The price level is the weighted average of prices A decrease in moneys purchasing power When the supply of money is growing faster than the production of goods and services Inflationwhat is it ID: 782500
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Slide1
Inflation
Slide2Slide3An increase in the economy’s price level
The price level is the weighted average of prices
A decrease in money’s purchasing power
When the supply of money is growing faster than the production of goods and services.
Inflation…what is it?
Slide42 immediate causes (what starts it)
Demand-pull – Increases in total spending that are not offset by increases in the supply of goods and services and so cause the average level of prices to rise
Cost-push – Increases in production costs that cause firms to raise prices to avoid losses
Ultimate cause (what sustains it)
Too much money chasing too few goods
This can lead to hyperinflation
What causes inflation
Slide5Consumer Price Index (CPI)
Used to measure consumer inflation
Market basket approach (typical basket of goods and services)
Quick, efficient
Ignores consumer substitution, quality changes
(if quality and price go up, it doesn’t account for quality)Consumer Price Index (CPI) is computed every month and uses prices for a market basket of 80,000 goods and services consumed by a typical family of
four
How
Is inflation measured
Slide6Price x Quantity for different years
Inflation
rate this year = 100 x (CPI this year – CPI last year) / (CPI last year)
Calculating CPI Market Basket
Slide7Cost of market basket in a given year
x 100
Cost of market basket in base yearPrice index in a given year
Slide8Slide9Slide10Slide11The fixed basket of goods and services is defined.
The prices for every item in the basket are found.
The cost of the fixed basket of goods and services must be calculated for each time period.
A base year is chosen and the index is computed.
CPI
- 4 Step process
Slide12Items in Market Basket
Quantity Consumed in
Yr
(pounds)
2008
Prices
2009 Prices
Salami
300
$4
$6
Corned
Beef
200
$5
$7
Bologna
100
$2$1.50Cheese500$3$2.50
Calculating CPI
2008 = (300x$4) + (200x$5) + (100x$2) + (500x$3) = $3,900
2009 = (300x$6) + (200x$7) + (100x$1.50) + (500x$2.50) = $4,600
100 x
CPI This Year – CPI Last Year
=
$4,600- $3,900
= 17.9% inflation
CPI Last Year $3,900
Slide13Items in Market Basket
Quantity Consumed in
Yr
(pounds)
2008
Prices
2009 Prices
Salami
300
$4
$6
Corned
Beef
200
$5
$7
Bologna
100
$2$1.50Cheese500$3$2.50
Calculating CPI
2008 = (300x$4) + (200x$5) + (100x$2) + (500x$3) = $3,900
2009 = (300x$6) + (200x$7) + (100x$1.50) + (500x$2.50) = $4,600
Price index in a given year =
Cost of market basket in a given year
x 100
Cost of market basket in base year
$3,900
x 100 = 100 (Base Year)
$4,600
x 100 = 117.94
$3,900 $3,900
Slide14Assume 5 bananas were purchased and 2 backrubs were purchased
1: (5 x $1) + (2 x $6) = $17
2: (5 x $2) + (2 x $7) = $24
3: (5 x $3) + (2 x $8) = $31
Any year can serve as the base year. Let’s use Time Period 1.
The CPI for time period 1 is ($17/$17) x 100 = 100
CPI for 2: ($24/$17) x 100 = 141
CPI for 3: ($31/$17) x 100 = 182
The percent change in the price level from the base year to the comparison year is calculated by subtracting 100 from the CPI.
Base year 1 to 2: 141-100 = 41%
Base year 1 to 3: 182-100 = 82%
Slide15Suppose the year 2000 is the base year for a price index. Between 2000 and 2020 prices double and at the same time your nominal income increases from $40,000 to $80,000.
A. What is the value of the price index in 2000?
B. What is the value of the price index in 2020?
C. What is the percentage increase in your nominal income between 2000 and 2020?
D. What has happened to your real income between 2000 and 2020?
Explain
Slide16Suppose the year 2000 is the base year for a price index. Between 2000 and 2020 prices double and at the same time your nominal income increases from $40,000 to $80,000.
A. What is the value of the price index in 2000?
100
B. What is the value of the price index in 2020?
200
C. What is the percentage increase in your nominal income between 2000 and 2020? 100% (($80,000-$40,000)/$40,000) x 100
D. What has happened to your real income between 2000 and 2020?
Explain
It stayed the same because real income is a measure of the purchasing power of my income,
and because
my income and the price both doubled, the purchasing power of my income has not been affected.
Slide171990
1991
1992
Price
of Plums
$0.50
$0.50
$1.00
Price of Lawnmowers
$100
$125
$150
Price per lb. of pasta
$1
$1.50
$1.50
In this nation, a typical household consumes 50 plums, 1 lawnmower, and 200 lbs. of pasta in a given year. Using 1992 as the base year, what is the CPI for 1991?
Slide181990
1991
1992
Price
of Plums
$0.50
$0.50
$1.00
Price of Lawnmowers
$100
$125
$150
Price per
lb
of pasta
$1
$1.50
$1.50
In this nation, a typical household consumes 50 plums, 1 lawnmower, and 200 lbs. of pasta in a given year. Using 1992 as the base year, what is the CPI for 1991?1991: ($0.50x50) + ($125x1) + ($1.50x200) = 450
1992: ($1x50) + ($150x1) + ($1.50x200) = 500Price index in a given year =
Cost of market basket in a given year
x 100
Cost of market basket in base year
(450/500) x 100 = 90
(Price Index)
90-100
x 100 = 10%
100
Slide19GDP deflator
(if nominal GDP were to increase 5% but real GDP does not change, the GDP deflator indicates aggregate
prices went
up 5%)Measures entire economy’s inflation
Includes everything
Used to deflate nominal GDPGDP Deflator =
Nominal GDP
x 100
Real GDP
Measuring Inflation
Slide20They tell a similar story, but the GDP deflator reflects the prices of all goods and services produced domestically whereas the CPI has a fixed basket of goods.
CPI vs. GDP Deflator
Slide21Nominal interest rate is the observed interest rate in the market and includes the effect of inflation.
Real interest rate is the nominal interest rate minus the rate of inflation.
Real interest rate = nominal interest rate – rate of inflation
nominal interest rate = real interest rate + expected inflation
Nominal vs.
Real interest
Slide22Year 1 money: $100
Year 2 money: $110
Inflation rate: 2%
“Real” Return on your investment (purchasing power) = 8% (10% return – 2% inflation)
Inflation Example
Slide23CPI Headline inflation
Includes entire CPI market basket
CPI Core Inflation
Excludes food and energy because they are volatile
2 ways inflation is reported
Slide24You and a friend agree that inflation next year will be 5% and you agree that your lending services are worth another 3%. You charge your friend 8% interest.
After a year, three scenarios could have happened:
Scenario 1:
You expected 5% inflation and you experienced exactly 5% inflation. The purchasing power of the $100 you lent was unchanged when your friend paid you back exactly enough to compensate for the inflation.
Scenario 2:
You expected 5% inflation and you experienced only 1% inflation. Your purchasing power has actually increased because your friend paid you back more than enough to compensate for the inflation.
Note: When actual inflation is below expected inflation, the lender (in this case you) gains and the borrower loses.
Scenario 3:
You expected 5% inflation and you experienced 8% inflation. Your purchasing power has actually decreased because your friend paid you back less than enough to compensate for the inflation.
Note
:
When actual inflation is above expected inflation, the lender (in this case you) loses and the borrower gains.
Who does inflation affect?
Slide25Everybody
Who wins?
Those with large debt
Those who borrowed at low fixed interest rates Those who make fixed payments
Who loses?
Those with large cash savingsThose who lent at low fixed interest rates Those receiving fixed payments
Who does
inflation affect
?
Slide26During a period of rapid unexpected inflation, Sam’s Meat Market must change the price of his products on a weekly basis.
The First Bank of
Feffville
has make many long-term loans with fixed interest rates assuming a stable inflation of 3% every year. For the last two years inflation has been even lower at 1.5%.
Sonya is retried and collecting her SS checks every month. Every year SS payments are adjusted to reflect any increase in the cost of living.
Dwight is renting a storage locker from Jim and signed a two-year lease that said his monthly payment would be $20 over the course of the lease. Since signing the lease, the inflation rate has been higher than expected, at about 5.5%
In the following scenarios, has inflation created: a) winners and losers at no net cost to the economy, or B) a net cost to the economy? If B, which type of cost is the inflation generating?
Slide27Expecting inflation causes inflation
Consumers demand more
Producers supply less
The role of the central bankControl actual inflation by controlling expected inflation
The importance of credibility
Expectations
Slide28Disinflation
Decreasing the inflation rate (policy makers)
Going from 7% inflation to 2% inflation
Disinflation is good for the economy
Referred to as price stability
DeflationNegative inflation ratePrices falling
Deflation is bad for the economy
Creates incentive to delay spending on durable goods and capital investments
Disinflation and Deflation
Slide29Inflation gone wild
Government wild with the printing press
Hyperinflation