Download Inflation 100 pts

Chapter 11
Inflation and
Unemployment
Inflation
 Is the general increase in the prices of
goods and services in an entire economy.
 For ex: an annual inflation of 3% would
mean that there is an overall increase in
prices by 3%
 Deflation is the general decrease in the
level of prices
The Consumer Price Index
 CPI is used to measure price changes for a
typical “basket” of consumer products.
 CPI is one indicator of inflation or changes
in the cost of living.
 Statistics Canada calculates CPI to see
what the typical Canadian mostly buys. For
ex. in 1986 housing was the biggest
expenditure
The Consumer Price index…..
Results of 1994 survey
Prices
Quantity
Consumed
Expenditure Weights
Hamburgers
$2.00
10
$20
0.4
milkshakes
$1.00
30
$30
0.6
$50
Prices in 1995
Prices
1995 Price x 1994 Quantity
hamburgers $2.20
$2.20 x 10 =
$22.00
Milkshakes
$1.05 x 30 =
$31.50
$1.05
$53.50
CPI=
($53.50-$50) x 100 = 7 % = 1.07
$50.00
Nominal Vs Real Income
 Nominal income is income valued in current dollars
 Real income is when income is expressed in base-year
dollars.
 Real income = nominal income
CPI
 A consumer’s income has to increase at the same rate of
inflation.
 Purchasing power is inversely related to CPI
 Therefore those whose incomes increase at a higher rate
than CPI enjoy a higher standard of living.
Limitations of the CPI
 The CPI has 3 basic limitations, which under certain
circumstances can severely reduce the CPI’s usefulness.
 Consumer differences: some consumer’s preferences
might not match up with the average consumer this
causes discrepancies in item weights.
 Changes in spending patterns: consumer consumption is
constantly changing and Statistics Canada needs to
constantly update item weights and contents
 Product quality: the index cannot reflect changes in
quality that are not matched by changes in prices
The GDP Deflator
 Unlike CPI, the GDP deflator measures
price changes for all goods and services
and weights them in terms of the
economy’s total output
 the GDP deflator is updated yearly and is
more accurate than the CPI but this causes
the values of the GDP deflator to be less
available than the CPI.
GDP Deflator…..
Year
Output Price
Output at
Output at 1994 GDP
Current Price Price
Deflator
1994 1000 $0.20 $200
$200
1.0
1995 2000 $0.30 $600
$400
1.5
Much like the CPI, the base year has a value of 1, which is
used as comparison for further years.
To calculate the GDP deflator the Output at Current price is
Divided by Output Price at 1994.
In this example we see that inflation rate was 50% in 1995
Nominal vs. Real GDP
 A nominal GDP is expressed in current
dollars.
 Real GDP, much like Real income, gives
an indication of the purchasing power of an
entire economy.
 Real GDP= nominal GDP/ GDP deflator
Inflation Effects
 In Figure 11.5 in the text book (p314) Canada’s
inflation record since 1926 is illustrated.
 Why are inflation rates considered a serious
problem? They redistribute purchasing power in
ways that can be economically harmful and
unjust.
 To see the effects of inflation lets look at the
effects on household incomes and on borrowing
and lending.
Incomes
 If a household income increases steadily but inflation
increases at a higher rate then the households lose
purchasing power.
 Fully indexed incomes: nominal incomes that
automatically increase at the rate of inflation.
 Partially indexed incomes: nominal incomes that increase
at rates less than that of inflation.
 Fixed incomes: nominal incomes that remain fixed at the
same dollar amount regardless of inflation.
Borrowing and Lending
 If the lender loans funds at an interest rate
that is not adjusted for inflation, then the
lender may lose out.
 The nominal interest rate is the interest rate
expressed in money terms.
 Real interest rate = nominal interest rate inflation rate
Borrowing and Lending….
 For ex: Company A borrows $2000 at 5% per annum. So
5% would be the nominal interest rate. If the inflation rate
is 3% the year Company A borrows the loan. Then the
real interest rate would be 2%.
 The real interest rate reflects the fact that due to inflation
the loan has less purchasing power at the end of one year
as opposed to the time when the loan was made.
 Once the nominal rate has been agreed on the lenders
have to anticipate the rate of inflation during the loan
period and this rate is added into the nominal interest rate
and is called inflation premium.
 Nominal interest rate = desired real interest rate +
inflation premium.
Borrowing and lending…
 If the inflation rate is predicted to be 2% and the
bank wanted a real interest rate of 3% the bank
would receive real interest of $60 ($2000 x 0.03)
and an inflation premium of $40 ($2000 x 0.02)
 This is to compensate for the reduced purchasing
power of the $2000.
 If the inflation rate turns out to be higher than
what was predicted then the lenders lose out.
INFLATION
100
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200
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300
300
300
300
What kind of income
increases by less
than the rate of
inflation?
Back
What are provisions
for income
adjustments to
accommodate changes
in price levels called?
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What is the formula
for real interest
rate?
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What kind of income is
a nominal income that
remains fixed at some
dollar amount
regardless of the rate of
inflation?
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Name 2 tools that are
used to measure
overall changes in
price
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What is the
formula for
nominal interest
rate?
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Name 3 limitations for the
consumer price index
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What is the formula for real
income?
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What is
nominal GDP
expressed in?
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What was the biggest
expenditure,
according to
Statistics Canada’s
1986 survey?
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If a consumer spends
$30 on hotdogs and
$20 on Coke, what
are the item weights
of each good?
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A workers original
monthly income is $1000,
and the inflation rate is
10%. If his income rises
to $1100 what kind of
income does he have?
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