Download Inflation `

Inflation
Second evil of society
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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
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!
• 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.
.
Who wins? Who loose?
Winners:
Loosers:
• Borrowers
• Producers(in short run)
• Lenders
• Savers
Nominal Income vs. Real Income
 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.
Raise vs inflation
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.
Another rule:
• 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.
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.
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.
How to measure rate of inflation
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
Macroeconomic Measures - Prices
Base Year - The year chosen as a
point of reference or basis of
comparison for prices in other
years; a benchmark year. (82-84)
Computing the Consumer Price Index
Consumer Price Index (CPI)
• 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.
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
 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.
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
shield against inflation?
But Congress has passed the Cost-of-living
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…
Answer:
not much!!!
Is there
a safety
Some bankersin
build
in that same philosophyBankers
business
to makeAdjustable-rate
a profit.
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.
Ways to measure inflation!
• Real-world price indexes
– Consumer Price Index (CPI)
– Producer Price Index (PPI)
– GDP deflator
– Personal Consumption Expenditure (PCE)
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
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
PCE
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
What really is the goal of fiscal and monetary
planners?
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 does a pair of Nike shoes cost
compared to a pair of Keds?