Download Inflation…

What about the other evil?
Inflation and Deflation

Inflation
◦ A sustained increase in the average of all
prices of goods and services in an economy

Deflation
◦ A sustained decrease in the average of all
prices of goods and services in an economy
Looking at the past
In 1923, prices in Germany rose a trillion
times over.
 Prices in Russia, Bulgaria, and some other
nations have witnessed a tenfold increase
in a year.
 In the 1990’s the U.S. inflation rate rose
between 1 and 4 percent a year.
 Argentina 1975-91 Hyperinflation
continued reaching a peak of 4,923.3
percent in December 1989 
What is inflation?
A continuing rise in the average level of
prices.(it costs more to purchase the
typical “bundle” of goods and services
that is produced or consumed or both.)
Bottom line: Too many $$$$ chasing too
few goods.
Inflation…is bad…is bad..is
bad!
http://www.tradingeconomics.com/countrylist/inflation-rate
World Look at current inflation
The CPI is based on what it costs an
average family to live.
 Just think… Inflation enables us to live
in more expensive neighborhoods
without having to move

Inflation is bad… see???
Shortened Time Horizons
 During the German hyperinflation, workers
were paid two or three times a day so that
they could buy goods in the morning before
prices increased in the afternoon.
Speculation
People may be encouraged to withhold
resources from the production process, hoping
to sell them later at higher prices.
Bracket Creep
 Under our progressive tax system, taxes go up
when prices rise.
 Savings, investment, and work effort decline.
Inflation discussion
Notice we said an increase in the Average Level of prices. Not a
change in any specific price…
Statisticians calculate the average then look for changes in the
average. The Consumer Price Index for All Urban Consumers (CPIU) decreased 0.4 percent in August, before seasonal adjustment, the
Bureau of Labor Statistics of the U.S. Department of Labor reported
today. The August level of 219.086 (1982-84=100) was 5.4 percent
higher than in August 2007.
 A decline in average prices = deflation.
Relative price means an increase in the price of apples (relative to
other fruits) apples cost more than pears.
Inflation does not make ALL persons worse off.
.
Winners:


Borrowers
Producers(in short
run)
Losers:


Lenders
Savers
Who wins? Who loose?
What is the difference between nominal income and
real income.
Nominal = income you receive in a particular
period
Real income = what you can use for purchasing
stuff.

***If your nominal income does not change and
there is an increase in the average level of
prices….. You cannot buy as much “stuff.”
If the number of dollars you receive every year is
always the same, your nominal income doesn’t
change- but your real income will rise or fall
with price changes.
Nominal Income vs. Real
Income
If you get a raise for 4% and inflation is
5% ….. You do the math.
Your increase in income will not cover the
increase in prices.
Raise vs inflation

If you put your money into savings and
keep it there rather than spending it,
and inflation comes along…

your money in savings will not buy as
much as it would prior to the wave of
inflation that hit.
Another rule:
Uncertainty and Misconception
Money Illusion
 Even people whose nominal incomes keep up
with inflation often feel oppressed by rising
prices.
 They feel cheated when they discover that
their higher nominal wages don’t buy
additional goods.
Uncertainty
 One of the most immediate consequences of
inflation is uncertainty.
 Uncertainties created by changing price levels
affect consumption and production decisions.
Inflation discussion
Uncertainty on the part of
the consumer in trying to
outguess the price of
goods and services.


If consumers or producers
postpone or cancel their
expenditure plans, the
demand for g & s will
fall. Eventually
production falls, and
unemployment occurs…
What Causes
Inflation?
Nearly all
economists
believe that rapid
expansion in the
supply of money is
the cause of
inflation.
Bracket creep is the movement of
taxpayers into higher tax brackets
(rates) as nominal incomes grow.
Deflation Dangers
 Deflation — a falling price level —
might not make people happy either.
 Deflation reverses the redistributions
caused by inflation. (Example: people
today – upside down on their houses.)

What happens if incomes go up to
keep pace with inflation?
Measuring Inflation
Measuring inflation serves two purposes:
◦ Gauges the average rate of inflation.
◦ Identifies its principal victims.
Consumer Price Index (CPI)
The CPI is the most common measure of
inflation.
 The consumer price index (CPI) is a
measure (index) of changes in the
average price of consumer goods and
services.


Macroeconomic Measures Prices
 Price
Level - A weighted average of the
prices of all goods and services.
 Price Index - A measure of the price level.
 Consumer Price Index (CPI) - A widely
cited index number for the price level; the
weighted average of prices of a specific set of
goods and services purchased by a typical
household.
Measuring the Rate of Inflation
 Market Basket
◦ Representative bundle of goods and services

Base Year
◦ The point of reference for comparison of prices
in other years
How to measure rate of inflation
Base Year - The year chosen as a point of
reference or basis of comparison for prices
in other years; a benchmark year. (82-84)
Macroeconomic Measures Prices
Computing the Consumer Price
Index

By observing the extent of price
increases, we can calculate the inflation
rate.
 The
inflation rate is the annual percentage
rate of increase in the average price level.
Consumer Price Index (CPI)
Percentage change in prices = Current year - later year
later year
x100
In 2005 the CPI was 195.3; in 2006 the index was
201.6. What was the percentage change in prices
from 2005-2006?
Click below for answer.
3.22 %
Changes in Prices
Here’s a little hint if you forget…C-L/L
CPI determined
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Calculates the inflation rate
Market basket of goods
and services (same each
year.)
Bureau of Labor Statistics
determines cost in 85 cities
by shopping 184 items.
19,000 stores visited and
60,000 landlords, renters and
homeowners surveyed each
month
Statistics released each
month.(3.15- .7%)
Yearly average compiled.
CPI expressed in
base year ’82-84
Constructing the
CPI
 The base period is
the time period used
for comparative
analysis — the basis
of indexing, for
example, of price
changes.

Shopping for CPI
 CPI
is constructed by identifying a typical
bundle of goods that the average consumer
buys. This bundle stays the same each year.
 The base year is changed periodically. The
base year used is ’82-’84 and prior to that it
was ’63.The price level in the base period is
designated as 100.
 The market basket (bundle) can be changed if
BLS research shows that the “average”
consumer no longer is purchasing that good or
service.
 Each item in the bundle is weighted percentwise in the market basket figures.
What is the difference?
So………if it cost you $225 in 2002 to buy
the same bundle of goods that you bought
in 1983, you would be paying 225% more
for the same “stuff.”
Look at the inflationary costs of: cars,
health care, housing, (house 4 bedrooms,
2 baths, in Highland Park in 1960 cost
approximately $30,000.) (Today?????)
Four Bedrooms, two bathrooms, often with a pool
House in Plano, 1960. $40,000
Calculations
Rate of Inflation = %
of PI(price index) from
one year to the next.
When prices are rising, on average, the price index
will rise.
i = This year’s PI – Last year’s PI
Last year’s PI x100
If price index this year was 220 compared to 200
last year, the inflation rate would equal 10%
220 – 200
200
x 100 = 10
Formula hint: c-l/l x 100
(current-last/last x 100)
In 2008 – CPI measured 215.3
In 2004 – CPI measured 188.9
What was the rate of inflation from 04 –
08?
Ans. 13.9
Let’s try another calculation
Is there a safety shield against
inflation?
Answer: not much!!!
But Congress has passed the Cost-ofliving adjustment (COLA) provision for
those receiving Social Security Checks.
Checks are indexed each January…in the
amount equal to inflation the previous
year.
If inflation was 3% then the checks are
adjusted accordingly.
Unions also negotiate for this COLA in
their pay proposals…
Some bankers build in that same philosophyAdjustable-rate mortgage (ARM) stipulates an
interest rate that changes during the term of
the loan.
Actually, banks build the inflation factor into all
their loans…the number of points depends on
many variables we will discuss later.
 The real interest rate is the nominal interest
rate minus the anticipated inflation rate.
Bankers in business to make a
profit.

Real-world price indexes
◦ Consumer Price Index (CPI)
◦ Producer Price Index (PPI)
◦ GDP deflator
◦ Personal Consumption Expenditure (PCE)
Ways to measure inflation!
What is stagflation?
High inflation and high
unemployment….
A period during which an economy is
experiencing both substantial inflation
and either declining or slow growth in
output.
Economists used to say this would and
could never happen… it did in the 80’s
Paul Volker entered the scene as Fed
chairman and held court on monetary
policy.. More of this story later…

Remember…………..too many $$$ chasing
too few goods…. Best street definition for
inflation.
CAUSES of inflation
1. Demand pull (too much aggregate
demand and not enough aggregate
supply.
 Cost Push (production costs rise) supply
decreases…

S
D
S1
S
D1
D
Explanations
Demand pull:
 Economy producing at capacity
 Consumers willing and able to buy more goods
 Can buy goods because of accumulated
savings or easy access to credit (refinancing
the house, second mortgages in Texas, low
interest loans, credit card interest rates low,
prime rate very low.)
 Pull to have more goods and only limited
amount of goods available… causes prices to
rise!
 Hence, a demand-driven rise in average prices
or demand-pull
Explanations Continued
Cost Push:
 When producers have to pay more for inputs
(resources for production), the price of the
good produced increases. ( also referred to as
a supply shock.)
OPEC- prices of crude escalates any product
dependent on crude (including heating costs,
increases)
Explanation of Dollars in Costpush
Labor has generally been the most
expensive of inputs for production up till
now in our economy.
If wage rates are pushed upward…. The
good or service would have an increase in
price (longshoreman’s union, pilots,)
Note that most of these are union
connected. Tech industry workers took
about a 50% cut to get jobs in 2002 as
opposed to their salaries in 1999.
If the Fed releases too much money in the
economy (continually pushing down
interest rates, the value of that money is
not as solid as if there were less
circulating… more later on that) 
Check the current inflation rate………..
http://inflationdata.com/inflation/
Bureau of Labor Statistics
Another way to measure U.S.
economic health
Producer Price Index:
 The PPIs keep track of average prices received
by producers.
 October 20, 2005….PPI up highest in 15 years.
 3 indices…crude materials, intermediate
goods, finished goods.
 Identified in monthly surveys just like CPI is.
 In SR, PPI increases before CPI (takes a little
while for the prices to be reflected in products
we buy.
Is the Growth of GDP real or
inflated?
This is the real test!!!!!!!
Was there actual increase in production
and services or did the prices just skew
the GDP statistics when C+I+G was
added?
Have to correct GDP for price changes so
we can measure actual production.
CPI tells the consumer if they have to
spend more dollars to get that loaf of
bread… but other measures have to be
evaluated.
Still another way to test the health
of the U.S. economy
The GDP Deflator…. The broadest price index
and covers all output including consumer
goods, investment goods and government
services. (C+I+G)
The GDP deflator isn’t a pure measure of price
change. Its value reflects both price
changes AND market responses to those
price changes as reflected in new
expenditure patterns.
The GDP deflator typically registers a lower
inflation rate than CPI and the
government watchdogs use this
barometer more readily than current CPI
Year
Price of good Quantity
(base
GDP
Real GDP
1
$10
100
$1,000
$1,000
2
$12
120
12x120
10 x 120
= $1,440 = $1,200
3
$14
140
14 x 140 10 x 140
= $1,960 = $1,400
Bottom Line
CPI is designed to measure the impact of price changes
on the cost of a typical bundle of goods purchased by
households(remember, market basket and only for
urban purchasers.)
GDP deflator is a broader price index and is designed to
measure the change in the average price of the market
basket of goods included in GDP (in addition to
consumer goods it includes capital goods, & g & s by
government.)
CPI measures money income of consumers in relation to
rising prices (only consumer goods.)
GDP deflator measures economy wide inflation- more g &
s included in measurement.
 More
accurate than CPI
 Quantifies changing expenditure patterns for
consumers.
 Is a weighted measure
 Doesn’t always have same items calculated
 BEA uses continually updated surveys of
consumer purchases to determine index
 Federal Reserve uses this measure for their
predictions and assessments.
Personal Consumption
Expenditure
PCE
Historical Record Graph
20
Inflation
16
A
12
8
4
B
0
4
8
Deflation
12
1920
1930
1940
1950
1960
1970
1980
1990
2000
The CPI’s market basket of goods and services
was overhauled in 1998.
Price Stability…..
 Major changes in the general level of prices
indicate upsets in the economic system.
 Prices
act as allocators of economic goods, they
are the mechanism that determines the answer
to the three basic questions, What, How and For
Whom.
 Prices act as the basic force in a capitalistic
economy 
What really is the goal of fiscal
and monetary planners?
What does a pair of Nike shoes
cost compared to a pair of
Keds?