Business Cycle

PeaPeakk

TroughTrough

One CycleOne Cycle

Expan

sion

Expan

sion

[Real GDP per year]

Peak:Peak: real GDP reaches its maximum.Recession:Recession: real GDP declines 6 months.

Expansion:Expansion: an upturn - real GDP rises.

Trough:Trough: real GDP reaches its minimum.

Recession

Recession

Time

PeaPeakk

[Have averaged five years][Have averaged five years]

Expansi

on

Expansi

on

TOTAL SPENDING EFFECTS BUSINESS CYCLE

• IF SPENDING DROPS BUSINESS PRODUCE LESS AND THEREFORE NEED LESS EMPLOYEES WHICH CAUSES A DOWNTURN IN THE ECONOMY OR BUSINESS CYCLE

• IF PEOPLE ARE SPENDING MORE BUSINESSES PRODUCE MORE AND THEREFORE NEED TO HIRE MORE PEOPLE WHICH CAUSES THE CYCLE TO EXPAND OR RECOVER.

Vocabulary You need to memorizeNET NATIONAL PRODUCT

• IS THE TOTAL INCOME OF A NATIONS Permanent RESIDENTS MINUS LOSSES FROM DEPRECIATION

• Depreciation is when things become worth less because of time or use. A new car losses its value as soon as you drive it off the lot.

What is depreciation?

• Depreciation is when things become worth less because of time or use. A new car losses its value as soon as you drive it off the lot.

National Income

• Is the total income earned by a nation’s residents in the production of goods and services.

Personal Income

• Income that households and noncorporate businesses receive.

Disposable Income

• Is money left over after satisfying all their obligations to the government=Personal income–personal taxes.

Productivity

© 2007 Thomson South-Western

Why Productivity Is So Important

Productivity plays a key role in determining living standards for all nations in the world.

LAW OF Diseconomies of Scale

© 2007 Thomson South-Western

Productivity: Its Role and Determinants

– Productivity plays a key role in determining living standards for all nations in the world.

– To understand the large differences in living standards across countries, we must focus on the production of goods and services.

© 2007 Thomson South-Western

ECONOMIC GROWTH AND PUBLIC POLICY • Government policies that raise productivity

and living standards– Encourage saving and investment.– Encourage investment from abroad.– Encourage education and training.– Establish secure property rights and maintain

political stability.– Promote free trade.– Promote research and development.

Added LeisureAdded Leisure[Workweek decreased [Workweek decreased

from 50 to 35 hours]from 50 to 35 hours]

From LPs to CDsFrom LPs to CDs

Icebox – cooled by Icebox – cooled by ““natural” icenatural” ice

1927 GE Monitor Top1927 GE Monitor Topelectric refrigerator-electric refrigerator-$300$300

““Knee Buster” foot pedalKnee Buster” foot pedal[step on it & the door opens][step on it & the door opens]

Improved Products - iceboxes to Improved Products - iceboxes to refrigeratorsrefrigerators

10 inch image10 inch imagewould cost would cost

$4,325$4,325 in 2010 in 2010

12 inch image12 inch imagewould cost would cost

$6,197$6,197 in 2010 in 2010

20 inch image20 inch imagewould cost would cost

$22,249 $22,249 in 2010in 2010

12 inch image12 inch image$695$695

10 inch image10 inch image$485$485

20 inch image20 inch image$2,495$2,495

It takes $9.00 to buy what $1 did in 1948.It takes $9.00 to buy what $1 did in 1948.

19481948 Tucker[2,450]Tucker[2,450]

The Tucker Torpedo The Tucker Torpedo would cost $22,050] today.would cost $22,050] today.

It was called the It was called the Dyna TAC 800XDyna TAC 800X. Motorola . Motorola says the says the wafer-thin RAZRwafer-thin RAZR represents the represents the tip of the icebergtip of the iceberg of what phone designers of what phone designers will be able to do. iPhone weighs about 5 oz. will be able to do. iPhone weighs about 5 oz. Cell phones, like computers, have becomeCell phones, like computers, have becomesmallersmaller, , smartersmarter, and , and cheapercheaper. The $3,995. The $3,995would be like $8,000 today, more expensivewould be like $8,000 today, more expensivethan a large screen plasma TV.than a large screen plasma TV.

The 11stst portable cell phone portable cell phone(1984)(1984) [Motorola’s “The Brick”“The Brick”] took 10 years and $150 million to develop10 years and $150 million to develop, and cost $3,995$3,995. It weighed 2 pounds2 pounds and offered just a half-hour of talk half-hour of talk timetime for every10 hr recharge. Consumers lined up in droves to lined up in droves to buy the world’s first cell phonebuy the world’s first cell phone. Servicewas $150 a month$150 a month.

The 2 pound The 2 pound ““BrickBrick””

We want the “brick.”Only $3,995, we want 2.”

ENIAC ENIAC [Electronic Numerical Integrator And Computer][Electronic Numerical Integrator And Computer] First Computer built in 1946-$486,804.22First Computer built in 1946-$486,804.22

1st general purpose electronic digital computer, being as big as a 3-3-bedroombedroom househouse. It weighed 3030 tonstons, was 80 ft long80 ft long & had 17,468 vacuum17,468 vacuum tubestubes. Price was $486,804.22$486,804.22.[the “beast”“beast”]

The first computer, at 30-tons30-tons, $486,804$486,804, and with 17,468 vacuum tubes17,468 vacuum tubes, could not do as much as a microchipmicrochip no bigger than the mole on Cindy’s facemole on Cindy’s face..

*These could execute 330,000computations per sec(2 billion now).These had 5 MB disk drives5 MB disk drives. TodayDell makes computers with 500GB500GB,70,000 times larger70,000 times larger. Stores were selling them for $3,300$3,300 after buyingthem for $2,000$2,000.

M. Dell – 2M. Dell – 2ndnd richest TX richest TXHe bought parts fromHe bought parts fromBYTE Magazine forBYTE Magazine for$600 and sold them$600 and sold themfor $1,500-$2,000.for $1,500-$2,000.

1981 IBM PC1981 IBM PC4.77MHz4.77MHz

160 KB floppy drives160 KB floppy drives

$3,300$3,300

1991 Compaq 4861991 Compaq 48633 MHz33 MHz

120 MB hard drive120 MB hard drive$2,300$2,300

2010 Dell Optiplex 1602010 Dell Optiplex 160

2 GB 2 GB 320 GB 320 GB hard drivehard drive

$700$700

1. Stock of physical capital Stock of physical capital [tools & machinery increase productivity]

a. Try writing a term paper without a computer.

b. Try painting a fence without a brush.

c. Increasing the quantity of physical capital in an economy can increase the quantity of more capital.

2. Human Capital Human Capital [knowledge & skills makes labor more productive]

a. College courses and improved health increase productivity.

b. A nurse who studies to become a physician’s assistant is increasing her human capital.

3. Natural Resources Natural Resources a. A nation’s stocks of minerals, fertile soil, timber, and navigable waterways contribute to productivity.

4. TTechnologyechnology [knowledge of how to produce goods in the best possible way]

[All of these productivity determinants require an investment, and funds for investment come from saving. [Goal of supply-side economics]

Factors that shift shift out the out the PPC PPC also increase productivityincrease productivity. Determinants of Productivity Determinants of Productivity increase a country’s growth.

4 Ways to Increase Productivity in an economy

• Physical Capital or Capital-These are the tools to help with production

© 2007 Thomson South-Western

How Productivity Is Determined

• Physical capital per worker is the stock of equipment and structures that are used to produce goods and services.

• Physical capital includes:• Tools used to build or repair automobiles.• Tools used to build furniture.• Office buildings, schools, etc.

• Physical capital is a produced factor of production.• It is an input into the production process that in the past was

an output from the production process.

4 Ways to Increase Productivity in an economy

• Human Capital-Production increases when you have more education or knowledge

© 2007 Thomson South-Western

How Productivity Is Determined

• Human capital per worker is the economist’s term for the knowledge and skills that workers acquire through education, training, and experience.

• Like physical capital, human capital raises a nation’s ability to produce goods and services.

4 Ways to Increase Productivity in an economy

• Natural Resources-land, rivers, and mineral deposits.

© 2007 Thomson South-Western

How Productivity Is Determined

• Natural resources are inputs used in production that are provided by nature, such as land, rivers, and mineral deposits.• Renewable resources include trees and forests.• Nonrenewable resources include petroleum and

coal.

• Natural resources can be important but are not necessary for an economy to be highly productive in producing goods and services.

4 Ways to Increase Productivity in an economy

Technological Knowledge-society’s understanding of the best ways to produce goods and services

© 2007 Thomson South-Western

How Productivity Is Determined

• Technological knowledge includes society’s understanding of the best ways to produce goods and services.

• Human capital includes the resources expended transmitting this understanding to the labor force.

© 2007 Thomson South-Western

Saving and Investment

• One way to raise future productivity is to invest more current resources in the production of capital.

© 2007 Thomson South-Western

Education

• An educated person might generate new ideas about how best to produce goods and services, which in turn, might enter society’s pool of knowledge and provide an external benefit to others.

• One problem facing some poor countries is the

brain drain — the emigration of many of the most highly educated workers to rich countries.

© 2007 Thomson South-Western

• High Productivity Makes Products Cheaper. The more productive your workers are the less each product you produce costs. This brings the price of goods down which means more people in society can afford them.

• Therefore productivity helps society become more wealthy.

Inflation

• How is the CPI market basket determined?• The CPI market basket is developed from detailed expenditure information provided by

families and individuals on what they actually bought. For the current CPI, this information was collected from the Consumer Expenditure Surveys for 2007 and 2008. In each of those years, about 7,000 families from around the country provided information each quarter on their spending habits in the interview survey. To collect information on frequently purchased items, such as food and personal care products, another 7,000 families in each of these years kept diaries listing everything they bought during a 2-week period.

• Over the 2 year period, then, expenditure information came from approximately 28,000 weekly diaries and 60,000 quarterly interviews used to determine the importance, or weight, of the more than 200 item categories in the CPI index structure.

• What goods and services does the CPI cover?• The CPI represents all goods and services purchased for consumption by the reference

population (U or W) BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

• FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)

• HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture) • APPAREL (men's shirts and sweaters, women's dresses, jewelry) • TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance) • MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses

and eye care, hospital services) • RECREATION (televisions, toys, pets and pet products, sports equipment, admissions); • EDUCATION AND COMMUNICATION (college tuition, postage, telephone services,

computer software and accessories); • OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other

personal services, funeral expenses).

Does not include• Core Consumer Price Index:• Two measures of inflation are often reported: Core CPI, which does

not include food and energy cost, and non-core CPI, which includes everything. Core CPI is important because this is what the Federal Reserve looks at to decide whether or not to raise the Fed Funds rate. The Fed uses the Core CPI because food and energy, specifically gasoline, are so volatile and the Fed's tools are so slow-acting. Therefore, inflation could be high if gas prices have increased dramatically, but the Fed won't react until those increases trickle through to the prices of other goods and services

• More important, the CPI does not include sales price of homes. Instead, it calculates the monthly equivalent of owning a home, which it derives from rents. This is very misleading, since rental prices are likely to drop when there is high vacancy, usually when interest rates are low and housing prices are rising. Conversely, when home prices are dropping due to high interest rates, rents tend to increase. Therefore, the CPI gives a false low reading when home prices are high (and rents are low). This is why it did not warn of asset inflation during the housing bubble of 2005.

• Calculator for different years.

• http://146.142.4.24/cgi-bin/cpicalc.pl?cost1=100.00&year1=1921&year2=2011

• Top movie adjusted for inflation

• http://boxofficemojo.com/alltime/adjusted.htm

• February 7, 2012, 12:01 PM • Bernanke Tries to Keep Balance on Inflation, Jobs• Article • Comments (6) • REAL TIME ECONOMICS HOME PAGE »• By Jon Hilsenrath• Federal Reserve Chairman Ben Bernanke makes an interesting point at his

Senate Budget Committee hearing about how the Fed pursues its inflation and employment mandates symmetrically.

• – Published Credit: Associated Press

• The law requires the Fed to pursue stable prices and maximum employment. Mr. Bernanke has said before that if inflation were above the Fed’s 2% target at a time of high unemployment, the Fed might not be very aggressive about raising interest rates to bring inflation down quickly because it would want to avoid making the job situation worse.

Inflation

• Inflation-is a rise in prices

• Does not mean all prices go up but on AVG prices go up.

• During periods of inflation some prices even go down

Future Value of Money and Present Value of Money

• Money is worth less in the future because of inflation.

• Loaf of breadbread – 8 cents– 8 cents• Stamps – 3 centsStamps – 3 cents• PostcardsPostcards – 1 cent – 1 cent• Median cost of a house - $2,900house - $2,900• Median monthly rent - $24rent - $24• Average 1940 car p1940 car pricerice - $650 - $650• Coke – 3 centsCoke – 3 cents

• Half Gal. milkmilk – .2525 delivered fresh

1962 Prices1962 Prices v. 2010 Prices2010 Prices [National Debt - $286 billion] [National Debt - $286 billion] [National Debt - $$12.1 trillion][National Debt - $$12.1 trillion]• Tuition at Harvard - $900Tuition at Harvard - $900• Starting salary - $6,000 Starting salary - $6,000

[college graduate][college graduate]• FICA of 3.125 of $4,800 FICA of 3.125 of $4,800

[$150 maximum][$150 maximum]• Top marginal tax rate of 91% Top marginal tax rate of 91%

of incomes over $200,000.of incomes over $200,000.• New house for $10-15,000 New house for $10-15,000

[2.5 times the income of a [2.5 times the income of a new college graduate]new college graduate]

• Coke - .5 centsCoke - .5 cents• Movies - .50 Movies - .50 • Gas, a gallon - $.29Gas, a gallon - $.29• 1962 Chevy Impala- $1,5001962 Chevy Impala- $1,500

• Tuition at Harvard - $32,557Tuition at Harvard - $32,557• Starting salary - $44,000 Starting salary - $44,000

[college graduate][college graduate]• FICA of 7.65 of $106,800 FICA of 7.65 of $106,800

[$8,170 maximum][$8,170 maximum]• Top marginal tax rate of 35% Top marginal tax rate of 35%

of incomes over $357,700of incomes over $357,700• New median house price is New median house price is

$242,000 [5.5 times the income of $242,000 [5.5 times the income of today’s college grads] today’s college grads]

• Coke - $1 Coke - $1 • Movies - $10Movies - $10• Gas, a gallon - $2.44Gas, a gallon - $2.44• 2010 Chevy Impala- $27,6502010 Chevy Impala- $27,650

62 Corvette62 Corvette $2,995$2,995 2010 Corvette Grand $60,0002010 Corvette Grand $60,000

Http://objflicks.com/TakeMeBacktotheSixties.htmHttp://objflicks.com/TakeMeBacktotheSixties.htm

Box Office ReceiptsMovieMovie Receipts (mil.)

1. Avatar $750$7502.2. TitanicTitanic 601 6013.3. Dark KnightDark Knight 533 5334. Star Wars (1977) 4615. Shrek 4416. ET (1982) 4357. Star Wars[Pha. Men] 4318. Pirates of Caribbean 4239. Spiderman 40410.LOTR: Return King 37711.Spiderman II 37312.Passion of Christ 37013.Jurassic Park 35714.Lord Rings(TT) 34115.Finding Nemo 34016.Forrest Gump 330

Inflation-Adjusted RInflation-Adjusted ReceiptseceiptsMovieMovie YearYear Receipts(mil.)Receipts(mil.)1. G1. Gone With theone With the WWindind 19391939 $$1,4851,4852. Star Wars2. Star Wars 19771977 1,309 1,3093. S3. Soundound of of MMusicusic 19651965 1,048 1,0484. ET4. ET 19821982 1,043 1,0435. Ten Com.5. Ten Com. 1956 962 1956 9626. Titanic6. Titanic 19971997 943 9437. Jaws7. Jaws 19751975 850 8508. Dr. Zhivago8. Dr. Zhivago 19651965 804 8049. Avatar9. Avatar 20092009 750 75010. The Jungle Book10. The Jungle Book19671967 720 72011. Snow White11. Snow White 19371937 706 706

What was the most popular movie of all time?What was the most popular movie of all time?

[Mr. Index Goes To Hollywood]

What about “Gone With The Wind”in 1939? #90 [$200 million]www.the-movie-times.com

Who is the Richest American Ever?Who is the Richest American Ever? John D. Rockefeller’sJohn D. Rockefeller’s [1839-1937] wealth would be worth $200 billion$200 billion in today’s money, or 4 times that of Bill Gates.

Babe RuthBabe Ruth made $80,000$80,000 in 1931in 1931. That would be equivalent to $1 $1 millionmillion today today. [BBarry arry BondsBonds got $18 million$18 million a year] President Herbert HHerbert Hoover’soover’s salarysalary in 1931 was $$75,00075,000. That would be equivalent to $900,000$900,000 today. George BushGeorge Bush is being paid $400,000$400,000 a year. President KennedyKennedy was paid $100,000$100,000 in 62 [[$650,000$650,000 today]

Although Rockefeller was worth $200 billion$200 billion, he could notnotwatch TV, play video games, surf the internet, or send email to his grandkids. For most of his life, he could not use AC, travel by car or plane, use a telephone to call friends, or take advantage of antibiotics to prolong & enhance life.

Perhaps the average American today is richer Perhaps the average American today is richer than the richest American a century ago.than the richest American a century ago.

$80,000=$1 M

From 1860-1945, deflationdeflation occurred about as often as inflationinflation. It took $1.50 to buy what a dollardollar bought in 1860.From 1960-1994, the average Argentine inflationArgentine inflation was 127127%%

per per yearyear. Or, $1 billion$1 billion in savings in savings in 1960 gave you 1/13th1/13thof a pennyof a penny of purchasing power in 1994.

HyperinflationHyperinflation in in BBrazil razil 11988-1994988-1994 If we had their same inflation for these six years, blue jeansblue jeans would have gone from $35$35 to $140 to $140 millionmillion per pairper pair; gasgas from $2.75$2.75 per gallon to $5 million$5 million per gallonper gallon; and $20$20 for a pizza and a moviepizza and a movie would now cost $90 mil$90 mil. DinnerDinner for twofor two cost cost $$120 mil120 mil. [In $100 $100 dollardollar bills, this would weigh more than a tonweigh more than a ton.

• Who is Who is Hurt by InflationHurt by Inflation??–Fixed-Income ReceiversFixed-Income Receivers–SaversSavers–CreditorsCreditors

• Who is Unaffected by InflationWho is Unaffected by Inflation??–Flexible-Income ReceiversFlexible-Income Receivers

• Cost-of-Living Adjustments (COLAs)Cost-of-Living Adjustments (COLAs)–DebtorsDebtors–Government (as a big debtor) Government (as a big debtor)

benefits big time.benefits big time.

Consequences of Inflation• Shrinking Incomes-People that don’t get raises at the same rate

as inflation are actually losing money each year. If inflation is 3% and their raise is 2% they are actually making less money the next year because their dollar can’t buy as much as it could before.

• Changes in Wealth-if inflation rise dramatically people that had money in the bank find that their savings are not worth anything.

• Effect on Interest Rates-if inflation is happening interest rates go up. If a bank loans out money and anticipates that inflation will go up they know money will be worth less in the future so to protect themselves they will raise interest rates. So they will get more of the money back from the loan because they know it will be worth less in the future.

The debtor winsdebtor wins with 20%20% unanticipated inflationunanticipated inflation.(some examples)

1. In 1914, total German mortgage debt was $10 German mortgage debt was $10 billionbillion marks marks. In 1923, $10 $10 billionbillion marks marks was was worth 1 worth 1 centcent. All debt All debt was was wiped outwiped out.

2. Signed union contracts agreeing to 3% raises3% raises for next 3 years3 years. (A $30,000 salary$30,000 salary would increase to $32,782$32,782 but it would take $51,840$51,840 to buy what $30,000 would buy 3 years before)

3. Signed union contracts agreeing to COLAsCOLAs for next 3 years. (So a $30,000 salary$30,000 salary of 3 years ago would now pay $51,840$51,840 which would buy what $30,000 would buy 3 years ago.

4. Your Econ teacher buys a $300,000 CD$300,000 CD from the 1st Econ Bank which pays him 5% interest5% interest for the next 3 years. [SaverSaver] Mr. Econ would earn $47,288earn $47,288 in interest at 5%5%, however at 20%20%,, he could earn $218,400$218,400.] So the saver looses heresaver looses here.

Who wins/loses with 20Who wins/loses with 20% % Unanticipated InflationUnanticipated Inflation??

[[CreditorsCreditors, , DebtorsDebtors, , SaversSavers]]

Demand-Pull and Cost-Push Inflation

• Demand pull-if consumers want more then producers can produce that drives up prices. Think of an Auction. If there is only one of something and more people then one want it that will drive up the price of that good.

• Cost-Push-The cost of goods are going up because production cost go up. If workers are not producing well then cost for things go up. If a worker used to produce 10 cars an hour and now only can produce 5 the avg cost of each car goes up.

Cost-Push InflationCost-Push Inflation – 3 things maycause “cost-push” inflation.1. Wage-pushWage-push – strong labor unions2. Profit-pushProfit-push – companies increase prices when their costs increase.3. Supply-side cost shocksSupply-side cost shocks – unanticipated increase in raw materials such as oil.

““Demand-pull”Demand-pull”

““Cost-push”Cost-push”

Demand-Pull InflationDemand-Pull Inflation – increase in AD.[[“Too many dollars chasing too few goods”“Too many dollars chasing too few goods”]] Originates from “buyers side of the market”“buyers side of the market”..

DD11 DD22

PP22

““Wage-price”Wage-price”SpiralSpiral

SS11SS22DD

PLPL22

PLPL11

SS

PP11

The 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 Bureau of Labor Statistics reports the CPI each month.

• It is used to monitor changes in the cost of living over time.

1

2

The Consumer Price Index

When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

© 2007 Thomson South-Western

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 two important differences between the indexes that can cause them to diverge.

© 2007 Thomson South-Western

The GDP Deflator versus the Consumer Price Index

• The GDP deflator reflects the prices of all goods and services produced domestically, whereas...

• …the consumer price index reflects the prices of all goods and services bought by consumers.

© 2007 Thomson South-Western

The GDP Deflator versus the Consumer Price Index

• The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)...

• …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

1965

Percentper Year

15

CPICPI

GDP deflatorGDP deflator

10

5

01970 1975 1980 1985 1990 20001995

Copyright©2004 South-Western

GDP DeflatorGDP Deflator compared to thecompared to the CPICPI [CPI is normally higher.][CPI is normally higher.]

HealthHealth4.3%4.3%

TransportationTransportation18.3%18.3%

ShelterShelter27.9%27.9%

HouseholdHousehold10.0%10.0%

ClothingClothing6.6%6.6% AlcoholAlcohol

4.5%4.5%RecreationRecreation

10.4%10.4%

FoodFood18.0%18.0%

Inflation Song

• Song

• Million Dollars link• If I had a 1,000,000 (If I had a 1,000,000)

I'd but you a house ( I would buy you a house) If I had a 1,000,000 (If I had a 1,000,000) I'd buy you furniture for your house ( maybe a nice chesterfield or an ottoman) If I had a 1,000,000 (If I had a 1,000,000) I'd but you a K-car ( a nice reliant automobile) If I had a 1,000,000, I'd buy you love

If I had a 1,000,000 I'd build a treefort in our yard If I had a 1,000,000 You could help it wouldn't be that hard If I had a 1,000,000 Maybe we could put a refrigerator in there Wouldn't that be fabulous!

If I had a 1,000,000 (If I had a 1,000,000) I but you a fur coat( but not a real fur coat that's cruel) If I had a 1,000,000 (If I had a 1,000,000) I'd buy you an exotic pet(like a llama or an emu) If I had a 1,000,000 (If I had a 1,000,000) I'd but you John Merick's remains (All them crazy elephant bones) If I had a 1,000,000 I'd buy your love

If I had a 1,000,000 We wouldn't have to walk to the store If I had a 1,000,000 We'd take a limousine cause it costs more If I had a 1,000,000 We wouldnt have to eat Kraft dinner

If I had a 1,000,000 (If I had a 1,000,000) i'd but you a green dress ( but not a real green dress that's cruel) If I had a 1,000,000 (If I had a 1,000,000) I'd but you some art ( A Picasso or a Garfunkel) If I had a 1,000,000 (If I had a 1,000,000) I'd buy you a monkey (haven't you always wanted a monkey?) If I had a 1,000,000 If I had a 1,000,000 If I had a 1,000,000 If I had a 1,000,000 I'd be RICH!

CP I = cost o f basket in current year

cost o f basket in base year 100

inflation rate = CP I - CP I

CP I 100%Y ear 2 Y ear 1

Y ear 1

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Inflation RateThe Inflation Rate

1001 Year in CPI

1 Year in CPI - 2 Year in CPI Year2in Rate Inflation

The inflation rate is calculated as follows:

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Calculating the Consumer Price Index and Calculating the Consumer Price Index and the Inflation Rate: An Examplethe Inflation Rate: An Example

Step 1:Survey Consumers to Determine a Fixed Basket of Goods

4 hot dogs, 2 hamburgers

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Calculating the Consumer Price Index Calculating the Consumer Price Index and the Inflation Rate: An Exampleand the Inflation Rate: An Example

YearPrice ofHot dogs

Price of Hamburgers

2001 $1 $2

2002 $2 $3

2003 $3 $4

Step 2: Find the Price of Each Good in Each Year

Fix the basket

4 hot dogs, 2 hamburgers

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Calculating the Consumer Price Index and Calculating the Consumer Price Index and the Inflation Rate: An Examplethe Inflation Rate: An Example

2001 ($1 per hot dog x 4 hot dogs) + ($2 per hamburger x 2 hamburgers) = $8

2002 ($2 per hot dog x 4 hot dogs) + ($3 per hamburger x 2 hamburgers) = $14

2003 ($3 per hot dog x 4 hot dogs) + ($4 per hamburger x 2 hamburgers) = $20

Step 3: Compute the Cost of the Basket of Goods in Each Year

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Calculating the Consumer Price Index and the Calculating the Consumer Price Index and the Inflation Rate: An ExampleInflation Rate: An Example

Step 4: Choose One Year as the Base Year (2001) and Compute the Consumer Price Index in Each Year

2001 ($8/$8) x 100 = 100

2002 ($14/$8) x 100 = 175

2003 ($20/$8) x 100 = 250

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Calculating the Consumer Price Index and the Calculating the Consumer Price Index and the Inflation Rate: An ExampleInflation Rate: An Example

2002 (175-100)/100 x 100 = 75%

2003 (250-175)175 x 100 = 43%

Step 5: Use the Consumer Price Index to Compute the Inflation Rate from Previous Year

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Calculating the Consumer Price Index and the Calculating the Consumer Price Index and the Inflation Rate: Another ExampleInflation Rate: Another Example

Base Year is 1998. Basket of goods in 1998 costs $1,200. The same basket in 2000 costs $1,236. CPI = ($1,236/$1,200) X 100 = 103. Prices increased 3 percent between 1998

and 2000.

© 2007 Thomson South-Western

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

© 2007 Thomson South-Western

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

© 2007 Thomson South-Western

How the Consumer Price Index Is Calculated

• Calculating the Consumer Price Index and the Inflation Rate: Another Example• Base Year is 2002.• Basket of goods in 2002 costs $1,200.• The same basket in 2004 costs $1,236.• CPI = ($1,236/$1,200) 100 = 103.• Prices increased 3 percent between 2002 and 2004.

• ALTERNATIVE CLASSROOM EXAMPLE:• Using the example from Chapter 22:

– .Fix the basket: 3 footballs and 4 basketballs.

– .Find the prices:• Year Price of Footballs Price of Basketballs• Year 1 $10 $12• Year 2 12 15• Year 3 14 18

– .Compute the Cost of the Basket:– Cost in Year 1 = (3 × $10) + (4 × $12) = $78– Cost in Year 2 = (3 × $12) + (4 × $15) = $96– Cost in Year 3 = (3 × $14) + (4 × $18) = $114

– .Using Year 1 as the base year, compute the index:– CPI in Year 1 = ($78/$78) × 100 = 1 × 100 = 100– CPI in Year 2 = ($96/$78) × 100 = 1.2308 × 100 = 123.08– CPI in Year 3 = ($114/$78) × 100 = 1.4615 × 100 = 146.15

– .Compute the inflation rate:– Inflation rate for Year 2 = [(123.08 – 100)/100] × 100% = 23.08%– Inflation rate for Year 3 = [(146.15 – 123.08)/123.08] × 100% = 18.74%

Fixed basket of goods: 100 heads of cauliflower, 50 bunches of

broccoli, 500 carrots

• Year Cauliflower Broccoli Carrots

• 2001$2 $1.50 $0.10

• 2002$3 $1.50 $0.20

• Compute CPI For 2001 and 2002

• Use the CPI to compute the inflation rate from the previous year

• Compute the cost of the basket of goods in each year:• 2001: (100 x $2) + (50 x $1.50) + (500 x $.10) = $325• 2002: (100 x $3) + (50 x $1.50) + (500 x $.20) = $475

• Choose one year as a base year (2001) and compute the CPI in each year:

• 2001: $325/$325 x 100 = 100• 2002: $475/$325 x 100 = 146

• Use the CPI to compute the inflation rate from the previous year:

• 2002: (146-100)/100 x 100% = 46%

• Quiz 2• Baseballs Basketballs• Price Quantity Price Quantity• 2001 10 50 10 100• 2002 15 30 20 80• 2003 20 20 60 70• Nominal GDP for 2001, 2002, 2003?

• Real GDP for 2001, 2002, 2003

• Deflator for 2001, 2002, 2003

• Inflation rate according to Deflator 2001, 2002, 2003

• If the Basket is 2 baseballs and three basketballs (assume 2001 is base year)

• What is CPI For 2001

• What is CPI for 2002

• What is CPI for 2003

• Inflation Rate in 2001,2002, 2003?

• Quiz 2• Baseballs Basketballs• Price Quantity Price Quantity• 2001 10 50 10 100• 2002 15 30 20 80• 2003 20 20 60 70• Nominal GDP for 2001, 2002, 2003?• 2001=$1500 2002= $2050 2003=$4600• Real GDP for 2001, 2002, 2003• 2001=$1500 2002=$1100 2003=$900

• Deflator for 2001, 2002, 2003• 2001=100 2002=186 2003=511

• Inflation rate according to Deflator 2001, 2002, 2003• 2001= 0% 2002= 86% 2003=174%

• If the Basket is 2 baseballs and three basketballs(2001 is baseyear)

• What is CPI For 2001• = 100• What is CPI for 2002• = 180• What is CPI for 2003• =440• Inflation Rate in 2001,2002, 2003?• 2001= 0% 2002= 80% 2003= 144%

• Baseballs Basketballs

• Price Quantity Price Quantity• 2001 10 10 5 5• 2002 12 20 7 10• 2003 15 30 8 24• Nominal GDP for 2001, 2002, 2003?

• Real GDP for 2001, 2002, 2003

• Deflator for 2001, 2002, 2003

• Inflation rate according to Deflator 2001, 2002, 2003

• If the Basket is 2 baseballs and three basketballs(2001 is baseyear)• What is CPI For 2001

• What is CPI for 2002

• What is CPI for 2003

• Inflation Rate in 2001,2002, 2003?

• Baseballs Basketballs

• Price Quantity Price Quantity• 2001 10 10 5 5• 2002 12 20 7 10• 2003 15 30 8 24• Nominal GDP for 2001, 2002, 2003?• 2001=125 2002=310 2003=642• Real GDP for 2001, 2002, 2003• 2001=125 2002=250 2003=420• Deflator for 2001, 2002, 2003• 2001=100 2002=124 2003=153• Inflation rate according to Deflator 2001, 2002, 2003• 2001=0% 2002=24% 2003=22%• If the Basket is 2 baseballs and three basketballs(2001 is baseyear)• What is CPI For 2001• 100• What is CPI for 2002• 128.5• What is CPI for 2003• 154.3• Inflation Rate in 2001,2002, 2003?• 2001=0% 2002=28.5% 2003=20.3%

A consumer in this economy buys only 2 goods–hot dogs & hamburgers.Step 1. Fix the market basket. What percent of income is spent on each. The consumer in this economy buys a basket of:

4 hot dogs and 2 hamburgers4 hot dogs and 2 hamburgers

Step 2. Find the prices of each good in each year. Year Price of Hot Dogs Price of Hamburgers 20012001 $1 $1 $2$2 20022002 $2 $2 $3$3

Step 3. Compute the market basket cost market basket cost for each year. 2001 ($1 per hot dog x 4 = $4) + ($2 per hamburger x 2 = $4), so $82001 ($1 per hot dog x 4 = $4) + ($2 per hamburger x 2 = $4), so $8 2002 ($2 per hot dog x 4 = $8) + ($3 per hamburger x 2 = $6), so $142002 ($2 per hot dog x 4 = $8) + ($3 per hamburger x 2 = $6), so $14

Step 4. Choose one year as a base year (2001) and compute the CPI 2001 ($8/$8) x 100 = 1002001 ($8/$8) x 100 = 100 2002 (14/$8) x 100 = 2002 (14/$8) x 100 = 175175Step 5. Use the CPI to compute the inflation rate from previous year 2002 (175175/100100 x 100 = 175%175%) or to get actual % (175-100)/100 x 100 =75%(175-100)/100 x 100 =75%Or, Or, ChangeChange $14$14-$8$8 ($6) OriginalOriginal $8 x 100 = 75%75%

(42%)(42%) 18. Suppose that a consumer buys the following quantities of buys the following quantities of these three commodities in 2007 and 2008these three commodities in 2007 and 2008.

CommodityCommodity QuantityQuantity 2007 per2007 per Unit PriceUnit Price 2008 per2008 per Unit PriceUnit PriceFood 5 units $6.00 $5.00Clothing 2 units $7.00 $9.00Shelter 3 units $12.00 $19.00

Which of the following can be concluded about the CPI for this individual concluded about the CPI for this individual from 2007 to 2008from 2007 to 2008? a. It remained unchanged. c. it decreased by 20% b. It decreased by 25%. d. It increased by 20% e. It increased by 25%.(Answer)(Answer) Year 1 [2007]: [5 food x $6 = Year 1 [2007]: [5 food x $6 = $30$30; 2 clothing x $7 = ; 2 clothing x $7 = $14$14; 3 shelters x $12 = ; 3 shelters x $12 = $36$36,,

for dollar value [or basket cost] of for dollar value [or basket cost] of $80$80. CPI = . CPI = 100100 ($80/$80 x 100 = 100 for 2007) ($80/$80 x 100 = 100 for 2007)

YYear ear 2 [2008]: [5 f2 [2008]: [5 foodood x $5 = x $5 = $25$25; 2 c; 2 clothinglothing x $9 = x $9 = $18$18; 3 s; 3 sheltershelters x $19 = x $19 = $57$57, ,

for dollar value for dollar value [basket cost ]of [basket cost ]of $100$100. CPI =. CPI =125125 ($100$100/$80/$80 X 100 = 125125) or (125125/100100 x 100 = 125125 for 2008)

ChangeChange $100-$80 [$100-$80 [$20$20]]OriginalOriginal = = $80$80 x 100 = 25%; so the CPI for this individual is x 100 = 25%; so the CPI for this individual is 25%25%..

NS 50, 51, & 52NS 50, 51, & 5250.The CPI was 166.6 in 1999166.6 in 1999 and 172.2 in 2000172.2 in 2000. Therefore, the rate of inflation for 2000 was (2.7/3.4/4.2)% 51. If the CPI falls from 160 to 149CPI falls from 160 to 149 in a particular year, the economy has experienced (inflation/deflation) of (5/4.9/6.9)%.52. If CPI rises from 160.5 to 163.0160.5 to 163.0 in a particular year, the rate of inflation for that year is (1.6/2.0/4.0)%.

[-11/160 x 100 = -6.9%][-11/160 x 100 = -6.9%]

(2006-later year) (2005-earlier year)(2006-later year) (2005-earlier year) Current year’s index – last year’s indexCurrent year’s index – last year’s index 199.1 – 192.7 [6.7]199.1 – 192.7 [6.7]C.P.I. = Last year’s index(2006-earlier year) x 100; 192.7 x100 = 3.3%C.P.I. = Last year’s index(2006-earlier year) x 100; 192.7 x100 = 3.3%

130.7-124.0(6.7)130.7-124.0(6.7) 116-120(-4)116-120(-4) 333-300(33)333-300(33) 124.0 x 100 = ____ 120 x 100 = ____ 300 x 100 = ____124.0 x 100 = ____ 120 x 100 = ____ 300 x 100 = ____

[Change/Original X 100 = inflation]

5.4%5.4% -3.3%-3.3% 11%11%

[5.6/166.6 x 100 = 3.4%][5.6/166.6 x 100 = 3.4%]

So, 3.3% increase in SocialSo, 3.3% increase in SocialSecurity benefits for 2007Security benefits for 2007

(42%)(42%) 18. Suppose that a consumer buys the following quantities of buys the following quantities of these three commodities in 2000 and 2001these three commodities in 2000 and 2001.

CommodityCommodity QuantityQuantity 2000 per2000 per Unit PriceUnit Price 2001 per2001 per Unit PriceUnit PriceFood 5 units $6.00 $5.00Clothing 2 units $7.00 $9.00Shelter 3 units $12.00 $19.00

Which of the following can be concluded about the CPI for this individual concluded about the CPI for this individual from 2000 to 2001from 2000 to 2001? a. It remained unchanged. c. it decreased by 20% b. It decreased by 25%. d. It increased by 20% e. It increased by 25%.(Answer)(Answer) Year 1 [2000]: [5 food x $6 = Year 1 [2000]: [5 food x $6 = $30$30; 2 clothing x $7 = ; 2 clothing x $7 = $14$14; 3 shelters x $12 = ; 3 shelters x $12 = $36$36,,

for dollar value [or basket cost] of for dollar value [or basket cost] of $80$80. CPI = . CPI = 100100 ($80/$80 x 100 = 100 for 2000) ($80/$80 x 100 = 100 for 2000)

YYear ear 2 [2001]: [5 f2 [2001]: [5 foodood x $5 = x $5 = $25$25; 2 c; 2 clothinglothing x $9 = x $9 = $18$18; 3 s; 3 sheltershelters x $19 = x $19 = $57$57, ,

for dollar value for dollar value [basket cost ]of [basket cost ]of $100$100. CPI =. CPI =125125 ($100$100/$80/$80 X 100 = 125125) or (125125/100100 x 100 = 125125 for 2001)

ChangeChange $100-$80 [$100-$80 [$20$20]]OriginalOriginal = = $80$80 x 100 = 25%; so the CPI for this individual is x 100 = 25%; so the CPI for this individual is 25%25%..

© 2007 Thomson South-Western

Dollar Figures from Different Times

• Do the following to convert dollar values from year T into today’s dollars:

Amount intoday’s dollars

Amount in year T’s dollars

Price level today

Price level in year T

© 2007 Thomson South-Western

Dollar Figures from Different Times

• Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2005:

Salary SalaryPrice level in 2005Price level in 1931

2005 1931

$80,.

$

000195152

1,026,316

Dollar Figures from Different Times

• Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 1995:

$873,684=

15.2166

$80,000=

1931 in level Price 1999 in level Price

Salary=Salary 19311999

• To change dollar values from one year to the next, we can use this formula:

•2. Example: Babe Ruth’s 1931 salary in 1999 dollars:

• Salary in 1999 dollars = Salary in 1931 dollars × price level in 1999

• price level in 1931•

• Salary in 1999 dollars = $80,000 × (166/15.2).• Salary in 1999 dollars = $873,684.

• ALTERNATIVE CLASSROOM EXAMPLE:

• Your father graduated from school and took his first job in 1972, which paid a salary of $7,000. What is this salary worth in 1999 dollars?

• CPI in 1972 = 41.8• CPI in 1999 = 166

• ALTERNATIVE CLASSROOM EXAMPLE:• Your father graduated from school and took his first job

in 1972, which paid a salary of $7,000. What is this salary worth in 1999 dollars?

• CPI in 1972 = 41.8• CPI in 1999 = 166

• Value in 1999 dollars = 1972 salary × (CPI in 1999/CPI in 1972)

• Value in 1999 dollars = $7,000 × (166/41.8) = $7,000 × 3.97 = $27,790

• CPI 2010=339

• CPI 2000=300

• Salary of Michael Jordan was 3,500,000 what is that equivalent to today?

• Grant Smith was a doctor in 1944 and earned $12,000 that year. His daughter, Lisa Smith, is a doctor today and she earned $210,000 in 2005. The price index in 1944 was 17.6 and the price index in 2005 was 184.

• What was her father getting paid in 2005 dollars?

• What would she have gotten paid in 1944?

• Ingrid took a university teaching job as an assistant professor in 1974 at a salary of $10,000. By 2003, she had been promoted to full professor, with a salary of $50,000. If the price index in 1974 was 50 and the price index in 2003 was 180, what is Ingrid's 2003 salary in 1974

• ALTERNATIVE CLASSROOM EXAMPLE:

• Your father graduated from school and took his first job in 1972, which paid a salary of $7,000. What is this salary worth in 1999 dollars?

• CPI in 1972 = 41.8• CPI in 1999 = 166

• ALTERNATIVE CLASSROOM EXAMPLE:• Your father graduated from school and took his first job

in 1972, which paid a salary of $7,000. What is this salary worth in 1999 dollars?

• CPI in 1972 = 41.8• CPI in 1999 = 166

• Value in 1999 dollars = 1972 salary × (CPI in 1999/CPI in 1972)

• Value in 1999 dollars = $7,000 × (166/41.8) = $7,000 × 3.97 = $27,790

Inflation Summary

• Causes and theories of inflation:• 1. Demand‑pull inflation: Spending increases faster

than production. (See Figure 8‑7) Inflation will occur in range 2 and range 3 of this illustration. Bottlenecks occur in some industries in range 2, and output cannot expand to meet demand in these industries so producers raise prices; in Range 3 full employment has been reached and resource prices will rise with increasing demand, causing producers to raise prices. Note: Chapter 7’s distinction between nominal and real GDP is helpful here.

Inflation Summary

• 2. Cost‑push or supply‑side inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units of output).

• a. Wage‑push can occur as result of union strength.

• b. Supply shocks may occur with unexpected increases in the price of raw materials.

• Complexities: It is difficult to distinguish between demand‑pull and cost‑push causes of inflation, although cost‑push will die out in a recession if spending does not also rise.

3. Gala Land produces 3 final goods: bread, water, and fruit. The table [right] shows this year’s output and price for each good. (a) Calculate this year’s nominal GDP.

(b) Assume that in Gala Land the GDP deflator [GDP price index) is 100 in the base year and 150 this year. Calculate the following. (i) The inflation rate, expressed as a percent, between the base year & this year.

(ii) This year’s real GDP

(c) Since the base year, workers have received a 20% increase in their nominal wages. If workers face the same inflation that you calculated in part (b)(i), what has happened to their real wages? Explain.

(d) If the GDP deflator [inflation] in Gala Land increases unexpectedly, would a borrower with a fixed-interest-rate loan be better off or worse off? Explain.

Answer to 3. (a): 400x$6=$2,400; 1,000x$2=$2,000;Answer to 3. (a): 400x$6=$2,400; 1,000x$2=$2,000; and 800x$2 = $1,600 for a Nominal GDP of $6,000.and 800x$2 = $1,600 for a Nominal GDP of $6,000.

Answer to 3. (b) (i): Answer to 3. (b) (i): Change/Original x 100; therefore 50/100 x 100 = 50% inflation rate. Change/Original x 100; therefore 50/100 x 100 = 50% inflation rate.

Answer to 3. (b) (ii): Answer to 3. (b) (ii): Nominal GDP/GDP deflator x 100 = Real GDP; $6,000/150 X 100 = Real GDP of $4,000. Nominal GDP/GDP deflator x 100 = Real GDP; $6,000/150 X 100 = Real GDP of $4,000.

Answer to 3. (c): Inflation between these years has increased 50%; wages have increasedAnswer to 3. (c): Inflation between these years has increased 50%; wages have increased only 20%; therefore workers real wages or real purchasing power has decreased. only 20%; therefore workers real wages or real purchasing power has decreased.

Answer to 3. (d): The borrower has borrowed “dear” money but is paying back “cheaper” Answer to 3. (d): The borrower has borrowed “dear” money but is paying back “cheaper” money. He is better off because he is paying back money that isn’t worth what it was when money. He is better off because he is paying back money that isn’t worth what it was when he took out the loan.he took out the loan.

This Year’s Output This Year’s Price400 loaves of bread $6 per loaf1,000 gallons of water $2 per gallon800 pieces of fruit $2 per piece

Interest Rates

• Nominal interest rates –Inflation or expected inflation= Real interest rates

• Real Interest rate includes taking out of inflation. So it is the real interest you receive.

Interest RatesInterest Rates• Nominal interest rate [5%]Nominal interest rate [5%]

– Measures interest in terms of the current dollars paid [let’s say 5%5% on a 3-month T-bill]

– Appears on the borrowing agreement– The rate quoted in the news media

• Real interest rate [3%]Real interest rate [3%]– Equals the nominal rate of interest [5%5%] minus

the anticipated inflation rate [let’s say 2%2%]– Expressed in dollars of constant purchasing

power [3%3%]

Interest Rates• With no inflation, the nominal and real interest

rates would be identical [let’s say, 3%3%]

• With inflation [2%2%], the nominal interest rate [5%5%] exceeds the real interest rate [3%3%]– If the inflation rate is high enough [6%6%], the real

interest rate can actually be negative [ -1%-1% or 5% - 6%- 6% = -1%-1%]

– The nominal interest would not even offset the loss in spending power because of inflation, so lenders would lose purchasing power

– This is why lenders and borrowers are concerned more about the real interest rate than the nominal interest rate

1965

Interest Rates(percentper year)

15

Real interest rateReal interest rate

10

5

0

–51970 1975 1980 1985 1990 1995 2000

Copyright©2004 South-Western

[negative here][negative here]

Nominal interest rateNominal interest rate

NominalNominalInterestInterest

RateRate

RealRealInterestInterest

RateRate

InflationInflationPremiumPremium

= 8%8%6%6%

[[Real I.R.Real I.R. + + anticipated inflationanticipated inflation == nominal I.R.nominal I.R.]]

+

+ =

NominalNominalInterestInterest

RateRate

RealRealInterestInterest

RateRate

InflationInflationPremiumPremium

-88%%

66%%

22%%

[[Nominal I.R.Nominal I.R. – – inflation rateinflation rate = = Real I.R.Real I.R.]]

==

==-

2 (c) Suppose that the nominal interest rate has been 6%nominal interest rate has been 6% with no expected inflationno expected inflation. If inflation is now expected to be 2%,inflation is now expected to be 2%, determine the value of eachvalue of each of the following. (i) The new nominal interest ratenew nominal interest rate (ii) The new real interest ratenew real interest rate

2(c)(i): The nominal interest rate is 8%.2(c)(i): The nominal interest rate is 8%. [6% real + 2% expected inflation premium][6% real + 2% expected inflation premium]

2(c)(ii): The new real interest rate would be 6%. 2(c)(ii): The new real interest rate would be 6%. [8% [8% new nominal new nominal in. ratein. rate –– 2% 2% anticipated inflationanticipated inflation = 6% real I.R.] = 6% real I.R.]

RealRealInterest RatesInterest Rates

66%%

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%

© 2007 Thomson South-Western

Real and Nominal Interest Rates

• Interest represents a payment in the future for a transfer of money in the past.

© 2007 Thomson South-Western

Real and Nominal Interest Rates

• The nominal interest rate is the interest rate usually reported and not corrected for inflation. • It is the interest rate that a bank pays.

• The real interest rate is the interest rate that is corrected for the effects of inflation.

© 2007 Thomson South-Western

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%

NominalNominalIncomeIncome

RealRealIncomeIncome

InflationInflationPremiumPremium

-

[[NominalNominal income income – – inflationinflation rate rate == RealReal Income Income]]

=

““Real Income”Real Income” measures the amount of goods/services nominal income will buy.

[% change[% change in in real incomereal income = % change% change in in nominal incomenominal income - % change% change in in PLPL.] 5%5% 10%10% 5%5%

Nominal income rose byNominal income rose by 10%, 10%, PL PL increased byincreased by 4% 4% - then real income rose byreal income rose by ___%.Nominal income rose byNominal income rose by 20%, 20%, PL PL increased byincreased by 5% 5% - then real income rose byreal income rose by ___%.

661515

““You will get a 10% raise”You will get a 10% raise”

© 2007 Thomson South-Western

Figure 3 Real and Nominal Interest Rates

1965

Interest Rates(percentper year)

15%

Real interest rate

10

5

0

51970 1975 1980 1985 1990 1995 2000 2005

Nominal interest rate

The EndThe End

“Thank you for bringing me to

Timmy’s house and not Michael Vick’s.”