Transcript Mr. Mayer AP Macroeconomics

Defining & Calculating
Inflation
AP Macroeconomics
Inflation
• An increase in the
price level of
goods & services
Deflation
• A decrease in the
price level of
goods & services
Federal vs. NJ
(Minimum Wage)
Fed
• $7.25
Effective: 7/24/09
NJ
• $7.25
Effective: 7/24/09
Causes of Inflation
• Demand-Pull Inflation
• Cost-Push Inflation
• Increases in the supply of money
circulating in the economy
When the economy starts
recovering…there will be a fear of
inflation…why?
Price Indexes
Are used to measure the overall price level
Examples:
Consumer Price Index
Producer Price Index
GDP Deflator
CPI
• Consumer Price Index
• Measures the change in prices urban
Americans pay for a fixed basket of
goods and services
• The CPI is among the key indicators that
the Federal Reserve Board monitors for
signs of inflation, so the CPI can offer
clues about the direction of interest rates
FYI: What’s in the CPI’s Basket?
16%
Food and
beverages
17%
Transportation
Education and
communication
41%
Housing
6%
6%
6% 4% 4%
Medical care
Recreation
Apparel
Other goods
and services
Copyright©2004 South-Western
CPI
• "headline" CPI
– 80,000 consumer items in a wide range
of categories, like apparel, medical
care, and transportation.
• "core" CPI
– Computation that excludes the
somewhat volatile food and energy
sectors.
CPI vs. Core CPI
CPI vs. PPI
How the Consumer Price Index Is
Calculated
• 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
(price of the basket in current year) X 100
(price in the base year)
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Whole
Pizza
30
$5.00
$7.00
$9.00
Cassettes
40
6.00
5.00
4.00
Soda
60
1.50
2.00
2.50
Total
-
-
-
-
Spending
in Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Year 2
Calculate spending for Base Year, Year 1, and Year 2
Use Q x P
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Base
Year
Spending
in Year 2
Whole
Pizza
30
$5.00
$150
$7.00
$210
$9.00
$270
Cassettes
40
6.00
240
5.00
200
4.00
160
Soda
60
1.50
90
2.00
120
2.50
150
Total
-
-
$480
-
$530
-
$580
What is the total cost of buying all the items in year 2?
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Base
Year
Spending
in Year 2
Whole
Pizza
30
$5.00
$150
$7.00
$210
$9.00
$270
Cassettes
40
6.00
240
5.00
200
4.00
160
Soda
60
1.50
90
2.00
120
2.50
150
Total
-
-
$480
-
$530
-
$580
What is the CPI for Year 2?
Year 2 Total Spending
Base Year Total Spending
$580 X 100
$480
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Base
Year
Spending
in Year 2
Whole
Pizza
30
$5.00
$150
$7.00
$210
$9.00
$270
Cassettes
40
6.00
240
5.00
200
4.00
160
Soda
60
1.50
90
2.00
120
2.50
150
Total
-
-
$480
-
$530
-
$580
What is the percentage increase in prices from the base
year to Year 2?
(Year 2 Total Spending – Base Year Total Spending) X 100
Base Year Total Spending
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Base
Year
Spending
in Year 2
Whole
Pizza
30
$5.00
$150
$7.00
$210
$9.00
$270
Cassettes
40
6.00
240
5.00
200
4.00
160
Soda
60
1.50
90
2.00
120
2.50
150
Total
-
-
$480
-
$530
-
$580
What is the percentage increase in prices from the base
year to Year 2?
($580-$480) X 100 = 20.8%
$480
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Base
Year
Spending
in Year 2
Whole
Pizza
30
$5.00
$150
$7.00
$210
$9.00
$270
Cassettes
40
6.00
240
5.00
200
4.00
160
Soda
60
1.50
90
2.00
120
2.50
150
Total
-
-
$480
-
$530
-
$580
In August 2000 the CPI was 172.8, and in August 2001
the CPI was 177.50. What was the percentage change
in prices for this 12 month period?
(Year 2 CPI – Year 1 CPI) X 100
(Year 1 CPI)
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Base
Year
Spending
in Year 2
Whole
Pizza
30
$5.00
$150
$7.00
$210
$9.00
$270
Cassettes
40
6.00
240
5.00
200
4.00
160
Soda
60
1.50
90
2.00
120
2.50
150
Total
-
-
$480
-
$530
-
$580
In August 2000 the CPI was 172.8, and in August 2001
the CPI was 177.50. What was the percentage change
in prices for this 12 month period?
(177.50 – 172.8) X 100 = 2.7%
(172.8)
Workbook Activity 11, Part B
Quantity
Bought
in Base
Year
Unit
Price in
Base
Year
Unit
Price in
Year 1
Spending
in Year 1
Unit
Price in
Year 2
Spending
in Base
Year
Spending
in Year 2
Whole
Pizza
30
$5.00
$150
$7.00
$210
$9.00
$270
Cassettes
40
6.00
240
5.00
200
4.00
160
Soda
60
1.50
90
2.00
120
2.50
150
Total
-
-
$480
-
$530
-
$580
You’ve just calculated the inflation rate!
How the Consumer Price Index Is
Calculated
• The Inflation Rate (π%)
– The inflation rate is calculated as
follows:
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year 2 =
 100
CPI in Year 1
Practice Problem
• Step 1 – Survey consumers to determine a
fixed basket of goods
• Step 2 – Find the price of each good in year
• Step 3 – Compute the cost of the basket of
goods in each year
• Step 4 – Choose one year as a base year
(2001) and compute the consumer price
index in each year
• Step 5 – Use the consumer price index to
compute the inflation rate from previous year
Practice Problem…
Suppose that a typical consumer buys the following items in 2009 and 2010.
Commodity
Box of Twinkies
Batteries
Movie Tickets
Quantity
5 units
2 units
3 units
2009 per
Unit Price
$6.00
$7.00
$12.00
2010 per
Unit Price
$5.00
$9.00
$19.00
Which of the following can be concluded about the consumer price index
(CPI) for this individual from 2009 to 2010?
A. It decreased by 25%.
B. It decreased by 20%.
C. It increased by 20%.
D. It increased by 25%.
E. It remained unchanged.
Problems in Measuring the Cost of
Living
• The CPI is an accurate measure of the
selected goods that make up the
typical bundle, but it is not a perfect
measure of the cost of living.
• Three reasons:
1. substitution bias
2. introduction of new goods
3. unmeasured quality changes
Problems in Measuring the Cost of
Living
• Substitution Bias
– The basket does not change to reflect
consumer reaction to changes in
relative prices.
• Consumers substitute toward goods that
have become relatively less expensive.
• The index overstates the increase in cost of
living by not considering consumer
substitution.
Problems in Measuring the Cost of
Living
• Introduction of New Goods
– The basket does not reflect the change
in purchasing power brought on by the
introduction of new products.
• New products result in greater variety,
which in turn makes each dollar more
valuable.
• Consumers need fewer dollars to maintain
any given standard of living.
Problems in Measuring the Cost of
Living
• Unmeasured Quality Changes
– If the quality of a good rises from one year to
the next, the value of a dollar rises, even if the
price of the good stays the same.
– If the quality of a good falls from one year to
the next, the value of a dollar falls, even if the
price of the good stays the same.
– The BLS tries to adjust the price for constant
quality, but such differences are hard to
measure.
Problems in Measuring the Cost of
Living
• The substitution bias, introduction of new
goods, and unmeasured quality changes
cause the CPI to overstate the true cost
of living.
– The issue is important because many
government programs use the CPI to adjust
for changes in the overall level of prices.
– The CPI overstates inflation by about 1
percentage point per year.
GDP Deflator
The GDP Deflator versus the
Consumer Price Index
• Economists and policymakers
monitor both the GDP deflator and
the consumer price index to gauge
how quickly prices are rising.
• There are few important differences
between the indexes that can
cause them to diverge.
Key Differences
1. The GDP deflator measures a changing basket
of commodities while CPI always indicates the
price of a fixed representative basket.
2. GDP deflator frequently changes weights while
CPI is revised very infrequently.
3. CPI will consider imported goods because they
are still considered as consumer goods while GDP
deflator will only contain prices of domestic
goods.
Two Measures of Inflation
Percent
per Year
15
CPI
10
5
0
GDP deflator
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western
Real (r%) and
Nominal Interest (i%) Rates
• Interest represents a payment in the
future for a transfer of money in the past.
• The nominal interest (i%) rate is the
interest rate usually reported and not
corrected for inflation (π%).
– It is the interest rate that a bank pays.
• The real interest rate (r%) is the nominal
interest rate that is corrected for the
effects of inflation (π%).
Real (r%) and
Nominal Interest (i%) 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
r% = i% - π%
r% = 15% - 10%
r% = 5%
Real and Nominal Interest Rates
Interest Rates
(percent
per year)
15
10
Nominal interest rate
5
0
Real interest rate
–5
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western
Medical Care costs…
Vocabulary
• COLA – Cost of living adjustment
• Disinflation – is the process of bringing the
inflation rate down
• Expected Inflation: gets priced into the
market without shock
• Unexpected Inflation: acts as a source of
volatility to the markets
Note: Do not confuse with hyperinflation
and stagflation!
Hyperinflation:
Extremely rapid or out of
control inflation. There is
no precise numerical
definition to hyperinflation.
Hyperinflation is a situation
where the price increases
are so out of control that
the concept of inflation
is meaningless.
Stagflation
• Stagflation is
defined as slow
economic growth
occurring
simultaneously
with high rates of
inflation
Winners and Losers
• Explain: “Inflation hurts lenders and helps
borrowers.”
• Explain: “People on fixed income are hurt by
inflation.”
• Explain: “I am always ahead of the game,
my annual raise is always above inflation.”
Note: Do not confuse expected inflation with
unexpected inflation!