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Chapter 10 Part One – Inflation Legend Black -> definitions Blue -> examples Red -> key terms Inflation The general _______ in the prices of goods and services in an entire economy over a period of time Canada's annual inflation rises 2.5% in total, therefore some prices may remain unchanged or maybe less. Deflation - The general _______ in prices of goods and services in an entire economy over a period of time Canada's annual inflation decreases 2.5% in total The Consumer Price Index (CPI) - The tool most commonly used to measure ______ _______ in prices Monitors price changes in a representative “________ ______” of consumer products Used to determine what Canadians typically buy Item weights are the __________ of each good in the total cost of the basket of consumer goods used to calculate CPI Base year is a survey year used as a point of ________ in subsequent years Figure 1a – Year 1 Consumer Product Prices Qty Expenditure/month Item weights Consumed/month Hamburgers $2.00 10 $20 20/50 = 0.4 Milkshakes 30 $30 30/50 = 0.6 $1.00 $50 Item weight indicates that 2/5 (0.4) of the consumer's total budget is spent on hamburgers and 3/5 (0.6) on milkshakes The base year is 1 Figure 1b – Year 2 Consumer Product Prices Year 2 price x year 1 quantity Hamburgers $2.20 $2.20 x 10 = $22.00 Milkshakes $1.05 $1.05 x 30 = $31.50 $53.50 How to calculate the CPI of year 1 & 2 Step 1: calculate the difference of the total cost between year 2 & 1 $53.50 – $50.00 = $3.50 Step 2: Take the difference and divide it by year 1's total cost $3.50 / $50.00 = 0.7 Step 3: Take the value of step 2 and multiply it by 100 0.7 x 100 = 7% or 7 (on CPI index) Step 4: Compare the CPI from the base year to the current year and add the value from step 3 year 1 CPI = 100 ($50.00 / $50.00 = 1 = 1 x 100 = 100) year 1 CPI + year 2 CPI increase (100 + 7 = 107) The change in the index is expressed as a percentage which is also the inflation rate Nominal versus Real Income Nominal income is expressed in ________ dollars Real income is expressed in ________ ____ _____ dollars Real GDP is GDP expressed is constant dollars from a chosen reference year Real GDP gives an indication of the purchasing power of an entire economy to see how consumer's purchasing power is affected by inflation, we can express nominal income and real income Real income = nominal income / CPI (in hundredths) To determine real income for a given year, the consumer's nominal income ($1050) is divided by the value of the CPI for that year expressed in hundredths (1.10) Real income = $1050 / (110 / 100 = 1.10) = $954.55 for the consumer's purchasing power ($954.55) to keep up with inflation, the income would have to increase by the same percentage as the increase in prices by 10% or $100.00 (= $1000 x 0.10) to $1100 (= $1000 + $100) The purchasing power of a current dollar is inversely related to the consumer price index The lower the CPI , the higher purchasing power of nominal income The higher the CPI, the lower purchasing power of nominal income Therefore, those whose incomes increase at a higher rate than the rise in prices have a higher standard of living, visa versa Limitations of CPI 1. ______________________ 2. ______________________ 3. ______________________ The GDP Deflator The GDP deflator is an indicator of _________ ___________ for all goods and services produced in the economy More accurate then CPI due to frequent updates, although the values of the index are not as quickly available compared to CPI To calculate the value of the GDP deflator in each subsequent year, multiply the output of each year by the current price, divided by the same output in reference year prices. Then multiplies by 100 Nominal versus Real GDP Nominal GDP is GDP in ________ dollars Real GDP gives an indication of the purchasing power of an entire economy Real GDP = Nominal GDP / GDP Deflator (in hundredths) Inflation’s Effects Inflation redistributes purchasing power among different groups in ways that can be both economically harmful and unjust, in other words it widens the gap between the rich and the poor To see the effects of inflation, you can look at its effects on household incomes and on borrowing and lending. Incomes If household’s income increases steadily every year, but inflation rises at a higher rate, the household loses purchasing power, therefore lowers standard of living If income increases at around the same rate as inflation, the household keeps its purchasing power Cost of Living Adjustment Clauses are provisions for income adjustments to accommodate changes in price levels, which are included in wage contracts Fully Indexed Incomes are nominal incomes that automatically increase by the rate of inflation Partially Indexed Income are nominal incomes that increase by less than the rate of inflation Fixed Incomes are nominal incomes that remain fixed at some dollar amount regardless of the rate of inflation Borrowing and Lending Nominal Interest Rate is the interest rate expressed in money terms Real Interest Rate is the nominal interest rate minus the rate of inflation Real Interest Rate = Nominal Interest Rate – Inflation Rate Inflation Premium is a percentage built into a nominal interest rate to anticipate the rate of inflation for the loan period Nominal Interest Rate = Desired real Interest Rate + Inflation premium