1. Topic 03Inflation and the Price Level12-1

2. Learning Objectives1. Explain how the Consumer Price Index is constructed and use it to calculate the inflation rate2. Show how the CPI is used to adjust economic data to eliminate the effects of inflation3. Discuss the two most important biases in the CPI4. Distinguish between inflation and relative price changes to find the true cost of inflation5. Summarize the connections among inflation, nominal interest rates, and real interest rates12-2 3. Keeping up with Grandpa Prices of goods change over time Adjust values, incomes, or spending for change inprices Constant purchasing power Baseball salaries Babe Ruth earned $80,000 in 1930 Barry Bonds earned $10.3 million in 2001 Inflation increases uncertainty when planning forthe future Consider costs of inflation12-3 4. Measuring the Price Level The Consumer Price Index (CPI) is a measureof the cost of living during a particular period The CPI measures The cost of a standard basket of goods andservices in a given year relative to the cost of the same basket of goods andservices in the base year 2005 is the base year for the CPI Base year changes periodically 12-4 5. Calculating the CPI2005 Spending Monthly Cost in 2005Rent (2 bedroom apartment)$500Hamburgers (60 at $2 each) 120Movie tickets (10 at $6 each) 60Monthly expenditures$6802011 Spending Monthly Cost in 2011Rent (2 bedroom apartment) $630Hamburgers (60 at $2.50 each)150Movie tickets (10 at $7 each) 70Monthly expenditures $850 12-5 6. Calculating the CPI CPI is the ratio of the cost of the basket of goodsin the current year to the cost in the base year Base year cost $680 2011 cost $850 CPI = (850 / 680) (100) = 1.25 Cost of living in 2011 is 25% higher than in 2005 CPI for the base year is always 1 CPI for a given period is the cost of living in that period relative to what it was in the base year BEA uses CPI as a percentage the ratio times 10012-6 7. Cost of LivingCPI = 1050 / 850 = 1.312005 SpendingMonthly Cost in 2005Rent (2 bedroom apartment) $500Hamburgers (60 at $2 each)120Movie tickets (10 at $6 each)60Sweaters (4 at $30) 120Monthly expenditures $8002011 SpendingMonthly Cost in 2011Rent (2 bedroom apartment) $630Hamburgers (60 at $2.50 each) 150Movie tickets (10 at $7 each)70Sweaters (4 at $50) 200Monthly expenditures$1,05012-7 8. Price Index A price index measures the average price of agiven class of goods and services relative to theprice of the same goods and services in a baseyear CPI measures the change in consumer prices Other indices Core inflation is CPI without energy and food Producer price index Import / export price index12-8 9. Inflation The rate of inflation is the Year CPI Inflation 2005 1.95annual percentage change 2006 2.02 3.6%in the price level 2007 2.07 2.5% Inflation in 20062008 2.15 3.9% (2.02 1.95) / 1.952009 2.150%= 0.036 = 3.6% Year00 CPI Inflation The Great Depression 1929 0.171 Period of falling output1930 0.1672.3% and prices1931 0.1529.0% When inflation rates are1932 0.1379.9% negative there is deflation 1933 0.1305.1%12-9 10. US Inflation Rates 12-10 11. Adjusting for Inflation A nominal quantity is measured in terms of itscurrent dollar value A real quantity is measured in physical terms Quantities of goods and services To compare values over time, use real quantities Deflating a nominal quantity converts it to a realquantity Divide a nominal quantity by its price index to express the quantity in real terms 12-11 12. Family Income in 2005 and 2011 Can a family buy more with $20,000 in income in2005 or with $22,000 in 2011?2005 is the base year for the CPIDeflate nominal income in both years to get real incomeCompare real income$20,000 in 2005 has the greater purchasing powerYear Nominal Income CPI Real Income2005 $20,000 1.00$20,000/1.00 = $20,0002011 $22,000 1.25$22,000/1.25 = $17,60012-12 13. Baseball Stars Compare Babe Ruths salary with Barry Bonds Requires a CPI series that includes 1930 CPI using 1982 1984 as base year Bonds had higher real salary Does not convey information about relative incomes 1930 was Great Depression Multi-million dollar salaries common for sports stars in2001PlayerYear Nominal SalaryCPIReal SalaryBabe Ruth 1930 $80,0000.167$479,042Barry Bonds 2001 $10,300,0001.780 $5,786,517 12-13 14. Real Wages The real wage is the wage paid to the workermeasured in terms of purchasing power The real wage for any given period is calculated bydividing the nominal wage by the CPI for that period US production worker wages CPI uses 1982 1984 as base year Real wages were higher in 1970Year Average WageCPIReal Average Wage1970 $3.40 0.39 $3.40 / 0.39 = $8.722009 $18.602.15 $15.68 / 2.15 = $8.6512-14 15. Production Workers Wages,1960 - 2009 12-15 16. Indexing Indexing increases a nominal quantity eachperiod by the percentage increase in a specifiedprice index Indexing prevents the purchasing power of thenominal quantity from being eroded by inflation Indexing automatically adjusts certain values,such as Social Security payments, by theamount of inflation If prices increase 3% in a given year, the SocialSecurity recipients receive 3% more No action by Congress required Indexing is sometimes included in labor contracts12-16 17. Adjusting for Inflation An indexed labor contract First year wage is $12 per hour Real wages rise by 2% per year for next 2 years Relevant price index is 1.00 in first year, 1.05 in thesecond, and 1.10 in the third Nominal wage is real wage times the price indexYear Real Wage Price Index Nominal Wage1 $12.00 1.00$12.002 $12.24 1.05$12.853 $12.48 1.10$13.7312-17 18. Minimum Wage Congress sets the national minimum wage innominal terms Publicized debate results in periodic increases Indexing would be simpler and less controversial Politicians appear to benefit from the debate Minimum wage increased 15 times between1970 and 2008 Real minimum wage has decreased by about one-third in that period12-18 19. CPI and Inflation CPI and other indexes influence policy decisionsand wage increases 1996 report said CPI overstates inflation by 1 to2 percentage points a year Unnecessarily increases government spending Underestimates increase in the standard of living Suppose CPI indicates 3% inflation when cost of living actually increases 2% Real income increases 1% Changes to calculations made since report toimprove the quality of the CPI calculations 12-19 20. CPI Quality Adjustment Bias One important bias in the CPI is itsmeasurement of price changes but not qualitychanges PC with 20% more memory has 20% higher price Not the same PC as the one with less memory If no adjustment is made for quality, PCs contribution to the CPI will be 20% Adjusting for quality is difficult Large numbers of goods Subjective differences Incorporating new goods is difficult No base year price for this years new goods12-20 21. CPI Biases CPI uses a fixed basket of goods and services When the price of a good increases, consumers buy less and substitute other goods Failing to account for substitution overstates inflation Example: base year cost of market basketItem 2005 price2005 SpendingCoffee (50 cups)$1.00 $50.00Tea (50 cups) $1.00 $50.00Scones (100)$1.00 $100.00Total $200.0012-21 22. CPI Substitution Bias In 2011, coffee and scones are more expensive Buying exactly the same basket of goods costs$300, compared to $200 in 2005 CPI = 300 / 200 = 1.50Item 2011 price 2011 SpendingCoffee (50 cups) $2.00$100.00Tea (50 cups)$1.00 $50.00Scones (100) $1.50$150.00Total $300.0012-22 23. CPI Substitution Bias Actually, consumer substitutes tea for coffee Scone purchases constant True CPI for consumer is 250 / 200 = 1.25 CPI estimate of 1.50 is 20% higher than theconsumers experienceItem 2011 price2011 SpendingCoffee (00 cups)$2.00 $0.00Tea (100 cups)$1.00 $100.00Scones (100)$1.50 $150.00Total $250.00 12-23 24. Relative Prices The price level is a measure of the overall levelof prices at a particular point in time Measured by a price index such as the CPI The relative price of a specific good is acomparison of its price to the prices of othergoods and services Calculated as a ratio Suppose we have a one-time doubling of thegas price Overall price level and inflation increase by a small amount The increase in the relative price of gasoline is large 12-24 25. Relative Prices Relative prices can change markedly withoutcorresponding changes in inflation Summer prices12-25 26. Inflation and Relative PricesOil Price Relative PriceYear CPIInflationChangeof Oil2008 1.202009 1.32 10% 8% -2%2010 1.40 6%8% 2% 12-26 27. Noisy Prices Prices transmit information about The cost of production and The value buyers place on buying an additional unit Inflation creates static in the communication Buyers and sellers cant easily tell whether The relative price of this good is increasing OR Inflation is increasing the price of this good and all others Deciding these issues requires market participantsgather information at a cost Response to changing prices is tentative and slow12-27 28. Indexing Avoids Distortions Income taxes have been indexed to avoidbracket creep Bracket creep occurs when a household is movedinto a higher tax bracket due to increases innominal but not real income Higher tax brackets have a higher tax rate Indexing income taxes matches tax rates to thereal income level Suppose the tax rate on $50,000 is 25% in 2000 CPI is 1 for 2000, 1.25 for 2005 Nominal income of $62,500 is taxed 25% in 2005 12-28 29. Distortions Caused by Taxes Not all taxes are indexed Capital depreciation allowance encouragespurchase of capital goods Allows firms to deduct a share of the purchase price as a business expense Machine cost is $1,000 and its useful life is 10 years Capital depreciation allowance of $100 per year $100 in year 1 is worth more than $100 in year 10because of inflation In times of high inflation, investment in plant andequipment decreases12-29 30. Distortions Caused by Taxes US tax system is complex Taxes are collected at the federal, state, and citylevels Conflicting incentives Taxes that are not indexed distort the taxincentives for people to work, save, and invest Lower savings and investment means lowereconomic growth a real cost of inflation12-30 31. Inflation Increases the Cost of Cash If there is no inflation, cash holds its value over time Some cash will be held for convenience When inflation is high, cash loses value over time Manage cash balances to limit losses More frequent, smaller withdrawals cost consumers and businesses time, travel a real cost of inflation Banks process more transactions, increasing costs another real cost of inflation Costs of managing cash holding are called "shoe leather" costs, referring to the cost of frequent trips to the bank 12-31 32. Unexpected Redistribution of Wealth Unexpected inflation redistributes wealth Suppose workers salaries are not indexed andinflation is higher than anticipated Salaries lose purchasing power Employers gain at the expense of workers Similarly, unexpectedly high inflation benefitsborrowers at the expense of lenders Borrowers repay with dollars worth less than anticipated Unexpected inflation confuses incentives12-32 33. Long-Run Planning Some decisions have a long time horizon Erratic inflation makes planning risky Retirement planning requires an estimated costfor your desired life-style Save too little and you live less well in the future Save too much and you live less well now Given the costs of inflation, most economistsagree that low and stable inflation promotes ahealthy economy 12-33 34. Hyperinflation Hyperinflation is an extremely high rate of inflation In 1923, German employers paid workers twice a day Magnifies the costs of inflation Minimize your cash holding A study of market economies, 1960 1996 showed45 episodes of high inflation (100+%) in 25 countries Real GDP/person fell by an average of 1.6% per year Real consumption/ person fell by an average of 1.3% per year Real investment per person fell by an average of 3.3% per year 12-34 35. Inflation and Interest Rates Unanticipated inflation helps borrowers andhurts lenders The real interest rate is the annual percentageincrease in the purchasing power of financialassets Real interest rate = nominal interest rate inflationr=i- The nominal interest rate is the annualpercentage increase in the dollar value of anasset Nominal interest rates are the most commonlystated rates 12-35 36. Inflation and Interest Rates Nominal interest ratesand inflation varyInterest Inflation Year Nominal interest rate range Rate (%) Rate (%)is 1.4% to 11.5% 1970 6.5% 5.7% Inflation rate range is 2.7% 1975 5.89.1to 13.5% 1980 11.5 13.5 Real interest rate is nominal1985 7.53.6interest rate minus inflation 1990 7.55.4 Real interest rate was 1995 5.52.8highest in 1985, 3.9% Real interest rate was 2000 5.93.4lowest in 1975, 3.3% 2005 3.23.412-36 37. US Real Interest Rates, 1960 -2009 12-37 38. Inflation and Interest Rates Unexpected inflation benefits borrowers andhurts lenders For a given nominal interest rate, the higher the inflation rate, the lower the real interest rate Expected inflation may not hurt lenders if theycan adjust the nominal interest rates Inflation-protected bonds pay a real rate of interest plus the inflation rate The Fisher effect is the tendency for nominalinterest rates to be high when inflation is highand low when inflation is low 12-38 39. US Inflation and Interest Rates,1960 - 2009 12-39 40. Inflation and Price Levels 12-40