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Fluctuations in Prices Zimbabwean Dollars At one point, $1 = 621,984,228 Zimbabwean dollars. • Inflation is an increase in the general level of prices. • The Rate of Inflation is calculated as: Inflation rate = This year’s price index - Last year’s price index Last year’s price index * 100 The Inflation Rate, 1956-2006 •Inflation rate •15 •10 •1973-1981 average inflation rate = 9.2 % •1956-1965 average inflation rate = 1.6 % •1983-2006 average inflation rate = 3.1 % •5 •0 •1956•1960 •1965 •1970 •1975 •1980 •1985 •1990 •1995 •2000 •2005 • Between 1956 and 1965, the general price level increased at an average annual rate of only 1.3%. • In contrast, the inflation rate averaged 9.2% from 1973 to 1981, reaching double-digits during several years. • Since 1982, the average rate of inflation has been lower (3.1% from 1983-2006) and more stable. Inflation, 1913 - 2014 (a)Inflation was highest just after World Wars I and II, and during the 1970s. (b)Deflation occurred several times in the first half of the century and in 2009 as well. International Inflation Price Comparison, 1970 and 2012 Items 1970 2012 Pound of ground beef $0.66 $3.24 Pound of butter $0.87 $2.80 Movie ticket $1.55 $7.96 Sales price of existing home $23,000 $185,283 New car $3,000 $30,303 Gallon of gas $0.36 $3.48 Average hourly wage for a manufacturing worker $3.23 $19.17 Per capita GDP $5,069 $43,063 •In 2012, $1 had about the same purchasing power as •18 cents did in 1972 Consumer Price Index The U.S. price level rose relatively little over the first half of the twentieth century The upward slope reflects the high rate of inflation in the 1970s. Creating a price index Year 1 $ Spending 170 2 180 •Current 3 Base year year spending 200 •Base year spending 4 200 Index 85 90 •x 100 100 100 5 224 112 6 250 125 7 280 140 Calculating inflation using Spending Year $ Spending 1 170 2 180 3 Base year 200 4 200 5 224 6 250 7 280 •From year 1 to year 3 •200 – 170 •= .18 • 170 •From year 3 to year 1 •170 – 200 • 200 •= .15 Calculating inflation using Index Year Index 1 85 2 90 3 100 4 100 5 112 6 125 7 140 •From year 1 to year 3 •100 – 85 • 85 •= .18 •From year 3 to year 1 •85 – 100 • 100 •= .15 •From year 6 to year 7 •140 – 125 • 125 •= .12 Creating a price index Year $ Spending Index 1 170 85 2 180 90 200 100 4 200 100 5 224 112 6 250 125 7 280 140 3 Base year measures the impact of price changes on the cost of a typical bundle of goods and services purchased by households. Consumer Price Index Eight categories of goods and services (Source: www.bls.gov/cpi) 1. prices paid for supplies and inputs PPI by producers prices of merchandise that is 2. IPI exported or imported. 3. ECI wage inflation in the labor market designed to measure the change in the average price of the market basket of goods included in GDP (a broader price index than the CPI). •Year •1996 •1997 •1998 •1999 •2000 •2001 •2002 •2003 •2004 •2005 •2006 •CPI •Inflation rate •GDP deflator •Inflation rate •156.9 •160.5 •163.0 •166.6 •172.2 •177.1 •179.9 •184.0 •188.9 •195.3 •201.6 •3.0 •2.3 •1.5 •2.2 •3.4 •2.8 •1.6 •2.3 •2.7 •3.4 •3.2 •93.9 •95.4 •96.5 •97.9 •100.0 •102.4 •104.1 •106.0 •109.4 •112.7 •116.0 •1.9 •1.7 •1.1 •1.4 •2.2 •2.4 •1.7 •1.8 •2.8 •3.0 •2.9 •(1982-84 = 100) •(percent) •(2000 = 100) •(percent) •Source: http://www.economagic.com. Even though the CPI and the GDP deflator yield similar estimates of the rate of inflation. •CPI 2005 to 2006 •195.3 – 201.6•= 3.2 • 195.3 •GDP 2005 to 2006 •112.7 – 116 •= 2.9 • 112.7 There are 2 Kinds of Inflation 1. Anticipated inflation: A widely expected change in the price level. 2. Unanticipated inflation: An increase in the price level that comes as a surprise, at least for most individuals. 1. Substitution Bias •Does not take into account that a person can substitute away from goods whose relative prices have risen. 2. Quality/New Goods Bias •Does not take into account how improvements in the quality of existing •goods or the invention of new goods improves the standard of living. 1. Hyperinflation Inflation in Controlled Economies Brazil, Argentina, and Russia experienced hyperinflation and China and Nigeria had high inflation rates in the mid1990s. Inflation in Controlled Economies Brazil, Argentina, and Russia experienced hyperinflation and China and Nigeria had high inflation rates in the mid1990s. 2. Money loses value •increases in wages may lag behind inflation for a year or two •If the minimum wage is adjusted for inflation only infrequently, minimum wage workers are losing purchasing power from their nominal wages Inflation and the Minimum Wage • The federal minimum wage dropped more than 30% 1967 to 2010, • The nominal figure climbed from $1.40 to $7.25 per hour. • Increases in the minimum wage in between 2008 and 2010 kept the decline from being worse 1. Savings Lose value 2. Loans Are easier to repay 3. Wealth May increase 4. Politics May cause changes 1. Demand-Pull 2. Cost-Push 1. Demand-Pull Price S1 New price and output P2 Orig. price and output P1 D2(increase in demand) D1 Q1 Q2 Quantity buyers demands greater than producers supply 2. Cost Push Price S2(new equilibrium) S1(initial equilibrium) P2 P1 D Q2 Q1 Quantity/time sellers’ costs are passed on to buyers 1. When a price, wage, or interest rate is adjusted automatically with inflation 2. Private Examples a. COLA - When a price, wage, or interest rate is adjusted automatically with inflation b. ARM - When the inflation rate rises, the interest rate on a loan increases as well. c. Contract adjustments - sellers are not locked into a low nominal selling price if inflation turns out higher than expected; - buyers are not locked into a high buying price if inflation turns out to be lower than expected. 3. Government Examples a. Income Taxes - tax rates are now indexed to rise automatically with inflation b. Social Security – rates automatically increase with inflation. c. Bonds- now interest payments are adjusted for inflation. Questions for Thought: 1. Suppose that the CPI was 150 at the end of last year and 157.5 at the end of this year. What was the inflation rate during the year? 2. If decision makers anticipate an inflation rate of 3% at the start of a year and prices during the year rise by 7%, this is an example of a. anticipated inflation. b. an inflation rate higher than anticipated. c. an inflation rate lower than anticipated. 3. True or false: when the inflation rate is high and variable, decision makers will generally be able to anticipate year-to-year changes in inflation quite accurately. • 4. How would an unanticipated 5 percent jump in inflation impact the wealth of: • a. Joe, who has a 30-year home mortgage at a fixed interest rate • b. The McCoy's, who hold most of their wealth in long-term fixed yield bonds • c. Hanna, a retiree drawing a pension of a fixed dollar amount • d. Jose, a heavily indebted small-business owner. • e. Mike, the owner of an apartment complex with substantial debt at a fixed interest rate • f. Tina, a worker whose wages are determined by a 3-year union contract ratified three months ago •1. Suppose that the consumer price index at year-end 2004 was 140 and by year-end 2005 had risen to 150. What was the inflation rate during 2005? •a. 7.1 % •b. 10 % •c. 14.2 % •d. 50 % •2. Which of the following is true? •a. Anticipated inflation is an increase in the price level that comes as a surprise, at least to most individuals •b. Unanticipated inflation is a change in the price level that is widely expected. •c. Decision makers are generally able to anticipate slow steady rates of inflation with a fairly high degree of accuracy. •d. Inflation will increase the prices of goods and services that households purchase but not the wage rates of workers