Transcript Inflation - cloudfront.net

INFLATION
INFLATION…WHAT IS IT?
An increase in the economy’s price level
The price level is the weighted average of
prices
A decrease in money’s purchasing power
When the supply of money is growing faster
than the production of goods and services.
WHAT CAUSES INFLATION
 2 immediate causes (what starts it)
Demand-pull – Increases in total spending that
are not offset by increases in the supply of goods
and services and so cause the average level of
prices to rise
Cost-push – Increases in production costs that
cause firms to raise prices to avoid losses
 Ultimate cause (what sustains it)
Too much money chasing too few goods
This can lead to hyperinflation
HOW IS INFLATION MEASURED
 Consumer Price Index (CPI)
 Used to measure consumer inflation
 Market basket approach (typical basket of goods and
services)
 Quick, efficient
 Ignores consumer substitution, quality changes
(if quality and price go up, it doesn’t account for
quality)
 Consumer Price Index (CPI) is computed every month
and uses prices for a market basket of 80,000 goods
and services consumed by a typical family of four
CALCULATING CPI MARKET BASKET
 Price x Quantity for dif ferent years
 Inflation rate this year = 100 x (CPI this year – CPI last year) /
(CPI last year)
PRICE INDEX IN A GIVEN YEAR
 Cost of market basket in a given year x 100
Cost of market basket in base year
CPI - 4 STEP PROCESS
1) The fixed basket of goods and services is defined.
2) The prices for every item in the basket are found.
3) The cost of the fixed basket of goods and services must be
calculated for each time period.
4) A base year is chosen and the index is computed.
CALCULATING CPI
Items in Market
Basket
Quantity
Consumed in Yr
(pounds)
2008 Prices
2009 Prices
Salami
300
$4
$6
Corned Beef
200
$5
$7
Bologna
100
$2
$1.50
Cheese
500
$3
$2.50
2008 = (300x$4) + (200x$5) + (100x$2) + (500x$3) = $3,900
2009 = (300x$6) + (200x$7) + (100x$1.50) + (500x$2.50) = $4,600
100 x CPI This Year – CPI Last Year
CPI Last Year
= $4,600- $3,900 =
$3,900
17.9% inflation
CALCULATING CPI
Items in Market
Basket
Quantity
Consumed in Yr
(pounds)
2008 Prices
2009 Prices
Salami
300
$4
$6
Corned Beef
200
$5
$7
Bologna
100
$2
$1.50
Cheese
500
$3
$2.50
2008 = (300x$4) + (200x$5) + (100x$2) + (500x$3) = $3,900
2009 = (300x$6) + (200x$7) + (100x$1.50) + (500x$2.50) = $4,600
Price index in a given year = Cost of market basket in a given year x 100
Cost of market basket in base year
$3,900 x 100 = 100 (Base Year)
$3,900
$4,600 x 100 = 117.94
$3,900
Assume 5 bananas were purchased and 2 backrubs were purchased
1: (5 x $1) + (2 x $6) = $17
2: (5 x $2) + (2 x $7) = $24
3: (5 x $3) + (2 x $8) = $31
Any year can serve as the base year. Let’s use Time Period 1.
The CPI for time period 1 is ($17/$17) x 100 = 100
CPI for 2: ($24/$17) x 100 = 141
CPI for 3: ($31/$17) x 100 = 182
The percent change in the price level from the base year to the
comparison year is calculated by subtracting 100 from the CPI.
Base year 1 to 2: 141-100 = 41%
Base year 1 to 3: 182-100 = 82%
 Suppose the year 2000 is the base year for a price index.
Between 2000 and 2020 prices double and at the same time
your nominal income increases from $40,000 to $80,000.
 A. What is the value of the price index in 2000?
 B. What is the value of the price index in 2020?
 C. What is the percentage increase in your nominal income between
2000 and 2020?
 D. What has happened to your real income between 2000 and 2020?
Explain
 Suppose the year 2000 is the base year for a price index.
Between 2000 and 2020 prices double and at the same time
your nominal income increases from $40,000 to $80,000.
 A. What is the value of the price index in 2000? 100
 B. What is the value of the price index in 2020? 200
 C. What is the percentage increase in your nominal income between
2000 and 2020? 100%
(($80,000-$40,000)/$40,000) x 100
 D. What has happened to your real income between 2000 and 2020?
Explain It stayed the same because real income is a measure of the
purchasing power of my income, and because my income and the
price both doubled, the purchasing power of my income has not been
affected.
1990
1991
1992
Price of Plums
$0.50
$0.50
$1.00
Price of
Lawnmowers
$100
$125
$150
Price per lb. of
pasta
$1
$1.50
$1.50
In this nation, a typical household consumes 50 plums, 1 lawnmower, and 200
lbs. of pasta in a given year. Using 1992 as the base year, what is the CPI for
1991?
1990
1991
1992
Price of Plums
$0.50
$0.50
$1.00
Price of
Lawnmowers
$100
$125
$150
$1.50
$1.50
Price per lb of pasta $1
In this nation, a typical household consumes 50 plums, 1 lawnmower, and 200 lbs.
of pasta in a given year. Using 1992 as the base year, what is the CPI for 1991?
1991: ($0.50x50) + ($125x1) + ($1.50x200) = 450
1992: ($1x50) + ($150x1) + ($1.50x200) = 500
Price index in a given year = Cost of market basket in a given year x 100
Cost of market basket in base year
(450/500) x 100 = 90 (Price Index)
90-100 x 100 = 10%
100
MEASURING INFLATION
 GDP deflator
(if nominal GDP were to increase 5% but real GDP
does not change, the GDP deflator indicates aggregate prices went
up 5%)
 Measures entire economy’s inflation
 Includes everything
 Used to deflate nominal GDP
 GDP Deflator = Nominal GDP x 100
Real GDP
CPI VS. GDP DEFLATOR
 They tell a similar story, but the GDP deflator reflects the
prices of all goods and services produced domestically
whereas the CPI has a fixed basket of goods.
NOMINAL VS. REAL INTEREST
 Nominal interest rate is the observed interest rate in the
market and includes the ef fect of inflation.
 Real interest rate is the nominal interest rate minus the rate
of inflation.
 Real interest rate = nominal interest rate – rate of inflation
 nominal interest rate = real interest rate + expected inflation
INFLATION EXAMPLE
Year 1 money: $100
Year 2 money: $110
Inflation rate: 2%
“Real” Return on your investment (purchasing
power) = 8%
(10% return – 2% inflation)
2 WAYS INFLATION IS REPORTED
CPI Headline inflation
Includes entire CPI market basket
CPI Core Inflation
Excludes food and energy because they are
volatile
WHO DOES INFLATION AFFECT?
 You and a friend agree that inflation next year will be 5% and you
agree that your lending ser vices are wor th another 3%. You charge
your friend 8% interest.
 Af ter a year, three scenarios could have happened:
 Scenario 1: You expected 5% inflation and you experienced exactly 5%
inflation. The purchasing power of the $100 you lent was unchanged when
your friend paid you back exactly enough to compensate for the inflation.
 Scenario 2: You expected 5% inflation and you experienced only 1% inflation.
Your purchasing power has actually increased because your friend paid you
back more than enough to compensate for the inflation.
Note: When actual inflation is below expected inflation, the
lender (in this case you) gains and the borrower loses.
 Scenario 3: You expected 5% inflation and you experienced 8% inflation.
Your purchasing power has actually decreased because your friend paid you
back less than enough to compensate for the inflation.
Note: When actual inflation is above expected inflation, the
lender (in this case you) loses and the borrower gains.
WHO DOES INFLATION AFFECT?
Everybody
Who wins?
Those with large debt
Those who borrowed at low fixed interest rates
Those who make fixed payments
Who loses?
Those with large cash savings
Those who lent at low fixed interest rates
Those receiving fixed payments
I N T HE FOLLOW I NG SC E N ARIOS, HA S I N F LATION C RE AT ED: A )
W I N NERS A N D LOSE RS AT N O N E T C OST TO T H E E C ON OM Y, OR
B) A N E T C OST TO T H E E C ON OMY ? I F B, W H I C H T Y P E OF C OST
I S T H E I N F LATION G E N E RATI NG ?
1. During a period of rapid unexpected inflation, Sam’s Meat
Market must change the price of his products on a weekly
basis.
2. The First Bank of Fef fville has make many long-term loans
with fixed interest rates assuming a stable inflation of 3%
every year. For the last two years inflation has been even
lower at 1 .5%.
3. Sonya is retried and collecting her SS checks every month.
Every year SS payments are adjusted to reflect any increase
in the cost of living.
4. Dwight is renting a storage locker from Jim and signed a
two-year lease that said his monthly payment would be $20
over the course of the lease. Since signing the lease, the
inflation rate has been higher than expected, at about 5.5%
EXPECTATIONS
Expecting inflation causes inflation
Consumers demand more
Producers supply less
The role of the central bank
Control actual inflation by controlling expected
inflation
The importance of credibility
DISINFLATION AND DEFLATION
 Disinflation
Decreasing the inflation rate (policy makers)
Going from 7% inflation to 2% inflation
Disinflation is good for the economy
Referred to as price stability
 Deflation
Negative inflation rate
Prices falling
Deflation is bad for the economy
Creates incentive to delay spending on durable
goods and capital investments
HYPERINFLATION
Inflation gone wild
Government wild with the printing press