Transcript Ch. 7 Overview Notes Fall 2013x

Turn & Talk: What’s this about?
Quick Definitions
INFLATION
• an increase in the average
level of prices, not a change
in any specific price
DEFLATION
• an decrease in the average
level of prices, not a change
in any specific price
Ch. 7: Inflation
Unit 2, Days 5-7
Ch. 7
INFLATION…CAUSES, EFFECTS &
MEASUREMENT
INFLATION IS A TAX
• Effects of inflation redistribute wealth
– Price Effects
– Income Effects
– Wealth Effects
• ALWAYS winners and losers
Price Effects
Better to be a couch potato or a college student?
Prices That Rose
(percent)
Prices That Fell
(percent)
Apples
+12.8
New cars
-0.2
Gasoline
+12.0
Cereal
-5.4
-2.5
College tuition
+6.7
Chicken
Textbooks
+6.4
Computers
-15.6
Coffee
+2.5
Televisions
-16.2
Average inflation rate: +3.2%
Definition: Buyers are unequally affected by the changing prices
of specific goods they purchase.
Income Effects
• Even if all prices rose at the same rate,
inflation would still redistribute income.
• Redistributive effects originate both in
expenditure and income patterns.
LO2
Income Effects…Your 5% “Raise”
NOMINAL INCOME
• Your income in today’s
dollars (inflation is included)
REAL INCOME
• Your income adjusted for
inflation (based on a based
period)
• You receive a 5% raise
• You receive a 5% raise
during a period of 10%
inflation
• Nominal income is UP 5%
• Real income is DOWN 5%
Wealth Effects
• Winners and losers from inflation depend on
the form of wealth they own.
• You lose when inflation reduces the real value
of wealth.
LO2
The Real Story of Wealth
Asset
Percentage change in value:
1991-2001
Asset
Percentage change in value:
1991-2001
Stocks
+250
U.S. farmland
+49
Diamonds
+71
Silver
+22
Oil
+66
Bonds
+20
Housing
+56
Stamps
-9
The average price level increased 32%
LO2
Money Illusion
• The use of nominal
dollars rather than real
dollars to gauge
changes in one’s income
or wealth is called the
money illusion.
LO2
Macro Consequences of Inflation
• Uncertainty: hard to save,
plan for the future (if
money loses value)
• Speculation: decreases in
output with focus on
price changes
– Hyperinflation (over 200%,
1yr)
• Bracket Creep: taxpayers
pushed into higher tax
levels because of nominal
income changes
Protecting Against Inflation
Cost of Living Adjustments
(COLAs)
Adjustable Rate Mortgages
(ARMs)
• Protect people on fixed
incomes
• Adjust nominal incomes to
rate of inflation
• Built into Social Security (to
an extent), many contracts,
pensions
• Protect lenders
• Adjust mortgage rate to
keep pace with inflation
• Use a real interest rate:
nominal interest rate minus
the anticipated inflation
rate.
Inflation: Winners & Losers
Does the person or group get HURT, GAIN from, or have
UNCERTAIN consequences from inflation? WHY?
1.
2.
3.
4.
5.
6.
7.
8.
Banks extend many fixed rate loans.
A farmer buys machinery with a fixed rate loan to be repaid over
10 years.
Your family buys a new home with an adjustable rate mortgage.
Your savings from your summer job are in a savings account
paying a fixed rate of interest.
A retired couple lives entirely on incomes from a pension a
woman receives from her former employer.
A firm signs a contract to provide maintenance services at a fixed
rate for the next five years.
The state government receives revenue mainly from a progressive
income tax.
A local government receives revenue mainly from fixed rate
license fees charged to local business.
POLITICAL CARTOONS IN
ECONOMICS
#1 Law of Economics
Economists Rarely Agree
Econ=Material for Cartoonists
Cartoons Decoded…4 strategies
– Labels:
• Make representations apparent
– Symbolism:
• Use simple objects for bigger
ideas
• Compare a simple concept to a
more complex one
• Highlight the difference between
things as they are and things as
they should be
– Analogy:
– Irony:
Cartoon Poster Walk…
• Spend 2 minutes per cartoon
– Identify
• Devices used (symbols, labels, analogy, irony)
• Cartoonist’s message
– Add thoughts in group marker color to poster
Create Your Own
Political Cartoon
Your Task – with a partner, apply the knowledge
learned about inflation to create a political cartoon
depicting one of the following themes:
 Wealth, price, or income effects
 The money illusion
 Be sure to explain what effect you chose
and who the winners/losers are
Causes of Inflation (Supply & Demand)
DEMAND PULL
• “Too much money chases
too few goods” enabling
producers to raise prices.
COST PUSH
• Higher production costs put
upward pressure on product
prices.
The Goal: Price Stability
• Every U.S. president since Franklin Roosevelt
has decreed price stability to be a foremost
policy goal.
– Full Employment & Balance Growth Act 1978
• Est. Inflation Rate at <3%
• Trade off between inflation & unemployment
LO3
The Historical Record
• In the long view of history, the U.S. has done a
good job in maintaining price stability.
• Upon closer inspection, however, our inflation
performance is very uneven.
Annual Inflation Rates
Unit 2, Day 6
MEASURING INFLATION
How do we measure inflation?
Price Level: relative size of prices at one point
in time.
• Price Index: constructed to measure inflation
– Most common  Consumer Price Index (CPI)
Inflation is reported in terms of annual rates of
change of the price level…
Formula:
Inflation Rate = Price Level 2 – Price Level 1 x 100
Price Level 1
Measuring Inflation
Consumer Price Index
2012 Avg
229.59
Aug. 2013
233.88
Percent
Change
2.06%
Percent Change
0.12%
2011 Avg
224.94
July 2013
233.60
Price Indexes
•
Consumer Price Index: changes in
the average price of consumer goods
and services.
– Core Inflation Rate: CPI-food & energy
(most volatile prices
•
Producer Price Index: changes in
price of crude, intermediate and
finished goods for suppliers
(increases usually precede CPI)
•
GDP Deflator: index of changes in all
G & S related to GDP, not a fixed
basket (reflects both price changes
and market responses)
Computing the CPI
• BLS determines what Consumers are buying
Est. Mkt. • Establishes a base period (year to compare prices against)
Basket
• BLS assigns a weight to items showing relative importance
Set Item • Big ticket items not always highest weight if less common
Weight
• Prices of weighted items are compared against base year
• Overall rate of inflation calculated by change in “basket’s”
Compare
value
Prices
The Market Basket
Transportation
18.0%
Housing
32.7%
Food
13.7%
Insurance and pensions 11.2%
Clothing 4.1%
Entertainment 5.1%
Miscellaneous 9.5%
Health care 5.7%
LO1
Real vs. Nominal GDP
• Nominal and Real GDP are connected by the
GDP deflator:
nominal GDP
Real GDP =
GDP deflator
nominal GDP
2000 real GDP =
GDP deflator
$10 trillion

 $8.06 trillion
1.24
Practice with Inflation!
1.
If nominal GDP in 2005 was $10Trillion, what
was real GDP?
Real=Nominal/ (GDP Deflator/100)
2.
If real income was 8 trillion in 2004, what
was nominal income?
Nominal=Real* (GDP Deflator/100)
3.
4.
5.
According to the CPI, what was the inflation
rate from 2004 to 2005?
Inflation Rate= (2005 CPI-2004 CPI)/2004 CPI
According to the GDP deflator, what was the
inflation rate from 2004 to 2005?
Inflation Rate= (2005 df-2004 df)/2004 df
If the market basket in the base year cost
$1,000, how much did that basket cost in
2006?
2006 basket=Base Year Basket*(2006
CPI/100)
Year
GDP
CPI
Deflator
2004
102
180
2005
105
190
2006
110
205
2007
112
210
Next Steps
• Use web quest to gather data on changes in
inflation and unemployment
• Complete Unit 2 Study Guide for Monday