Lecture_4_spring_2009.ppt

Lecture 4
Principles of Macroeconomics
Econ 2
Spring, 2009

Unemployment
• How many people unemployed?
• A) 1 million
• B) 6 million
• C) 10 million
• D) 13 million
• E) 18 million

Unemployment
• How many people unemployed?
• D) 13 million

Tracking the Economy
• Obama: Job creation
• 3 to 4 million jobs
• Job Openings and Labor Turnover
Survey

Aplia
• Problems labeled practice are just
that, they are NOT graded
• Problems labeled as graded are the
ones that count

Iclicker
• If the serial number is missing
• See Mat Some NH 2nd floor from 4-6
today
• If your points are not showing up by
tomorrow (perm number): See if your
Iclicker serial number is there

(Year 1) Quantity Index
Method 2: by value
quantity weight total
apples 2 $0.50
per
apple
$1.00 of apples
oranges 3 $0.25
per
orange
$0.75 of
oranges
Tot.
prod.
$1.75 of fruit

Quantity Index
Year 2
apples 2 $1.00
per
apple
$2.00 of apples
oranges 3 $0.50
per
orange
$1.50 of
oranges
Tot.
prod.
$3.50 of fruit

Real and Nominal
• Now, add another year of data

Quantity Index
Year 3
apples 4 $1.00
per
apple
$4.00 of apples
oranges 6 $0.50
per
orange
$3.00 of
oranges
Tot.
prod.
$7.00 of fruit

Real and Nominal
• Nominal GDP in year 3 = $7.00
• What is Real GDP in year 3?
• With year 1 as the base year:
• Use quantities in the given year
• Evaluated using prices in the base
year

Real GDP Year 3
• Real GDP in Year 3 (with Year 1 as
base year) is:
• A) $1.00
• B) $1.75
• C) $2.00
• D) $3.50
• E) $7.00

Real GDP Year 3
• Real GDP in Year 3 (with Year 1 as
base year) is:
• D) $3.50

Real and Nominal
• Year 3 quantities:
• 4 apples and 6 oranges
• Base year (year 1) prices:
• $0.50 per apple; $0.25 per orange
• Real GDP in year 3 (year 1 prices):
4 x $0.50 + 6 x $0.25 = $3.50

Real and Nominal
• Real GDP in year 3=
4 x $0.50 + 6 x $0.25 = $3.50
• How does this compare with year 1?
• Since the base year is year 1, nominal
and real are the same in year 1:
• Real GDP in year 1 =
2 x $0.50 + 3 x $0.25 = $1.75

Real and Nominal
• Real GDP in year 3: $3.50
• Real GDP in year 1: $1.75
• The point:
• Since real GDP is twice as high in
year 3 it means we have twice as
many goods to consume in year 3

The distinction between real and
nominal GDP suggests a measure of
the “price level,” defined to be the
average of the prices of an
economy’s goods and services.

In practice, the price level is measured
by an index of average prices.
Consumer Price Index: CPI
A price index calculated as the
current cost of a fixed basket of
consumer goods divided by the cost
of the basket in the base period.

Calculating the CPI
• Method:
• Pick a base year
• Determine a basket of goods
consumed by an average urban
family (base-year basket)
• The BLS then sends their minions
to survey prices of these items at
stores each month

Calculating the CPI
• Bureau of Labor Statistics (BLS) is
the agency responsible for
calculating the CPI
• NPR, Calculating the CPI

Calculating the CPI
CPI
t
= Cost of base-year basket in year t
Cost of base-year basket in base year

Calculating the CPI
CPI
t
= Cost of base-year basket in year t
For our simple example, CPI in base year:
CPI
baseyear
=
$1.75
$1.75
= 1

Calculating the CPI
• And for year 2
CPI
2
= Cost of base-year basket in year 2
For our simple example, CPI in year 2:
CPI
Year 2
=
$3.50
$1.75
= 2

Calculating the CPI
• Note that sometimes you will see the
CPI for the base year as 100 instead
of 1
• So that the formula from before just
gets multiplied by 100

100
1
1
x
CPI
CPI
CPI
t
t
t
t 






 -
=
-
-
p
Inflation: A Computational Definition
Note: The “times 100” is optional

CPI-U and Inflation
1982-84=100
Year CPI-U Inflation
2002 179.9 .
2003 184.0 2.28%
2004 188.9 2.66%
2005 195.3 3.39%
2006 201.6 3.23%
p

Uses of the CPI
• Convert current dollars into real,
deflating
• Interesting example from the book
• In 1930 Babe Ruth earned $80,000
• In 2001 Barry Bonds earned $10,300,000
• In real terms who was better off?
• What does real mean?

Uses of the CPI
• We need to deflate the current
dollars to account for inflation
• Divide the current dollar (nominal)
by the CPI for that year
• Using 1982-1984 as the base year:
• CPI in 1930 = 0.167
• CPI in 2001 = 1.78

Uses of the CPI
• Using 1982-1984 as the base year:
• CPI in 1930 = 0.167
• CPI in 2001 = 1.78
• Babe: $80,000 ÷ 0.167 = $479,000
• Barry: $10,300,000 ÷ 1.78 =
$5,790,000

Uses of the CPI
• Indexing
• CPI can also be used to convert
real to nominal
• This is often done to keep
purchasing power constant
• Suppose you get $1,000 per year for
the next ten years
• How much is $1,000 worth 10 years
from now?

Uses of the CPI
• This is an issue for things like Social
Security payments, minimum
wages, and for contracts (Cost of
Living Adjustments)

Uses of the CPI
• Example: If average prices are
expected to rise by 10% over the next
year,
• How much would you need to get
next year to keep purchasing power
of $10,000 constant?

Uses of the CPI
• You would need:
• $10,000 + (.10)*$10,000 =
• $10,000 x (1.10) = $11,000

Is the Nominal/Real
Distinction Important?

Nominal and Real
• Let’s look at some actual goods:

How much does that cost in “real” dollars?
Product Cost (year) Cost (today) Increase
Dollar
Dollar
Refrigerator $375 (1970) $500 (2005) 33%
“Cheap” or “Expensive”?
Source: Bureau of Labor Statistics

Product Cost (year) Cost (today) Increase Inflation Price
Dollar
Homework: How do you get the real
price of $99?
Dollar
Refrigerator $375 (1970) $500 (2005) 33% 404% $99
CHEAP!
“Real”

Dollar
Dollar
Large
Pepperoni Pizza $1.99 (1958) $12.99 (2005) 553%

Dollar
Dollar
Large
Pepperoni Pizza $1.99 (1958) $12.99 (2005) 553% 556% $1.98
ALMOST THE SAME!
“Real”

Dollar
Dollar
7-Day Caribbean
Cruise $195 (1972) $599 (2005) 207%

Dollar
Dollar
7-Day Caribbean
Cruise $195 (1972) $599 (2005) 207% 284% $156
CHEAP!
“Real”

Dollar
Dollar
Woman’s Haircut $1.50 (1950) $30.00 (2005) 566%

Dollar
Dollar
Woman’s Haircut $1.50 (1950) $30.00 (2005) 1900% 675% $3.87
EXPENSIVE!
“Real”

Is Money Value (Even Adjusted
For Inflation) The Right Thing
To Be Chasing?
What might be a better “value”
consideration is how much time
does it take to be able to purchase
goods?

Product Cost (year) Cost (today) Cost (1970) Cost (2005)
Dollar
Dollar
Refrigerator $375 (1970) $500 (2005) 110.3 hours 31.1 hours
Time Time
How long do you have to work for that?

Dollar
Dollar
Large
Pepperoni Pizza $1.99 (1958) $12.99 (2005) 57 min. 49 min.
Time Time

Dollar
Dollar
7-Day Caribbean
Cruise $195 (1972) $599 (2005) 44.8 hours 37.2 hours
Time Time

Dollar
Dollar
Woman’s Haircut $1.50 (1950) $30.00 (2005) 58 min. 112 min.
Time Time

The Christmas Price Index
• Index of the current costs of the gifts
given by the True Love to the singer
of the song The Twelve Days of
Christmas

12 Days of Christmas Price
Index
• Price index

• Each year, the Cincinnati Zoo provides the
cost of most of the birds in the song,
including the partridge, the turtle doves,
the French hens, the swans and the geese.
• National pet chain PetCo provides the
price of the calling birds, or canaries.

• The pear tree price comes from Waterloo
Gardens, a Philadelphia nursery
• Gordon’s Jewelers provides the cost of
five fourteen carat gold rings
• Philadanco, a modern dance company in
Philadelphia offers the price of ladies
dancing.
• The Pennsylvania Ballet offers the price of
the lords a-leaping.

• Prices for the musicians in the song - the
drummers and pipers - are provided by a
Pennsylvania musicians union.
• Lastly, maids-a-milking are the only
unskilled laborers in the index, and as
such, they reflect the minimum wage.

• Over the last 24 years, the prices of services in
general have increased, while the price of goods
has decreased. In the 1984 Christmas Price Index,
goods were by far the more expensive
component of the index.
• Today, services are a much bigger piece of the
Index.

Price Measurement Issues
• Boskin Commission, 1996
• Found that the official measure may be
overstating inflation by as much as 1.5
percentage points
• This would cost the government billions
of dollars due to indexing of social
security
• Understates real growth

• Base-year expenditure shares
• An index constructed with base-year
weights is known as a Laspeyres Index
• If update the base-year then have to
change all previous measures as well
• To keep expenditure weights up-to-date
used to change them every ten years;
since 2002, every two years

• Substitution Bias
• When prices change people will
substitute other products
• Price data is for consumers in urban
regions—might shop at outlet malls

• Quality changes
• Cars today are of higher quality
• Computers get faster
• Hedonic adjustment
– Price characteristics of the good
• New goods
• Since not in base year, no price to
compare with

Chained CPI
• A new method to overcome many of
the problems
• Similar method but---expenditure
shares change each year

Chained CPI
• Benefits:
• Eliminates substitution bias
• Never will be revised
• Reduces need for hedonics

Important Distinction
• We defined inflation as the percent change
in the price level (that is, general prices)
• Many confuse changes in the price level
with a change in relative prices
• Inflation does not refer to a change in the
price of a particular good, like oil

Important Distinction
• Often hear (and it is WRONG):
• The price of gasoline went up 10%
last month leading to higher
inflation
• Gasoline is just one price in the
basket of goods, there are thousands
more

Some Alternative Price Measures
• CPI or Personal Consumption Expenditure Index
(PCE)
• Implicit GDP Price Deflator
• The Producer Price Index
The stuff that, ultimately, makes people “happy”.
All the stuff that is newly produced by the economy.
All the stuff that is used in production.

0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
Year-over-year percent change
PRICE INDICES: US
CPI
PCE Chain-Type
Price Index
GDP Deflator
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics

Price Indices
• There are others:
• Headline Inflation (CPI)
• Core Inflation
• CPI – food and energy
• Median CPI
• Trimmed mean

This definition represents the
statistic that is reported when we
read stories about the rate of inflation
in the press, or hear it on the news.
This definition is an ex post measure
of inflation: It tells us how prices
changed between yesterday and
today.

A more important measure of inflation
from the standpoint of businesses and
consumers making economic decisions
is the ex ante, or expected, rate of
inflation:
What do we anticipate to happen to
prices between today and tomorrow (or,
more generally, sometime in the future)?

100
1
x
CPI
CPI
CPI
t
t
e
t
e
t 






 -
= +
p
The expected rate of inflation (over two
periods) is given by:
The superscript e indicates that the
variable is being defined in expectation
(that is, as an “informed guess”).

"Price stability means that expected changes in
the average price level…do not materially enter
business and household financial decisions."
Alan Greenspan (1989)
THE IMPORTANCE OF
INFLATION EXPECTATIONS

Percent
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
1999 2001 2003 2005 2007
Treasury Inflation Indexed Securities
10-year corrected TIPS-
derived expected inflation
12-Month CPI Inflation
Sources: Bureau of Labor Statistics, Federal Reserve Bank of Cleveland

Inflation and Interest Rates
• We have defined inflation as the
percentage change in a price index
between two periods
• So, what are the problems
associated with inflation?

Inflation
• Some problems
• Adds noise to the price system
• You learned in Econ 1 that prices
convey information
• Scarcity, etc.
• Example, oil

Oil Example
• As the price of oil rises:
• We demand less of it
• More fuel efficient cars
• Public transportation
• But, more will be supplied
• New oil fields drilled, etc.
• This is a change in the relative price

Price Changes
• We learned last time that there is a
distinction between all prices
changing and a relative price change
• Why is it a problem, then, if all
prices double?

Inflation
• Adds noise to the price signal
• Makes it difficult to distinguish a
change in relative prices from a
change in the price level

Inflation
• Some problems
• Tax distortions

Taxes
• The income tax system in the U.S. is:
• A) a value added tax system
• B) regressive tax system
• C) progressive tax system
• D) a flat tax system

Taxes
• The income tax system in the U.S. is:
• C) progressive tax system

Inflation and Taxes
• Tax distortions
• In the U.S., income taxes are
progressive
• That is, people with higher
incomes pay a higher percentage
of their income in taxes

Inflation and Taxes
• Tax distortions
• Note: Inflation means a general
rise in prices—including the price
of labor (wages)
• So, when all prices double, you
can still buy the same stuff as
before

Inflation and Taxes
• Tax distortions
• If all prices rise, due to the
progressivity of the tax system,
you might go into a higher tax
bracket—bracket creep
• However, income tax brackets are
indexed to the CPI

Inflation
• Some problems
• Tax distortions
• Shoe-leather costs

Inflation
• When inflation is high keeping
cash in your pocket is expensive
• Its purchasing power is eroding
• Therefore, must make more trips to
the bank

Hyperinflation
• Some countries, during some
periods, experience very high
inflation

Israeli Inflation, 1985
• In 1985 Israel experienced monthly
inflation of approximately:
• A) 20 %
• B) 100 %
• C) 300 %
• D) 400 %

Israeli Inflation, 1985
• In 1985 Israel experienced inflation of
approximately:
• A) 20 %
• B) 100 %
• C) 300 %
• D) 400 % 

South America Inflation, 1988
• In 1988 several South American
countries experienced inflation of
approximately:
• A) 220 %
• B) 1,100 %
• C) 5,500 %
• D) 33,000 %

South America Inflation, 1988
• In 1988 several South American
countries experienced inflation of
approximately:
• A) 220 %
• B) 1,100 %
• C) 5,500 %
• D) 33,000 % 

Hyperinflation
• Some countries, during some periods,
experience very high inflation
• Hungary, 1945: largest recorded monthly
inflation
• 12,950,000,000,000,000%
• Prices doubled every 15 hours
• Zimbabwe, Nov., 2008 inflation

Hyperinflation
• Obviously, money ceases to have any
value
• Any assets denoted in that currency
(savings accounts) are wiped out.

Yugoslavian 50 billion bank
note (1993?)
QuickTime™ and a
decompressor
are needed to see this picture.

Inflation
• Some problems
• Tax distortions
• Unexpected redistribution of
wealth

Inflation
• Unexpected redistribution
• Nominal contracts (union wages,
e.g.)
• Wealth is not “lost” here, just
redistributed
• Between borrowers and lenders

Inflation
• Between borrowers and lenders
• Friday night, you are out of cash
• Ask roommate for $6 to buy a six
pack
–“I’ll pay you back later”

Inflation
• You: borrower $6
• Roommate: lender, $6
• You buy a six pack for $6
• “Later” arrives

Inflation
• You: borrower $6
• Roommate: lender, $6
• You buy a six pack for $6
• “Later” arrives
• In the meantime inflation has risen
by 10%

Inflation
• What’s happened:
• You pay the roommate $6
• She goes to the store to buy a six
pack—but can’t
• The price of a six pack is $6.60

Inflation
• What’s happened:
• You have paid back less than a six
pack in real terms
• Yet, you borrowed a six pack
• Borrowers gain, lenders lose when
there is unexpected inflation

Inflation
• If you expected the inflation
1. Charge interest of 10%
2. Ask to be paid back in beer, i.e., a
six pack

Inflation
• Question: what if charged 10% interest
and inflation went up by only 8%?
• A) can buy less than a six pack
• B) can buy more than a six pack
• C) buy the same because inflation
is a rise in general prices
• D) I don’t like beer, so wouldn’t
buy any (hint: this is not the right
answer)

Inflation
• Question: what if charged 10% interest
and inflation went up by only 8%?
• B) can buy more than a six pack 

Inflation
• BTW: our example was just an
illustration
• Replace “beer” with “house” and
think of a mortgage instead
• The same rationale applies

Inflation
• Some problems
• Tax distortions
• Unexpected redistribution of
wealth
• Interferes with long-run planning

Lecture_4_spring_2009.ppt

Recommended

Recommended

More Related Content

Similar to Lecture_4_spring_2009.ppt

Similar to Lecture_4_spring_2009.ppt (20)

Recently uploaded

Recently uploaded (20)

Lecture_4_spring_2009.ppt