Transcript Frank & Bernanke 4th edition, 2009 Ch. 5: Inflation and the Price Level.

Frank & Bernanke
4th edition, 2009
Ch. 5: Inflation and the Price Level
1
2
Who Is Making More?
• A 2008 graduate of Hiram College got a job
that pays $40,000 per year.
• Thirty-four years ago (1974), her father
started his career with a $8,000 job.
• Is she making five times as much as her
father did?
3
Who Is Making More?
• In order to compare the incomes of two
different periods we have to eliminate
the effect of inflation.
• What happened to prices between 1974
and 2008?
• Let’s find out the Consumer Price Index
(CPI).
4
Who Is Making More?
• According to Bureau of Labor Statistics
(ftp://ftp.bls.gov/pub/special.requests/cpi/
cpiai.txt), CPI in 1974 was 49.3.
• CPI in 2008 was 215.3. Base year was
1982-84.
• If the average price level in 1974 was
lower than in 2008, our graduate must
not have been five times better off.
5
Who Is Making More?
• In real terms:
– She made (40,000/2.153) = $18,578.73 in
1983 dollars.
– He made (8,000/.493) = $16,227.18 in
1983 dollars.
• How much was his pay in 2008 dollars?
– His pay is (8,000)(2.153/.493) =
$34,937.12
6
How To Calculate The CPI?
• Fix the basket a typical consumer will buy.
• Find the prices of the items for different
years.
• Compute the basket’s cost for each year.
• Choose a base year.
• Calculate the cost of the basket for other
years in terms of the base year.
• Calculate inflation rates.
7
The Consumer Price Index:
Measuring the Price Level

Constructing the CPI

Bureau of Labor Statistics (BLS)



CPI 
Pick a base year
Conduct the consumer expenditure survey to determine
the base-year basket of goods and services
Measure the current prices of the base-year basket
Cost of base - year basket of goods and servicesin current year
Cost of base - year basket of goods and servicesin base year
8
CPI Calculation
BASKET
P (2000)
P (2010)
Beer
20
$1.00
$1.50
Pizza
10
$2.00
$2.50
DVD
5
$5.00
$6.00
$65.00
$85.00
Value
CPI = 85/65 = 1.325
9
Problems With CPI
•Substitution bias.
–Basket changes as a response to relative price
changes do not get accounted.
•New products.
–Basket changes are ignored.
–Prices of new products fall before they are included
in the new basket.
•Quality change.
–If the same gadget has higher quality now than in
the past but viewed as the same item, an increase in
price is not inflationary.
10
Calculating Inflation
Rates: 1972 - 1976
Year
CPI
1972
0.418
1973
0.444
1974
0.493
1975
0.538
1976
0.569
0.444 - 0.418
Inflationrate : 1972 - '73 
 0.062 x 100  6.2%
0.418
0.493 - 0.444
Inflationrate : 1973 - '74 
 0.110 x 100  11.0%11
0.444
Calculating Inflation
Rates: 1929 - 1933
Year
CPI
1929
0.171
1930
0.167
1931
0.152
1932
0.137
1933
0.130
Inflationrate : 1929 - '30 
Inflationrate : 1930 - '31 
0.167 - 0.171
 - 0.023 x 100  - 2.3%
0.171
0.152 - 0.167
 - 0.090 x 100  - 9.0%
0.167
12
Does the CPI Measure
“True” Inflation?


1996 report by the Boskin Commission
estimated that the CPI overstates inflation by
as much as 1 to 2 percentage points a year.
Overstating Inflation


Would unnecessarily increase government
spending
Underestimate the improvements in the standard
of living
13
Adjusting for Inflation

Real Wage
The wage paid to workers measured in
terms of real purchasing power
 The real wage for any given period is
calculated by dividing the nominal (dollar)
wage by the CPI for that period

14
Nominal and Real Wages for
Production Workers’ 1960 - 2001
15
GDP Deflator vs. CPI
• Space shuttle costs more to operate.
– Deflator is up, CPI unchanged.
• Antiques cost more.
– CPI is up, deflator unchanged.
• Porsche increases the price.
– CPI is up, deflator unchanged.
• New homes cost more.
– Both CPI and deflator up.
16
Indexation
• If payments are automatically corrected for
inflation, they are said to be indexed.
–
–
–
–
COLA
Social Security
TIPS
Variable mortgage rates
17
Adjusting for Inflation

Indexing to Maintain Buying Power

An example:
Social Security Payment
Inflation
2000
$1,000/month
2000 - 2005 = 20%
2005
$1,200/month indexed to inflation
18
The Costs of Inflation:
Not What You Think

Observations
Changes in relative price do not
necessarily imply a significant
amount of inflation.
 Inflation can be high without
affecting relative prices.

19
The Costs of Inflation:
Not What You Think

Observations
To counteract relative price changes,
government policy would have to affect the
market for specific goods.
 To counteract inflation, the government
must use monetary and fiscal policy.

20
Costs of Inflation

Shoe-leather costs
Economizing on cash
 More frequent trips to the bank
 More bank employees
 Efforts to avoid the erosion of purchasing
power

21
Costs of Inflation

Noise in the price system
Is it an increase in the demand for a product
or is it a general increase in prices?
 Should the supplier increase output or not?

22
Costs of Inflation

Distortions of the tax system
Depreciation allowance and the replacement
cost
 Bracket creep

23
Costs of Inflation

Unexpected distribution of wealth
Real wage down => workers lose, employers
gain
 Borrowers gain and creditors lose

24
Costs of Inflation

Interference with long-run planning
Increase uncertainty
 Impossible to predict the future

25
Hyperinflation
Inflation of 500 or more per cent per
year.
 Germany in early twenties.
 Latin America.
 Zimbabwe: 150,000% in 2007!

26
Hyperinflation

Economic Naturalist

Fischer, Sahay, and Vegh examined 133
market economies 1960 - 96
 45
episodes of high inflation (100% +) in 25
countries



Real GDP/person fell by an average of 1.6%/yr
Real consumption/ person fell by an average of
1.3%/yr
Real investment/person fell by an average of 3.3%/yr
"Modern Hyper- and High Inflations", Journal of Economic Literature. September 2002, Volume XL, Number 3, 837-880.
27
Hyperinflation in Zimbabwe
http://www.dallasfed.org/assets/documents
/institute/annual/2011/annual11b.pdf
28
Real and Nominal Interest Rates
• If you lend someone $1000 for a year and
ask for a 5% interest, you will get $1050 at
the end of the year.
• If inflation during the year were 10%, the
products you could buy with your $1000 at
the beginning of the year now costs $1100.
• Are you better-off or worse-off?
29
Real and Nominal Interest Rates
• Lenders will always ask a higher interest
rate than the expected inflation to earn
income.
• Nominal interest rates are what the bank
quotes, what the car dealer quotes.
• Real interest rates are nominal rates
corrected for inflation.
• i=r+π
30
The Real Interest Rate in the
United States, 1960 - 2001
31
Inflation and Interest Rates in
the United States, 1960 - 2001
32
33