Download Inflation - Granbury ISD

Measuring the Cost of
Living
Copyright © 2001 by Harcourt, Inc.
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Measuring the Cost of Living
 Inflation
refers to a situation in which the
economy’s overall price level is rising.
 The inflation rate is the percentage
change in the price level from the
previous period.
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Using Price Indexes
 Because
inflation may overstate the value
of our GDP we need to make adjustments
accordingly.
 A price index is a measurement of how
the average price of a standard group of
goods changes over time.
 Price indexes are the way we adjust
nominal GDP (the value of GDP in
current dollars) to real GDP (the value of
GDP in constant dollars)
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Consumer Price Index
The consumer price
index (CPI) is a measure
of the overall cost of the
goods and services
bought by a typical
consumer.
 The consumer price
index uses a “fixed
basket of goods” and
evaluates changes in the
basket’s costs each
month.

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Calculating a Price Index and
the Rate of Inflation
Price Index in given year =
Cost of market basket in a given year
Cost of market basket in base year
Price index in year 2 - Price index in year 1
Inflation Rate =
Price index in year 1
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X 100
X 100
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Current changes in the CPI
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How the Consumer Price Index Is Calculated
1.
2.
3.
Fix the Basket: Determine what
prices are most important to the
typical consumer.
Find the Prices: Find the prices of
each of the goods and services in the
basket for each point in time.
Compute the Basket’s Cost: Use the
data on prices to calculate the cost of
the basket of goods and services at
different times.
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How the Consumer Price Index Is
Calculated
4. Choose a Base Year and Compute the Index:
 Designate one year as the base year, making
it the benchmark against which other years
are compared.
 Compute the index by dividing the price of
the basket in one year by the price in the
base year and multiplying by 100.
Current prices x 100 = CPI
Base prices
CPI data 2004-2014
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The Inflation Rate

We use the Consumer Price Index to calculate the
inflation rate.

Compute the inflation rate: The inflation rate is
the percentage change in the price index from the
preceding period.
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year2 
 100
CPI in Year 1
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Causes of inflation
Pull Theory – demand for
goods & services exceeds existing
supply. One reason for this may be
too much money in circulation.
 Cost Push Theory- producers raise
prices in order to meet increased
costs. This is also known as supply
shocks (supply curve shifts left).
 Demand
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Demand-pull
Cost-push or Supply
Shock
P
R
I
C
E
L
E
V
E
L
AS
AD1
AD2
REAL GDP
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P
R
I
C
E
AS2
AS1
L
E
V
E
L
AD
REAL GDP
Effects of Inflation
Interest Rates:
• Interest represents a payment in
the future for a transfer of money
in the past.
• When you save or loan someone
money you expect a return on that
money (interest).
• Inflation affects the future value of
our money.
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Real and Nominal Interest Rates
 The
nominal interest rate is the interest
rate not corrected for inflation.
 It
is the stated interest rate that a bank pays.
 The
real interest rate is the nominal
interest rate that is corrected for
inflation. When evaluating your return
you need to focus on the real interest rate
Real interest rate = (Nominal interest rate –
Inflation rate)
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Real and Nominal Interest Rates
 You
borrowed $1,000 for one year.
 Nominal interest rate was 15%.
 During the year inflation was 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%
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Anticipated and Unanticipated
Inflation
 If
a bank anticipates inflation they will
set the nominal rate high enough to
insure a return on any loans they make
and inflation will not harm them.
 If inflation is unanticipated then the
interest rate will not be set high enough
and the bank (savers) will lose money.
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Real and Nominal Interest Rates
Interest Rates
(percent per
year)
15
Nominal
interest rate
10
5
0
Real interest rate
-5
1965
1970
1975
1980
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1985
1990
1995 1998
Who’s Hurt? Who’s Helped?
By Unanticipated Inflation
You’re hurt if you are a
 Creditor – the money
you loan out is worth less
when its paid back
 Saver – inflation rates
are normally higher than
interest rates
 Fixed income receiver- a
constant income will buy
less.
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You’re helped if you are a
 Borrower- the money you
are repaying is worth less
 Flexible income earner if your income is tied to
profits you will earn more
 If your income is adjusted
for inflation you will earn
more (COLA)

Payer of fixed amounts