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lec11 Inflation and CPI.pptx

  2. Inflation  You might notice inflation on a routine shopping trip or especially when you see a reference to prices in an old book or movie.  For example, in the 1960 movie Psycho, a hotel room for one night was priced at just $10.  Recall that inflation is defined as the growth in the overall level of prices in an economy—so inflation occurs when prices rise throughout the economy.  When overall prices rise, our budget is affected; we can buy less with our income.  When overall prices fall, our income goes farther and we can buy more goods and services.
  3. Cont.  Imagine an annual inflation rate of 100%.  At this rate, prices would double every year.  How would this inflation affect your life?  Would it change what you buy?  Would it change your savings plans?  Would it change the salary you negotiate with your employer?  Yes, it would change your life on a daily basis.  Now imagine that prices double every day.This is the situation currently inVenezuela .  TheVenezuela situation is an example of hyperinflation, an extremely high rate of inflation that completely stymies economic activity.
  4. Inflation and deflation  Figure 11.8 shows inflation in the United States from 1960 to 2013.  The long- run average over this period was 4%, meaning that prices as a whole rose 4% per year on average.  In some years, the rate was much higher than 4%.  At one point in 1980, the inflation rate was almost 15%.  But since the early 1980s, inflation seems well controlled in the United States.  Looking again at Figure 11.8, you might notice a brief spell of deflation in 2009.  Deflation occurs when overall prices fall; it is negative inflation. Notice, too, that periods of recessions— the blue- shaded vertical bars in Figure 11.8—often (but not always) coincide with falling inflation rates. See, for example, 1982, 1991, and 2009.
  5. Stagflation  Stagflation occurs when inflation rises during times of recession.  (The term is a combination of the words “stagnation” and “inflation.”)  Stagflation occurred during the recession of the mid-1970s.This unexpected outcome caused economists to re- evaluate the deficit spending suggestions of Keynesian economists .  The result was the supply- side revolution of the 1980s, when policy focused on promoting business activity.  Whenever unusual macroeconomic events take place, new thinking about the macroeconomy often comes to the forefront.
  6. Price Level  Measuring inflation accurately requires great care. 1. First, prices don’t all move together; some prices fall even when most others rise. 2. Second, some prices affect consumers more than others. For example, a 10% increase in the cost of housing is significantly more painful than a 10% increase in the cost of hot dogs. Before we arrive at a useful measure of inflation, we have to agree on what prices to monitor and how much weight we’ll give to each price. In the United States, the Bureau of Labor Statistics (BLS) measures and reports inflation data. In this section, we describe how the BLS estimates the overall price level. The price level (P) is a measure of the average prices of goods and services throughout an economy.
  7. The Consumer Price Index (CPI)  Let’s look at the most common price level used to compute inflation.  The consumer price index (CPI) is a measure of the price level based on the consumption patterns of a typical consumer.  When you read or hear about inflation in the media, the report almost certainly focuses on this measure.  The CPI is essentially the price of a typical “basket” of goods purchased by a representative consumer in the United States.  Think about this situation as if you were going to the planet’s hugest SuperWalmart.You get an enormous shopping cart and start buying things to include in the basket. But what exactly goes in the basket?
  8. CPI cont.  In addition to groceries, you would buy clothing, transportation, housing, medical care, education, and many other goods and services.  The goal of the CPI is to include everything a typical consumer buys, thereby giving a realistic measure of a typical consumer’s cost of living.
  9. CPI Cont.  Figure 11.9 displays how the CPI was allocated among major spending categories in December 2014.  Prices for very specific goods are included in each of these categories.  For example, “Food and beverages” includes prices for everything from potato chips to oranges (bothValencia and navel) to flour (both white and all- purpose).  These are the goods in the “basket” purchased by typical American consumers.
  10. CPI Cont.  Of course, none of us is exactly typical in our spending.  College students allocate significantly more than 3.3% of their spending on education,  senior citizens spend a lot more than average on medical care,  a fashionista spends more than average on clothing, and  those with lengthy commutes spend more than average on transportation.  The CPI reflects the overall rise in prices for consumers on average.
  11. Computing the CPI  Each month, the BLS conducts surveys by sending employees into stores in 38 different geographic locations to gather and input price information on over 8,000 goods.  The BLS estimates prices on everything from apples in Chicago, Illinois, to electricity in Scranton, Pennsylvania, to gasoline in San Diego, California.  In addition to inputting price information, the BLS surveyors estimate how each good and service affects a typical consumer’s budget.
  12. Cont.  Once they do this, they attach a weight to the price of each good in the consumer’s “basket” so that the things people spend more money on are counted more heavily.  For example, Figure 11.9 indicates that the typical consumer spends 15.3% of his or her budget on transportation. Therefore, transportation prices receive 15.3% of the total weight in the typical consumer’s basket of goods.  Once the BLS has compiled the prices and budget- allocation weights, it can construct the CPI.
  13. Economics in the Real World Follow the ‘Price Chaser’  Tracking the prices in the CPI requires a great deal of effort and precision.  In September 2007, Nancy Luna of the Orange County Register followed one of the 350 employees of the Bureau of Labor Statistics who is charged with finding current prices of the goods included in the CPI.  The BLS employee, Frank Dubich, traveled 800 miles per month tracking prices.
  14. CPI in real world Cont.  The items to be priced were very specific.  For example, Dubich was asked to visit a grocery store to find the price of “an 18.5-ounce can of Progresso Rich & Hearty creamy chicken soup with wild rice,” which turned out to be $1.98.  Dubich also had to note that this was a sale price.
  15. Cont.  In another instance, Dubich was embarrassed to be seen pricing because the item was a prom dress.  He noticed several clerks staring at him as he hunted for the price tag, so he quickly recorded the price and left.  In macroeconomics, we generally see one single number that indicates how much prices have changed.  But it’s important to remember that there are thousands of prices tracked each month by government workers like Frank Dubich.
  16. Measuring Inflation Rates  Once the CPI is computed, economists use it to measure the inflation rate.  The inflation rate (i) is calculated as the percentage change in the price level (P).  Using the CPI as the price level, the inflation rate from period 1 to period 2 is:
  17. Measuring inflation Cont.  Note that this is a growth rate, computed just like the growth rate of GDP we computed earlier.  Assume the CPI rises from 100 to 125 in one year.  The inflation for that year would be 25%, computed as:
  18. Cont.  The US Bureau of Labor Statisitcs releases CPI estimates every month;  however, inflation rates are officially measured over the course of a year, showing how much the price level grows in a 12- month period.  Over time, we see significant changes in the overall price level.  The CPI was just 30 in 1961 and rose to 233 by 2013.  This means that the typical basket of consumer goods rose in price nearly eightfold between 1961 and 2013.  Sum: CPI measured every month, inflation every year
  19. Real World Case: Prices don’t all move together  While it’s clear that prices generally rise, not all prices go up.  An increase in the CPI indicates that the price of the overall consumer basket rises.  However, some individual prices stay the same or even fall.  For example, consumer electronic prices almost always fall.  When flat- panel plasmaTVs were introduced in the late 1990s, a 40-inch model cost more than $7,000. Fifteen years later, 50-inch flat- panelTVs are available for less than $500.  This drop in price is the result of technological advancements: as time passes, it often takes fewer resources to produce the same item or something better.
  20. EX: Cont.  Computers are another example. In 1984, Apple introduced the Macintosh computer at a price of $2,495.The CPU for the Macintosh ran at 7.83 MHz, and the 9-inch monitor was black and white.  Today, you can buy an Apple iMac for less than $1,800.This new Apple computer has a quad- core processor that runs at a total of 11,200 MHz.  The new computer is better by any measure, yet it costs less than the early model.These kinds of changes in quality make it difficult to measure the CPI over time.
  21. The Accuracy of the CPI  Computing the CPI isn’t simple.  Yet for economists to understand what’s happening in the macroeconomy, it’s important that the CPI be accurate.  For example, sometimes a rapid fall in inflation signals a recession, as it did in 1982 and 2008.  Like real GDP and the unemployment rate, inflation is an indicator of national economic conditions.
  22. The Accuracy of the CPI cont.  How accurate is the CPI?  If consumers always bought the same goods from the same suppliers, it would be extremely accurate,  and economists would be able to compare the changes in price from one year to the next very easily.  But this isn’t a realistic scenario. Consumers buy different goods from different stores at different locations, and the quality of goods changes over time.  Because the typical basket of consumer goods keeps changing, it’s difficult to measure its price.  The most common concern is that the CPI overstates true inflation.  There are three reasons for this concern:  (1) the substitution of different goods and services,  (2) changes in quality, and  (3) the availability of new goods, services, and locations.
  23. 1. Substitution  When the price of a good rises, consumers instinctively look to substitute less expensive alternatives.  This substitution makes CPI calculations difficult because the typical consumer basket changes.  If you go to the store looking for potato chips but find that pretzels are on sale, you’re substituting away from a more expensive good if you buy the pretzels instead of the potato chips.  This substitution alters the weights of all the goods in the typical consumption basket.
  24. Substitution cont.  If the CPI didn’t acknowledge the substitution of less- expensive items, it would exaggerate the effects of the price increase, leading to upward bias (that is, an estimate of inflation that is too high).  Since 1999, the BLS has attempted to deal with this problem by using a formula that accounts for both the price increase and the shift in goods consumption; however, keeping track of changing consumer behavior is very difficult.
  25. 2. Changes in Quality  Over time, the quality of goods generally increases.  For example, the movies that you watch at home are probably on Blu-ray Discs.You can still get DVDs, but Blu-ray Discs are a higher quality and thus more expensive: the price of movies has risen from about $15 to about $25.  This price increase might seem like inflation, since movie prices on disc have gone up.  Yet consumers are getting “more” movie for their buck, because the quality has improved.  If the CPI did not account for quality changes, it would have an upward bias, but the BLS also uses an adjustment method to try to account for quality changes.
  26. 3. New Products and Locations  In a dynamic, growing economy, new goods are introduced and new buying options become available.  For example, tablet computers, iTunes downloads, and even cell phones weren’t in the typical consumer’s basket 20 years ago.  In addition, ,Taobao, JD weren’t options for consumers to make purchases before the 1990s.
  27. New Products and Locations cont.  Traditionally, the BLS updated the CPI goods basket only after long time delays.  This strategy biased the CPI in an upward direction for two reasons.  First, the prices of new products typically drop in the first few years after their introduction. If the CPI basket doesn’t include the latest prices, this price drop is lost.  Second, new retail outlets such as Internet stores typically offer lower prices than traditional retail stores do.  If the BLS continued to check prices only at traditional retail stores, it would overstate the price that consumers actually pay for goods and services.
  28. #Inflation
  29. What Problems Does Inflation Bring?  We intuitively understand that something is wrong when a country doesn’t grow or when unemployment rates are high.  But inflation is a problem too,  and most people understand that if prices rise and their incomes don’t, they are worse off as a result.  But inflation also brings other problems that directly impact you. Let’s look at the most important ones.
  30. Uncertainty about Future Price Levels  Imagine you decide to open a new coffee shop in your college town.  You want to produce espressos, tea, and cappuccinos.  Of course, you hope to sell these for a profit.  You have to buy (that is, invest in) capital goods like an espresso bar, tables, chairs, and a cash register.  You also have to hire workers and promise to pay them.  Before any revenue arrives from the sales of output, firms have to spend on resources.  The same is true of the overall macroeconomy:  to increase GDP in the future, firms must invest today.  The funds required to make these investments are typically borrowed from others.
  31. Uncertainty about Future Price Levels  The timeline of production shown in Figure 11.10 illustrates how this process works.  At the end, the firm sells its output.  The important point is that in a normal production process, funds must be spent today and then be repaid in the future— after the output sells.  But for this sequence of events to occur, businesses must make promises to deliver payments in the future, including payments to workers and lenders.  Thus, two types of long- term agreements form the foundation for production: wage and loan contracts.  Both of these involve agreements for dollars to be delivered in future periods.
  32. Uncertainty about Future Price Levels  But inflation affects the real value of these future dollars. When inflation confuses workers and lenders, these essential long- term agreements seem risky and people are less likely to enter into them.  Inflation can cripple loan markets because people don’t know what future price levels will be.  When firms cannot borrow money or hire long- term workers, future production is limited.  PPF is limited!!  Thus, inflation risk can lead to lower economic output (that is, lower GDP).  curb efficiency !
  33. Wealth Redistribution  Inflation can also redistribute wealth between borrowers and lenders.  EX:  If you borrow $20,000 to finance your college education, you’re doing so with the promise to pay back more than what you borrowed because you’ll be paying interest on the loan.  Let’s say you agree to a 5% interest rate.This means you will pay back $21,000.
  34. EX cont.  The catch is that you have time to repay the loan.  Assume you have 10 years to pay it back.  If inflation unexpectedly rises during those years, the inflation will devalue your future payment to the lender.  As a result, you’ll be better off because the money you’re repaying has less purchasing power than what you borrowed, but the lender will be worse off.  Thus, inflation redistributes wealth from lenders to borrowers.
  35. Cont.  If both you and the lender fully expect the inflation to occur, the lender will require more in return for the loan.  In the United States, inflation has been low and steady since the mid- 1980s.Therefore, surprises are rare.  But nations with higher inflation rates also have a higher variability of inflation, which makes it difficult to predict the future.  This is one more reason why high inflation increases the risk of making the loans that are an important source of funding for business ventures.
  36. Impact on Savings  You may have heard the phrase “saving is a virtue.”  When you were younger, perhaps you saved money to buy a new bike or video game.  Later in life, it’s important that you save in order to put a down payment on a house and provide for your retirement.  However, inflation can erode your savings.
  37. Impact on Savings cont.  One way to think about the effect of inflation on future dollars is to ask what amount of future dollars it will take to match the real value of $1.00 today.  Figure 11.11 answers this question based on a retirement date of 40 years in the future.  The different inflation rates are specified at the bottom of the graph.  If the inflation rate averages 4% over the next four decades, you’ll need $4.80 in savings just to buy the same goods and services you can buy today for $1.00.
  38. Impact on Savings cont.  What does this mean for your overall retirement plans?  Let’s say that you decide you could live on $50,000 per year if you retired today.  If the inflation rate is 4% between now and your actual future retirement date, though, you would need enough savings to supply yourself with $50,000 * $4.80,  or  $240,000 per year, just to keep pace with inflation.
  39. Class Task  How Much Does the bank have to PayYou to Make saving Worthwhile?  Suppose you’re hoping to save money to buy your first house.  You look around to find the best place to put your money and find that banks are paying interest rates of 1%.  This means that they’ll pay you 1% of whatever amount you have in your account at the end of each year just for keeping your money in the bank.  Now 1% isn’t a lot, and when you compare it to inflation, it may mean that saving is actually a bad idea. For example, if the inflation rate is 3% per year, then you need a 3% interest rate just to keep pace with inflation.
  40. Class Task cont. Question: What happens to the purchasing power of your money if the interest rate you earn is 1% but inflation is 3%?
  41. Answer:  If the inflation rate is greater than the 1% interest rate,  then keeping your money in the bank would actually cause a decline in your purchasing power since prices rise faster than the interest you earn.
  42. Case Study New York Times Economic reports in the media are often misleading. Now that you have perspective on economic statistics, you can determine for yourself whether economic news is positive or negative.  For example, a NewYorkTimes article from July 2014 offers the following description of economic growth in the United States for the second quarter:  (Source: Dionne Searcey, “EconomyGrew 4% for Quarter,” NewYorkTimes, July 30, 2014.)
  43. Article: “The United States economy rebounded strongly in the second quarter of the year, shaking off the negative effects of an unusually harsh winter and stirring hopes that it might finally be establishing a solid enough footing to put the lingering effects of the recession squarely in the past. The Commerce Department . . . reported on Wednesday that the economy grew at a seasonally adjusted annual rate of 4 percent, surpassing expectations.”
  44. Evaluation of the Article  Good economists are very careful with language, because certain terms have very specific meanings.  For example, we know that “economic growth” always refers to changes in per capita real GDP, not simply GDP or real GDP.  But economic reports in mainstream media outlets often blur this distinction.That is exactly the case with the report in the NewYorkTimes article excerpted above.
  45. Evaluation cont.  Even though the author of the article uses the term “seasonally adjusted annual rate,” additional research reveals that she’s talking about real GDP growth, but not adjusting the data for population changes.  This is a fairly common mistake, so you should watch out for it when you read economic growth reports.  It turns out that the population growth rate in the United States was about 0.7% in 2013.  Assuming the same rate for 2014, this means that the growth rate of per capita real GDP in the second quarter was closer to 3.3%.
  46. Chapter Summary  This chapter began with the misconception that measuring the macroeconomy is a straightforward process.  While we have ways of calculating the three primary data points of macroeconomics— unemployment, output, and inflation—each of them has its own challenges.  Nevertheless, economists stick to the processes that they have been using for some time, making changes when new measurement techniques allow them to do so.
  47. << Questions? >> 1. How is GDP computed?
  48. Answer:  Economists typically compute GDP by adding four types of expenditures in the economy:  consumption (C),  investment (I),  Government spending (G), and  net exports (NX).  For many applications, it is necessary to compute real GDP, which is nominal GDP adjusted for changes in prices.
  49. << Questions? >> 2.What are some shortcomings of GDP data?
  50. Answer:  GDP data does not include the production of non- marke goods,  The underground economy,  production effects on the environment, or  The value placed on leisure time.
  51. << Questions? >> 3.What can we learn from unemployment data??
  52. Answer:  The unemployment rate reflects the portion of the labor force that is not working and is unsuccessfully searching for a job.  The natural rate of unemployment is the typical rate of unemployment that occurs when the economy is growing normally.  Most economists feel that the natural rate of unemployment in the United States is between 4% and 6%.  The labor- force participation rate reflects the portion of the population that is working or searching for work.  Unemployment rates differ among groups based on age, race, and gender.
  53. << Questions? >> 4. How is inflation measured?
  54. Answer:  The inflation rate is calculated as the percentage change in the price level.  Economists most commonly use the CPI to determine the general level of prices in the economy.  Determining which prices to include in the CPI can be challenging for several reasons: consumers change what they buy over time, the quality of goods changes, and new products and sales locations are introduced.
  55. << Questions? >> 5.What problems does inflation bring?
  56. Answer:  Inflation causes uncertainty about future price levels and can lead to a redistribution of wealth.  Inflation can also impact how much people save.  Inflation erodes purchasing power over time, so you need to save more to meet savings targets.
  57. Keywords:  consumer price index (CPI)  consumption (C)  deflation  discouraged workers  durable consumption goods  exports  final good  government spending (G)  price level (P)  recession  service  stagflation  transfer payments  hyperinflation  imports  intermediate good  investment (I)  labor force  labor-force participation rate  natural rate of unemployment (u*)  net exports (NX)  nominal GDP  non-durable consumption goods  underemployed workers  underground economy  unemployment rate (u)
  58. Review Questions (p.341)  1.What is the most important component (C, I, G, or NX) of GDP? Give an example of each component.  2. Is a larger GDP always better than a smaller GDP? Explain your answer with an example.  3. If Max receives an unemployment check, would we include that transfer payment from the government in this year’s GDP?Why or why not?
  59. Review Questions cont.  4. Phil owns an old set of golf clubs that he purchased for $1,000 seven years ago. He decides to post them on Craigslist and quickly sells the clubs for $250. How does this sale affect GDP?  5.What groups does the Bureau of Labor Statistics count in the labor force? Explain why the official unemployment rate tends to underestimate the level of labor market problems.
  60. Review Questions cont.  6. Does the duration of unemployment matter? Explain your answer.  7.What are three issues regarding the accuracy of the CPI? Give an example of each issue.  8. If the prices of houses go up by 5% and the prices of concert tickets rise by 10%, which will have the larger impact on the CPI? Why?  9.What are some problems caused by inflation, other than a decrease in purchasing power? Briefly explain each one.
  61. Study Section 1. In the following situations, explain what is counted in this year’s GDP and what isn’t: a. You bought a new PS4 at GameStop last year and resold it on eBay this year. b. You purchase a new copy of an Investing for Dummies book at Barnes & Noble. c.You purchase a historic home using the services of a real estate agent. d.You detail your car so that it is spotless inside and out. e.You purchase a new hard drive for your old laptop. f. Apple buys 1,000 motherboards for use in making new computers.
  62. Cont.  2.To which component of GDP expenditure (C, I, G, or NX) does each of the following belong?  a. Swiss chocolates imported from Europe  b. the salary of a new employee at the Department of Justice inWashington, D.C.  c. a candle you buy at a local store  d. a new house  e. the sale of a U.S.-made Ford F-150 truck to a man in Mexico City  f. a new watch that you bought from Amazon .com
  63. Cont.  A country with a civilian population of 90,000 (all over age 16) has 70,000 employed and 10,000 unemployed persons. Of the unemployed, 5,000 are frictionally unemployed and another 3,000 are structurally unemployed.  On the basis of this data, answer the following questions:  a.What is the size of the labor force?  b.What is the unemployment rate?  c.What is the natural rate of unemployment for this country?  d. Is this economy doing well or poorly? Explain.
  64. Cont. Consider a country with 300 million residents, a labor force of 150 million, and 10 million unemployed. Answer the following questions:  a.What is the labor- force participation rate?  b.What is the unemployment rate?  c. If 5 million of the unemployed become discouraged and stop looking for work, what is the new unemployment rate?
  65. Cont. Suppose that you also take out a $1,000 loan at the Colonial Credit Union.The loan agreement stipulates that you must pay it back with 4% interest in one year, and again, the inflation rate is expected to be 2%.  a. If the inflation rate turns out to be 3% rather than 2%, who will be hurt?Why?  b. If the inflation rate turns out to be 3% rather than 2%, who will be helped?Why?
  66. Next chapter