Transcript Measuring the Price Level and Inflation

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Measuring the Price Level
and Inflation
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Value of Money
Value of money depends upon
the prices of goods and services
Rapid and ongoing increases in the
prices of most goods and services
can radically reduce the buying
power of a given amount of money
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Problems of Inflation
Makes comparisons of economic
conditions over time difficult
Creates uncertainty about the future
How much should I save for retirement?
Imposes many costs on an economy
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Measuring Inflation
Consumer Price Index, CPI
It measures, for any time period, the cost
of a standard basket of goods and services
relative to the cost of the same basket of
goods and services in a fixed year
The fixed year is called the base year
It uses a constant basket of goods and
services
It is collected by the BLS
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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CPI
CPI 
cost of base  year basket in current year
cost of base  year basket in base  year
Measures changes in prices of a typical
market basket
Is used to eliminate the effects of
inflation from economic data
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Inflation
Rate of inflation
The annual percentage rate of change in
the price level, as measured, for example,
by the CPI
A measure of how fast the average price
level is changing over time
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Deflation
Deflation
A situation in which the prices of most
goods and services are falling over time so
that inflation is negative
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Adjusting for Inflation
Nominal quantity
A quantity that is measured in terms of its current
dollar value
Real quantity
A quantity that is measured in physical terms—
for example, in terms of quantities of goods and
services
Deflating
The process of dividing a nominal quantity by a
price index to express the quantity in real terms
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Real Wage
Real wage
The wage paid to workers measured
in terms of real purchasing power
The real wage for any given period is
calculated by dividing the nominal
wage by the CPI for that period
nominal wage
Real Wage 
CPI for that period
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 7.1
Nominal and Real Wages for Production
Workers, 1960-1999
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Indexing
Indexing
The practice of increasing a nominal
quantity each period by an amount equal
to the percentage increase in a specified
price index
Prevents the purchasing power of the
nominal quantity from being eroded by
inflation (e.g., a Social Security payment)
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Accuracy of CPI
Changes in the CPI are important
Directly impacts government budgets
Study shows CPI overstates inflation
between 1 - 2% a year
Costing federal government billions of
dollars more than necessary every year
Underestimating of true living standard
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Reasons for Overstatement
of Inflation
Quality adjustment bias: statistics do
not account for the fact that
The quality of goods and services change
over time
New goods appear
Substitution bias
CPI uses a fixed market basket
Consumers seek out cheaper substitutes
when prices rise
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Price Level vs. Relative
Price
Price level
A measure of the overall level of prices at a
particular point in time as measured by a price
index such as the CPI
Relative price
The price of a specific good or service in
comparison to the prices of other goods and
services
If the price of oil decreases by 10% and all other prices
decrease by 3%, then the relative price of oil decreases
(i.e. oil is cheaper relatively)
Serious misunderstanding by the public
The remedies are different
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Costs of Inflation
Reduces efficiency of the economy
“Shoe-leather” costs
More frequent trips to the bank
Inflation raises the cost of holding cash
“Noise” in the price system
Difficult to interpret information conveyed by prices
Relative price change or inflation?
Distortions of the tax system
Many provisions in the tax codes are not indexed
Causes bracket creep
Causes paying more than initially intended
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Costs of Inflation
Reduces efficiency of the economy
Unexpected redistribution of wealth
Inflation higher than expected
Under contracts, wage earners are hurt to the
benefit of employers
Hurts creditors to the benefit of debtors
Interference with long-run planning
Difficult to forecast prices over long periods
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Hyperinflation
Hyperinflation
A situation in which the inflation rate is
“extremely” high
Experienced by
Several Latin American countries
Israel
Transition economies like Russia
Confederacy of U.S. 1861-1865
Magnifies the costs of inflation
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Real Interest Rate
Real interest rate (i.e., real rate of return)
The annual percentage increase in the purchasing
power of a financial asset
Equals the nominal interest rate on that asset
minus the inflation rate
Financial investors and lenders do best when
the real (not the nominal) interest rate is high
Increasing purchasing power
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Nominal Interest Rate
Nominal interest rate
(i.e., the market interest rate)
The annual percentage increase in the
nominal value of a financial asset
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Real vs. Nominal
r = real interest rate
i = nominal, market, interest rate
p = inflation rate
r  ip
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 7.2
The Real Interest Rate
in the United States, 1960-1999
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Lenders vs. Borrowers
Unexpected inflation
Hurt creditors, aids borrowers
reduces the value of the dollars with which the
debts are repaid
For a given nominal interest rate, the
higher the inflation rate (higher than
expected), the lower the real interest rate
the lender receives
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Inflation and Interest Rates
Economists have noticed that
During periods of high inflation
Interest rates are high as well
During periods of low inflation
Interest rates are low as well
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fig. 7.3
Inflation and Interest Rates
in the United State, 1960-1998
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
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Fisher Effect
Fisher effect
The tendency for nominal interest rates to
be high when inflation is high and low
when inflation is low
If inflation has been high recently
Lenders anticipate that it will continue to
be high
Lenders raise the nominal interest rate so
that the real rate of return is not affected
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.