causedby by pressure on prices originatingfrom the buyers side of the market.On the other hand, cost-pushinflation is caused by pressure onprices originating from the sellersside of the market. 57
  58. 58. Hyperinflation can seriouslydisrupt an economy by causinginflation psychosis, credit marketcollapses, a wage-price spiral, andspeculation. A wage-price spiraloccurs when increases in nominalwages cause higher prices and, inturn, higher wages and prices. 58
  59. 59. Chapter 17 Quiz ©2000 South-Western College Publishing 59
  60. 60. 1. Inflation is a. an increase in the general price level. b. not a concern during war. c. a result of high unemployment. d. an increase is the relative price level.A. Inflation is always a concern and it is not caused by a high unemployment rate. 60
  61. 61. 2. If the consumer price index in Year X was 300 and the CPI in Year Y was 315, the rate of inflation was a. 5 per cent. b. 15 per cent. c. 25 per cent. d. 315 per cent. A. CPI = 315 - 300 / 300 x 100 = 5% 61
  62. 62. 3. Consider an economy with only two goods: bread and wine. In 1982, the the typical family bought 4 loaves of bread at 50 cents per loaf and two bottles of wine for $9 per bottle. In 1996, bread cost 75 cents per loaf, and wine cost $10 per bottle. The CPI for 1996 (using a 1982 base year) is a. 100. b. 115. c. 126. d. 130. B. 62
  63. 63. *CYP = cost of the market basket of products at current-year prices*BYP = cost of the market basket of products at base-year prices CYP X 100 CPI = BYP $23 X 100 115 = $20 63
  64. 64. Exhibit 5Year CPI 1 100 2 110 3 115 4 120 5 125 64
  65. 65. 4. As shown in Exhibit 5, the rate of inflation for Year 2 is a. 5 percent. b. 10 percent. c. 20 percent. d. 25 percent.B. A percent increase of decrease between two numbers is the difference divided by the original number. In this case, it is 10 / 100 = 10% 65
  66. 66. 5. As shown in Exhibit 5, the rate of inflation for Year 5 is a. 4.2 percent. b. 5 percent. c. 20 percent. d. 25 percent.A. A percent increase of decrease between two numbers is the difference divided by the original number. In this case, it is 5 / 100 = 4.2% 66
  67. 67. 6. Deflation is a (an): a. increase in most prices. b. decrease in the general price level. c. situation that has never occurred in U.S. history. d. decrease in the inflation rate.B. Inflation is an increase in most prices and deflation did occur in the U.S. during the Great Depression of the 1930’s. 67
  68. 68. 7. Which of the following would overstate the consumer price index? a. Substitution bias. b. Improving quality of products. c. Neither (a) nor (b). d. Both (a) and (b). D. Substitution bias refers to the law of demand in which people buy less when the price rises. However, the CPI is based on a fixed market basket. Since quality is difficult to measure, a decline in quality understates inflation. 68
  69. 69. 8. Suppose a typical automobile tire cost $50 in the base year and had a useful life of 40,000 miles. Ten years later, the typical automobile tire cost $75 and had a useful life of 75,000 miles. If no adjustment is made for mileage, the CPI would a. underestimate inflation between the two years. b. overestimate inflation between the two years. c. accurately measure inflation between the two years. d. not measure inflation in this case. B. Quality changes are difficult to measure. When the quality of items improves, increases in the CPI overstate the change in prices. 69
  70. 70. 9. When the inflation rate rises, the purchasing power of nominal income a. remains unchanged. b. decreases. c. increases. d. changes by the inflation rate minus one. nominal income B. Real income = CPI ÷ 100 A larger value for CPI decrease nominal income. 70
  71. 71. 10. Last year the Harrison family earned $50,000. This year their income is $52,000. In an economy with an inflation rate of 5 per cent, which of the following is correct? a. The Harrison’s nominal income and real income have both risen. b. The Harrison’s nominal income and real income have both fallen. c. The Harrison’s nominal income has fallen, and their real income has risen. . d. The Harrison’s nominal income has risen, and their real income has fallen.D. % change real income 52,000 - 50,000 - 5%, 50,000 4% - 5% = -1% 71
  72. 72. 11. If the nominal rate of interest is less than the inflation rate, a. lenders win. b. savers win. c. the real interest rate is negative. d. the economy is at full employment.C. The real rate of interest is negative because the lender is receiving less money back, in real terms, then was lent out. 72
  73. 73. 12. Demand-pull inflation is caused by a. monopoly power. b. energy cost increases. c. tax increases. d. full employment.D. Demand-pull inflation is caused by an excess of total spending (demand) at or close to full employment real GDP. Sellers respond by raising prices because they do not have the capacity to produce more goods. 73
  74. 74. 13. Cost-push inflation is due to a. excess total spending. b. too much money chasing too few goods. c. resource cost increases. d. the economy operating at full employment. C. Answers a, b, and d describe demand-pull inflation. 74
  75. 75. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises 75
  76. 76. END 76

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