Transcript Chapter 7

Inflation and the
Business Cycle
Chapter Checklist
When you have completed your study of this
chapter, you will be able to
1
Explain what the Consumer Price Index (CPI) is and
how it is calculated.
2
Explain the limitations of the CPI as a measure of
the cost of living.
3
Adjust money values for inflation and calculate real
wage rates and real interest rates.
Inflation
Inflation
An upward movement in the average level of prices
Deflation
A downward movement in the average level of prices
Inflation
Purchasing Power
The value of money for buying goods and services
Varies with prices and income
Disposable Income
*During inflation purchasing power of a dollar falls
*During deflation purchasing power of a dollar rises
Inflation
Nominal Value
Price expressed in today’s dollars
Real Value
Varies with the rate of inflation
Value expressed in purchasing power which varies with
inflation
Inflation
Question
Is a 30 second ad during the Super Bowl
really 85 times more expensive today
($4.25 million) compared to 1967
($50,000)?
Inflation
Answer
Depends on what has happened to the price level and
the size of the audience during this time
Prices: Fourfold increase
Audience: Doubled
Inflation
Analysis
Adjusting for viewership and inflation
the cost per viewer is less than four
times what it was in 1967 -- not 25
times.
Inflation
Inflation- Measured by computing a price index
which is defined as the cost of a market basket
today, expressed as a percentage of the cost of that
market basket in some starting or base year.
 In the base year the price index is always equal to
100. Inflation is measured by the rise in a price
index.
 Base year chosen as a point of reference for
comparison.
THE CONSUMER PRICE INDEX
Consumer Price Index (CPI)
A measure of the average of the
prices paid by urban consumers for a
fixed market basket of consumer
goods and services (final products).
Inflation
Market Basket
Representative bundle of goods and services
Reference Base Year (Period)
The point of reference for comparison of prices in other
year.
A period for which the CPI is defined to equal 100.
Currently, the reference base period is 19821984.
THE CONSUMER PRICE INDEX
In May 2005, the CPI was 194.4.
The average of the prices paid by urban consumers for
a fixed market basket of consumer goods and services
was 94.4 percent higher in May 2005 than it was on the
average during 19821984.
In April 2005, the CPI was 194.6.
The average of the prices paid by urban consumers for
a fixed market basket of consumer goods and services
decreased by 0.2 of a percentage point in May 2005.
THE CONSUMER PRICE INDEX
Constructing the CPI
Three stages:
• Selecting the CPI basket
• Conducting the monthly price survey
• Calculating the CPI
THE CONSUMER PRICE INDEX
Figure below shows the CPI basket.
This shopping cart is filled with the items that an average
household buys.
THE CONSUMER PRICE INDEX
The Monthly Price Survey
Each month, BLS employees check the prices of the
80,000 goods and services in the CPI basket in 30
metropolitan areas.
BECAUSE the CPI measures price changes, it is
IMPORTANT that the prices recorded refer to exactly
the same items and quantity.
THE CONSUMER PRICE INDEX
Calculating the CPI
The CPI calculation has three steps:
• Find the cost of the CPI basket at base period
prices.
• Find the cost of the CPI basket at current period
prices.
• Calculate the CPI for the base period and the
current period.
THE CONSUMER PRICE INDEX
Note- Always use the same quantity to determine the CPI for each year.
The only thing that is changing is the price.
THE CONSUMER PRICE INDEX
CPI =
Cost of CPI basket at current period prices
x 100
Cost of CPI basket at base period prices
For 2000, the CPI is:
$50
x 100 = 100
$50
The CPI for the base period is always 100. Always!!!
For 2003, the CPI is:
$70
$50
x 100 = 140
Once we determine the CPI for these years
we can now determine the inflation for these years!
Formula for the Rate of Inflation
Measuring Inflation
Inflation rate
The percentage change in the price level from one year to
the next.
CPI in current year  CPI in previous year x 100
Inflation rate =
CPI in previous year
Inflation rate =
140  100 x 100 = 40% percent
100
This means there has been a 40% increase in inflation between the
previous year and current year. But that is easy because you are working
from the base year. Try this!
Formula for the Rate of Inflation
Measuring Inflation
Inflation rate- CPI for 2002 is 120 and CPI for 2003 is 140
What is the rate of inflation between 2002 and 2003?
CPI in current year  CPI in previous year x 100
Inflation rate =
CPI in previous year
Inflation rate =
140  120 x 100 = 16.7 percent
120
This means there has been a 16.7% increase in inflation
between the previous year and current year.
Dollar Figures from Different Times
In 1931, Babe Ruth made $80,000. What is his
salary equal to in 2007 dollars.
Need to know the CPI in 1931 and in 2007.
CPI in 1931 is 15.2
CPI in 2007 is 207
Formula to convert dollar amounts from different times.
Amount in today’s = Amount in X CPI today
dollars
old dollars
CPI in past
Dollar Figures from Different Times
In 1931, Babe Ruth made $80,000. What is his
salary equal to in 2007 dollars.
Need to know the CPI in 1931 and in 2007.
CPI in 1931 is 15.2
CPI in 2007 is 207
Formula to convert dollar amounts from different times.
207
Amount in today’s = $80,000 X 15.2
dollars
Answer is $1,089,474
THE CONSUMER PRICE INDEX
In part (a), the price level has increased every year. The
rate of increase was rapid during the early 1980s and
slower during the 1990s.
THE CONSUMER PRICE INDEX
In part (b), the inflation rate was high during the early
1980s, but low during the 1990s.
THE CPI AND THE COST OF LIVING
Cost of living index
A measure of changes in the amount of money that
people would need to spend to achieve a given
standard of living.
The CPI does not measure the cost of living because
• It does not measure all the components of the cost
of living
• Some components are not measured exactly
So the CPI is possibly a biased measure.
THE CPI AND THE COST OF LIVING
 Sources of Bias (Discrepancies) in the CPI
The potential sources of bias in the CPI are
•
•
•
•
Goods Evolve/New Good Bias
Quality Differences
Consumer substitutes
Outlet substitution bias
THE CPI AND THE COST OF LIVING
New Goods Bias
What if the market basket base year was from
1912?
• New goods do a better job than the old goods that
they replace, but cost more.
• The arrival of new goods puts an upward bias into
the CPI and its measure of the inflation rate.
Quality Change Bias
• Better cars and televisions cost more than the
versions they replace.
• A price rise that is a payment for improved quality
is not inflation but might get measured as inflation.
THE CPI AND THE COST OF LIVING
Commodity Substitution Bias
• If the price of beef rises faster than the price of
chicken, people buy more chicken and less beef.
• The CPI basket doesn’t change to allow for the
effects of substitution between goods.
Outlet Substitution Bias
• If prices rise more rapidly, people use discount
stores more frequently.
• The CPI basket doesn’t change to allow for the
effects of outlet substitution.
THE CPI AND THE COST OF LIVING
 The Magnitude of the Bias
The Boskin Commission estimated the bias to be 1.1
percentage points per year.
If the measured inflation rate is 3.1 percent a year, most
likely the actual inflation rate is 2.0 percent a year.
To reduce the bias, the BLS has decided to increase
the frequency of its Consumer Expenditure Survey and
revise the CPI basket every two years.
When the BLS revises the CPI basket, the reference
base period does not change.
Cost to Consumers
 High Rates of Inflation Impose Economic Costs
• Shoe-Leather Costs
– Purchasing power of money eroding
– Discourages people from holding money in bank accounts or
wallets
– Many trips to the ATM/bank
• Menu Costs
– Most items we buy have a listed price
– Changing a listed price has a real cost
– Businesses update prices intermittently
• Unit-of-Account Costs
– Role of the dollar as a basis for contracts and calculation of the
tax system
– Makes money a less reliable unit of measurement
Decreasing Value of
the Dollar Since 1970
1970
1985
Today
Inflation
Real World Price Indexes
Producer Price Index (PPI)
A statistical measure of a weighted average or prices of
commodities that firms purchase from other firms.
Generally for non-retail markets
Used as a leading indicator of the CPI
PPI’s for:
• Food materials
• Intermediate goods
• Finished goods
Inflation
Real World Price Indexes
GDP Deflator
A price index measuring the changes in prices of all
new goods and services produced in the economy
Broadest measure
Not based on a fixed market basket, but a survey of a
wide variety of goods.
The GDP Deflator
The GDP Deflator: A Better Measure?
In principle, the GDP deflator is not subject to the
biases of the CPI because it uses the price change and
the public response to those price changes in the
basket of goods and services produced in the current
year and the preceding year.
In practice, the GDP deflator suffers from some of the
CPI’s problems because the Commerce Department
does not directly measure the physical quantities of all
the goods and services that are produced.
THE CPI AND THE COST OF LIVING
The two measures of the
inflation rate fluctuate together,
but the CPI measure rises more
rapidly than the GDP deflator
measure.
But the price levels get farther
apart.
Both measures probably
overstate the inflation rate.
Inflationary Periods
in U.S. History
NOMINAL AND REAL VALUES
Nominal and Real Values in Macroeconomics
Macroeconomics makes a big issue of the distinction
between nominal values and real values:
• Nominal GDP and real GDP
• Nominal wage rate and real wage rate
• Nominal interest rate and real interest rate
NOMINAL AND REAL VALUES
 Just because you get an increase in the nominal value,
doesn’t mean you are better off than you were before.
 We will need to deflate nominal values by the price index
to calculate real values for anything- Wages, Income,
GDP, etc…
Formula for Real Values
Nominal
__________________
Real =
X 100
Price Index
* The price index can be the CPI, PPI,
or the GDP Deflator.
NOMINAL AND REAL VALUES
Nominal and Real Wage Rates
Nominal wage rate
The average hourly wage rate measured in current
dollars.
Real wage rate
The average hourly wage rate measured in the dollars
of a given reference base year. Reflects inflation!
NOMINAL AND REAL VALUES
What is the nominal hourly wage of $14.28 in 2002 worth in
1982-1984 dollars. CPI is 179.9.
To calculate the real wage rate, we divide the nominal
wage rate by the CPI and multiply by 100.
That is,
Nominal wage rate in 2002
Real wage rate in 2002 =
x 100
CPI in 2002
$14.28
x 100 = $7.93
Real wage rate in June 2002 =
179.9
So the $14.28 in the nominal hourly wage in 2002 is
worth $7.93 in 19821984 dollars.
22.3 NOMINAL AND REAL VALUES
Figure 22.4 shows
nominal and real wage
rates: 1975–2005.
The nominal wage rate
has increased every year
since 1975.
The real wage rate
increased briefly during
the late 1970s, decreased
through the mid-1990s,
and then increased
slightly.
Nominal and Real Income
Example:
2002- Nominal income is $40,000
2003- Nominal Income is $41,000
2002- CPI 181.6
2003- CPI 185
Q. 1- What is my real income for each year?
Q. 2- Did my purchasing power increase in
2003? Am I better off in 2003?
Nominal and Real Income
 2002 Real Income= $40,000/181.6 x 100= $22,026
 2003 Real Income= $41,000/185 x 100= $22,162
 Real income has increased by $136. You are better
off in 2003 than in 2002.
Nominal and Real Income
What if your income only increased to
$40,500 in 2003.
Calculate: 1) Real income for each year.
2) Did your purchasing power
increase in 2003?
Nominal and Real Income
 2002 Real Income= $40,000/181.6 x 100= $22,026
 2003 Real Income= $40,500/185 x 100= $21,891
 Real income has decreased by $135. So even though
your nominal income has increased by $500, your
real income has decreased by $135.
Inflation
Anticipated Versus Unanticipated Inflation
The effects of inflation on individuals depends upon
which type of inflation exists.
Anticipated Inflation
Anticipated Inflation
The rate of inflation that the majority of individuals
believe will occur. If the rate of inflation is 10% and that
is what the majority expected, then inflation was fully
anticipated.
Unanticipated Inflation
Unanticipated Inflation
Inflation that comes as a surprise to individuals in the
economy. If people expected an inflation rate of 5% and
the actual rate of inflation was 10%, then 5% of the
actual inflation rate was unanticipated inflation.
This is the inflation that wreaks havoc on the economy!
Unanticipated inflation hurts many people. When
inflation is anticipated some of these people (lenders)
are able to protect themselves.
All of this is important when dealing with interest rates!
22.3 NOMINAL AND REAL VALUES
Nominal and Real Interest Rates
Nominal interest rate
The percentage return on a loan expressed in todays
dollars.
Real interest rate
The percentage return on a loan, calculated by purchasing
power—the nominal interest rate adjusted for the effects of
inflation.
Real interest rate = Nominal interest rate – Inflation rate
Inflation/Interest Rates
Real Interest Rate
1982 -- Home Mortgage
• Nominal Interest Rate 15%
• Increase in the price of housing of 25% (inflation)
Real Rate = 15% - 25% = -10%
Inflation/Interest Rates
Real Interest Rate
1998 -- Home Mortgage
• Nominal Interest Rate 6.5%
• Increase in the price of housing of 2%
Real Rate = 6.5% - 2% = 4.5%
Question
Which scenario is the best for the lender? the borrower?
Does Inflation Necessarily Hurt Everyone?
 All of this is extremely important with borrowers and
creditors.
 Banks must anticipate the inflation rate to cover all loans.
Try to increase interest rates with the rate of inflation.
This is not an exact science. Creditors/lenders must
make sure that the nominal rate of interest is greater
than anticipated inflation. It is the unanticipated inflation
they can not predict.
Creditor gains if real interest rate is positive.
Debtor gains if real rate of interest is negative
Unanticipated inflation is the key!!
Higher unanticipated inflation helps borrowers/hurts
creditors.
Does Inflation Necessarily Hurt Everyone?
Nom. Int. Rate - Infl. Rate =
10%
5%
10%
10%
10%
15%
Real Int. Rate
5% creditor wins
0% draw
-5% debtor wins
In the past inflation and nominal interest have risen and
fallen together.
Effects of Inflation
 Creditors (Lenders) Lose: Net creditors are individuals
or businesses that have more savings than debt. A net
creditor receives interest and, therefore, receives a
reduced real interest return when there is unanticipated
inflation.
 Debtors (borrowers) Win: Net debtors are individuals
or businesses that have more debt than savings. A net
debtor pays interest, and therefore, pays a lower real
interest rate when there is unanticipated inflation. A fixed
rate of interest helps a debtor in the long term. Paying
back a loan with less purchasing power during times of
inflation.
NOMINAL AND REAL VALUES
Figure shows real and
nominal interest rates:
1965–2005.
During the 1970s,
the real interest rate
became negative.
The nominal interest
rate increased during
the high-inflation 1980s.
Inflation
Protecting Against Inflation
Cost-of-living adjustments (COLAs)
• Clauses in contracts that allow for increases in
specified nominal values to take account of
changes in the cost of living
ARMS- Banks offer “Adjustable Rate Mortgages” that
adjust the interest rate to keep up with changes in
inflation
5
Types of Inflation
Demand- Pull Inflation- More dollars chasing
less goods. An increase in aggregate demand.
Often results for too much money in the
economy.
Cost-Push Inflation- Inflation due to an
increase in production/ input costs. Results in a
decrease of aggregate supply.
Types of Inflation
Double Digit Inflation
Hyperinflation
Stagflation- High inflation and unemployment.
Worst possible economic
situation.
Changing Inflation and Unemployment:
Business Fluctuations
Business Fluctuations
The ups and downs in economywide economic activity
• National income
• Employment
• Prices
The Typical Course of Business
Fluctuations
Four faces, measured by “Trough to Trough”. Phase 1 is
Expansion. Avg. expansion 2 ½ years, contraction 1 ½ years.
Changing Inflation and Unemployment:
Business Fluctuations
Expansion
Peak
Contraction
Trough
Changing Inflation and Unemployment:
Business Fluctuations
Recession
A period of time during which the rate of growth of
business activity is consistently less than its long-term
trend or is negative
Depression
An extremely severe recession
6
National Business
Activity, 1880 to Present
Causes of Changes in the Business Cycle
External Factors
Internal Factors
International Relations
Capital investment
Inventories
Aggregate demand
Government spending and
the fluctuating money
supply
OPEC, war
New Discoveries
Resources, technology and
innovation
Social/Political Changes
Immigration, shift in attitudes,
political party
Weather
Predicting Business Cycles
Leading Indicators
 Come before a change
in a phase of the cycle
• Building permits issued
• Orders for capital goods
• Orders for consumer
goods
• Price of raw materials
• Stock prices
Coincident Indicators
 Change as you move
into a phase
• Personal income
• Sales volume
• Industrial production levels
Predicting Business Cycles
Lagging Indicators- months after a cycle has
changed
• Use of credit
• Number and size of business income
Unemployment
Labor Force  the employed  the unemployed
Unemployed
Unemployme nt rate 
Labor force
Labor force
participation rate =
X 100
Labor force
Working-age population
x 100
Price Indexes/Inflation
CPI Market Basket
Fixed Quantity X Prices of G/S= CPI Market Basket
Consumer Price Index
CPI =
Cost of CPI basket at current period prices x 100
Cost of CPI basket at base period prices
Rate of Inflation
Inflation Rate = CPI in current year  CPI in previous year x 100
CPI in previous year
Dollar Figures from Different Times
Formula to convert dollar amounts from different times.
Amount in today’s = Amount in X CPI today
old dollars
CPI in past
dollars
Nominal and Real (Income or Wages)
Real Income:
Nominal Income current year X 100
CPI (Index)
Nominal Income:
Real Income X CPI (Index)
100
Inflation and Interest
Nom. Int. Rate - Infl. Rate =
Real Int. Rate
OR
Real Int. Rate + Infl. Rate = Nominal Int. Rate
Price Indexes
GDP Deflator used as a price index for all goods and services
in the economy.
Price of good in current year
Price of good in base year
Nominal GDP
X 100
Real GDP
X 100
Real Values
Real GDP- Two ways to determine
nominal GDP
1)
x 100
GDP Deflator
2) Price of good in base year X Quantity of good in current year
*More of this in Ch. 8