2. What is Inflation?
• The general upward movement in
the average level of prices of the
goods and services in an economy
3. What is Deflation?
• The general decrease in the
average level of prices of the
goods and services in an
economy
What the state of Inflation/Deflation
around the world?
www.nationmaster.comeco_inf_200&int=-1
5. Consumer Price Index (CPI)
[CPI measures cost of living relative to a base year[100]
The CPI is a market basket of 364 items at 21,000
establishments in 91 cities that the typical
householder buys. It does not include exports
because we do not buy exports but does include
imports. About 55% of the CPI is services.services
6. What is actually measured in this
market basket?
http://www.bls.gov/news.release/cpi.t02.htm
7. How is the CPI calculated?
Value of the market basket
in the current period
CPI =
x 100 = PRICE INDEX
Value of the market basket in
the base period
(See Handout)
http://inflationdata.com/Inflation/Consumer_Price_Index/CurrentCPI.asp
8. Consumers in this economy buy only two goods–hot dogs & hamburgers.
Step 1. Fix the basket. What percent of income is spent on each.
Consumers in this economy buy a basket of:
4 hot dogs and 2 hamburgers
Step 2. Find the prices of each good in each year.
Year Price of Hot Dogs Price of Hamburgers
2001 $1 $2
2002 $2 $3
Step 3. Compute the basket cost for each year.
2001 ($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 $14
Step 4. Choose one year as a base year (2001) and compute the CPI
2001 ($8/$8) x 100 = 100
2002 (14/$8) x 100 = 175
Step 5. Use the CPI to compute the inflation rate from previous year
2002 (175/100 x 100 = 175%) or to get actual % (175-100)/100 x 100 =75%
9. (42%) 18. Suppose that a typical consumer buys the following quantities of these
three commodities in 2000 and 2001.
2001
Commodity Quantity 2000 per Unit Price 2001 per Unit Price
Food 5 units $6.00 $5.00
Clothing 2 units $7.00 $9.00
Shelter 3 units $12.00 $19.00
Which of the following can be concluded about the CPI for this individual from
2000 to 2001?
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)
Year 1 [2000]: [5 food x $6 = $30; 2 clothing x $7 = $14; 3 shelters x $12 = $36,
for dollar value of $80. CPI = 100 ($80/$80 x 100 = 100 for 2000)]
Year 2 [2001]: [5 food x $5 = $25; 2 clothing x $9 = $18; 3 shelters x $19 = $57,
for value of $100. CPI =125 ($100/$80 x 100 = 125% for 2001)]
So, the CPI increased by 25%.
10. If the value of the CPI equals
120, what does this mean?
• The fixed market basket of goods costs
20% more than in the base period of time
12. 1962 Prices v. 2006 Prices
• Tuition at MIT - $1,500 • Tuition at MIT - $32,300
• Starting salary - $6,000 • Starting salary - $44,000 [college
[college graduate] [college graduate]
• FICA of 3.125 of $4,800 • FICA of 7.65 of $94,600
[$150 maximum] [$7,237 maximum]
• Top marginal tax rate of 91% of • Top marginal tax rate of 35% of
incomes over $200,000. incomes over $326,450
• New house for $10-15,000 [2.5 • New median house price is
times the income of a new $218,000 [5 times the income of
college graduate] today’s college grads]
• Coke - 10 cents • Coke - 60 cents
• Movies - .50 • Movies - $7
• 1962 Chevy - $1,500 • 2006 Chevy - $23,000
2006 Corvette $58,000
62 Corvette $2,995
13.
14. Dollar Figures From Different Times
Babe Ruth made $80,000 in 1931. That would
1931
be equivalent to $1 million today. [Barry Bonds
today
gets $18 million a year]
President Herbert Hoover’s salary in 1931
was $75,000. That would be equivalent to
75,000
$900,000 today. George Bush is being
paid $400,000 a year. President Kennedy
was paid $100,000 in 62 [$650,000 today] $80,000=$1 M
Who is the Richest American Ever?
John D. Rockefeller’s [1839-1937] wealth would be worth
$200 billion in today’s money, or 4 times that of Bill Gates.
Although Rockefeller was worth $200 billion, he could not
watch 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 than
the richest American a century ago.
15. GDP Deflator – more broad
GDP Deflator includes prices
for all goods that we produce:
produce
• What householders are buying
• What businesses are buying
• What the government is buying
• What foreigners are buying
[does not include imports because
we don’t produce imports]
18. What are the effects of
unexpected inflation?
• Inflation redistributes income
– some people win – the ones getting the higher
prices (think oil/gas companies)
– Some people lose – the ones paying the
higher prices (think YOU!)
19. Who wins and who loses from
inflation?
• Debtors win
– Borrowers pay back loans with inflated dollars
(dollars that are worth less)
• Creditors lose
– Lenders are paid back with inflated dollars
(dollars that are worth less)
20. More winners and losers of inflation
• Those on fixed incomes lose
– Income does not keep up with prices - standard of living goes
down.
– Exception – if fixed income is INDEXED to inflation (CPI)
• Savers often lose
– If prices rise faster than the rate of interest they are getting from
their savings (investment) then they lose purchasing power
• Government sometimes wins
– Government wins – Biggest debtor in the World (Debtors WIN!)
– Government loses – surplus in savings, increase in salaries and
other prices paid
• Menu costs of inflation
– Individuals and business must allocate resources to keep up with
changing prices – increases transaction costs
• Inflation and uncertainty
– Do I spend today, or save? Prices going up or not? What is happening to
my purchasing power? ARRRGGHH!
21.
22.
23. President Bush’s College Transcript
“So - - If you are having a hard time in economics,
don’t worry about it. You can always be President
of the United States.”
24. The Inflation-GDP-Unemployment
Connection
• GDP is calculated by taking the price of a
good or service and multiplying it by the
quantity of the good or service produced.
– Example (assume a one product economy)
• Dry Erase Marker (sold this year)
– $1.00 (Price of one) X 1,000 produced this year
»GDP = $1,000
25. The Inflation-GDP-Unemployment
Connection
• Let’s assume next year the price of Dry
• Erase Markers is $2.00 each and the
economy still produces 1,000 markers.
$2.00 X 1,000
GDP = $2,000
Has our GDP grown?
What caused GDP to rise? Is this good?
What should be our main concern?
26. The Inflation-GDP-Unemployment
Connection
• Our main concern should be the growth of
the production of goods and services
(G/S). The implication is that with the
growth of production of G/S more workers
will be needed to produce the G/S,
thereby putting people to work and getting
closer to the Economic Goal of Full-
employment.
27. The Inflation-GDP-Unemployment
Connection
• Our example tells us that we only
experienced a rise in price, not a rise in
the quantity of the good produced.
– We had inflation.
To see how we are doing from year to year in
the production of G/S we need to factor out
Inflation
28. The Inflation-GDP-Unemployment
Connection
• Terms we need to know and understand:
– Nominal GDP – the GDP calculated in any given year
using that particular years prices or price level.
– Real GDP – the GDP calculated for a given year with
the change in price level (Inflation) factored out.
Measures the production of G/S in terms of a base
year price level
– GDP Deflator- calculates the change in price level for
a particular year compared to an established base
year price level.
29. Year Price of Quantity Nominal GDP Real GDP
Goods of Goods GDP (adjusted for
Deflator
(unadjusted Price
and and
for Price Change)
Services Services
Change)
Produced Produced
1999 .50 1,000
2000 .75 1,000
2001 .75 1,200
2002 1.00 1,100
2003 1.50 1,150
Nominal GDP = Price of G&S x Quantity of G &S
GDP Deflator = Current Price/Base Year Price
Real GDP = Nominal GDP/GDP Deflator X 100
30.
31. What does all this mean???
Unemployment Inflation GDP Real
Growth
Rate
Good 6% or less 1% to 4% 2.5% to 5%
Worry 6.5% to 8% 5% to 8% 1% to 2%
Bad 8.5% or more 9% or more .5% or less
Unemployment Rate 9.7 % Inflation Rate -2.10% Real GDP -6.0%
32. IT IS A MUST TO REMEMBER
THIS FORMULA:
• Real = Nominal - Inflation
GDP GDP
Interest
Interest rate
rate
