Download Mrs. Thompson`s Notes on Defining, Calculating, and Measuring

Mrs. Thompson’s Notes on Defining, Calculating, and Measuring Inflation
I.
Price Level and Real Income
a. Price levels don’t make people poorer. Wages and prices both rise (over time).
Real wage =
II.
wage rate
price index
Real income=
income
price index
Rate of Price Changes
a. Inflation RATE (overall percentage increase per year) makes people poorer (because it outpaces wage
increases).
Inflation rate= Price level in Year 2 – Price level in base year X 100
Price level in base year
III.
Three Costs of High Inflation Rates
a. Shoe-leather costs: In attempt to avoid holding money, individuals and businesses do more banking
transactions (i.e., trading money for more stable alternatives). This expenditure of time, effort, and
banking fees is “shoe-leather costs.”
i. Substantial in places with very high inflation (100%+ annually), but not so much in the U.S.
(where peacetime inflation is never higher than 15%)
b. Menu costs: Costs associated with changing listed products to keep up with inflation (i.e., having
someone change all of the prices in the computer and all of the signs on shelves in a supermarket daily
or even more often).
i. In high inflation countries (like Zimbabwe in 2008, where inflation was 1,694,000%), firms begin
listing prices in more stables measures (like U.S. dollars) although they expect payment in local
currency (with exchange rates constantly changing).
c. Unit-of-account costs: The dollar is our “unit-of-account” because this is the basis for all contract
financial transactions. These are costs that result from the fact that – in most cases – contract terms
don’t change when the value of the dollar does.
i. A house purchased for $100,000 in one year with a 10% rate of interest and sold the next year
for $110,000 is no real profit, as the purchasing power of the $110,000 is the same as the
$100,000 was in the previous year.
IV.
Winners and Losers in Inflation
a. Most contracts lock people into paying a fixed interest rate, regardless of future trends in purchasing
power. The interest rate is the extra percentage that borrowers must pay to the lender for the use of
the money.
i. Nominal interest rate – the interest rate as stated in the contract (i.e., a car loan with 7%
interest)
ii. Real interest rate – interest rate after adjustment for inflation
Nominal interest rate – Inflation rate = Real interest rate
b. If the inflation rate is higher than expected, borrowers win! The money they pay back has lower real
value (less purchasing power) than the money they borrowed.
i. For this reason, long-term contracts are rare in regions with high inflation.
ii. If lenders attempt to battle this by setting higher nominal interest rates, borrowers lose!
c. If the inflation rate is lower, lenders win! The money they receive back from the borrower is worth more
than the money they lent.
d. Inflation erodes purchasing power, hurting consumers’ ability to buy. This is related to the idea of “real
income” – and both consumers and producers lose!
e. Inflation reduces the real interest rate of savings. Money in the bank/invested is earning interest, but
inflation cuts into the value of the money saved and earned in interest (“real interest rate”), so savers
lose!
f. Inflationary spirals
Inflation reduces incentive to save, so consumers spend – causing demand-pull inflation
Higher prices cause workers to demand higher wages, which
increases cost of production – and increases inflation
V.
Disinflation
a. Recessions/depressions bring down inflation. Government actions to deflate (bring down the inflation
rate) can create a decrease in GDP, so the government responds early (2% or so) in order to minimize
the impact of these policies.
b. Disinflation is NOT deflation. Deflation is a decrease in price levels. Disinflation is a decrease in the
inflation rate. More on the distinction between them:
http://www.nbcnews.com/id/7149156/ns/business-answer_desk/#.UR58QR2ceSo
VI.
Price indexes
a. Price indexes are based on the aggregate price level across the economy. You can’t measure inflation by
looking at a single item or even just a few, as price levels are rising at different rates. You must look at
the economy as a whole in order to understand the impact of inflation.
b. To get a picture of the economy as a whole, economists looks at a “typical consumption bundle” (also
known as a market basket).
Price index in a given year =
Cost of basket for that year X 100
Cost of market basket in base year
c. Price index for the base year is always 100 (C/C X 100)
d. This is the method for calculating both Consumer Price Index and Producer Price Index.
Inflation rate(for consecutive years) = PI in Year 2 – PI in Year 1 X 100
PI in Year 1
VII.
Consumer Price Index
a. The CPI reflects how costs of purchases by families change over time
b. The CPI is based on the period 1982-1984 (aggregate “base year”). To measure the prices, the Bureau of
Labor Statistics sends employees to 23,000 stores in 87 cities and tabulates approximately 80,000 prices
each month. The greatest rise in CPI was in the 1970s and 1980s.
c. Some reasons CPI is criticized for not being accurate:
i. Substitutes – Consumers alter purchase products as prices rise. The “market basket” stays the
same, so this might overstate CPI if people are moving to cheaper foods.
ii. Innovation – New products offer greater choice, makes money worth more. Some items didn’t
exist in the 1980s (like cell phone bills) that are now part of the average consumer’s monthly
expenses.
*A graph of CPI from 1913-2005 (and estimated numbers beyond) follows:
VIII.
Other Measures
a. Producer Price Index – Measures the cost of purchases by producers (raw commodities, etc.)
i. Because supply responds more quickly to changes than demand, the PPI reacts to
inflation/deflation more quickly than the CPI. For this reason, the PPI is seen as an “early
warning signal” of inflation changes.
b. GDP deflator – Measures the ratio of the nominal GDP to real GDP (and thus the degree to which GDP
has been impacted by inflation). The base year for this measure is 2005.
GDP deflator = nominal GDP X 100
real GDP
c. In practice, this number is very close to the CPI.
*This graph shows that PPI responds more quickly and more dramatically to change.
IX.
Cost-Push and Demand-Pull Inflation
a. Cost-push inflation occurs when certain inputs that are universally important to business operations rise
in price (i.e., oil). For all businesses, this creates a situation in which the cost of producing has gone up –
so many will choose to produce less. The result of this leftward shift of the supply curve is higher prices
for consumers and a rise in the aggregate price level.
Quantity
b. Demand-pull inflation occurs when aggregate demand is greater than aggregate supply. People have
money to spend and there simply isn’t enough for consumers to buy. An example of this would be the
market for consumer goods during World War II. More people had a steady paycheck, but so many
factories had been converted to wartime production that luxury goods were in short supply. When the
war ended, this was one of the causes of rapid inflation.