INFLATION INFLATIONWHAT IS IT An increase in the

INFLATION

INFLATION…WHAT IS IT? An 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.

WHAT CAUSES INFLATION 2 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

HOW IS INFLATION MEASURED Consumer 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

CALCULATING CPI MARKET BASKET Price x Quantity for different years Inflation rate this year = 100 x (CPI this year – CPI last year) / (CPI last year)

PRICE INDEX IN A GIVEN YEAR Cost of market basket in a given year x 100 Cost of market basket in base year

CPI - 4 STEP PROCESS 1) The fixed basket of goods and services is defined. 2) The prices for every item in the basket are found. 3) The cost of the fixed basket of goods and services must be calculated for each time period. 4) A base year is chosen and the index is computed.

CALCULATING CPI Items in Market Basket Quantity Consumed 2008 Prices in Yr (pounds) 2009 Prices Salami 300 $4 $6 Corned Beef 200 $5 $7 Bologna 100 $2 $1. 50 Cheese 500 $3 $2. 50 2008 = (300 x$4) + (200 x$5) + (100 x$2) + (500 x$3) = $3, 900 2009 = (300 x$6) + (200 x$7) + (100 x$1. 50) + (500 x$2. 50) = $4, 600 100 x CPI This Year – CPI Last Year = $4, 600 - $3, 900 = $3, 900 17. 9% inflation

CALCULATING CPI Items in Market Basket Quantity Consumed 2008 Prices in Yr (pounds) 2009 Prices Salami 300 $4 $6 Corned Beef 200 $5 $7 Bologna 100 $2 $1. 50 Cheese 500 $3 $2. 50 2008 = (300 x$4) + (200 x$5) + (100 x$2) + (500 x$3) = $3, 900 2009 = (300 x$6) + (200 x$7) + (100 x$1. 50) + (500 x$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) $3, 900 $4, 600 x 100 = 117. 94 $3, 900

Assume 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%

Suppose 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

Suppose 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.

1990 1991 1992 Price of Plums $0. 50 $1. 00 Price of Lawnmowers $100 $125 $150 Price per lb. of pasta $1 $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?

1990 1991 1992 Price of Plums $0. 50 $1. 00 Price of Lawnmowers $100 $125 $150 $1. 50 Price per lb of pasta $1 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. 50 x 50) + ($125 x 1) + ($1. 50 x 200) = 450 1992: ($1 x 50) + ($150 x 1) + ($1. 50 x 200) = 500 Price 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

MEASURING INFLATION GDP 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 GDP § GDP Deflator = Nominal GDP x 100 Real GDP

CPI VS. GDP DEFLATOR They 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.

NOMINAL VS. REAL INTEREST Nominal 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

INFLATION EXAMPLE Year 1 money: $100 Year 2 money: $110 Inflation rate: 2% “Real” Return on your investment (purchasing power) = 8% (10% return – 2% inflation)

2 WAYS INFLATION IS REPORTED CPI Headline inflation § Includes entire CPI market basket CPI Core Inflation § Excludes food and energy because they are volatile

WHO DOES INFLATION AFFECT? You 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? Everybody 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 savings § Those who lent at low fixed interest rates § Those receiving fixed payments

I N T HE FOLLOWING SCENARIOS, HAS INFLATION C REAT ED: A) WI NNERS AND LOSERS AT NO NET COST TO THE ECO NOMY , OR B) A NET COST TO THE ECONOMY? IF B, WHICH TY PE OF CO ST IS THE INFLATION GENERATING? 1. During a period of rapid unexpected inflation, Sam’s Meat Market must change the price of his products on a weekly basis. 2. 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%. 3. 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. 4. 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%

EXPECTATIONS Expecting inflation causes inflation § Consumers demand more § Producers supply less The role of the central bank § Control actual inflation by controlling expected inflation § The importance of credibility

DISINFLATION AND DEFLATION Disinflation § Decreasing the inflation rate (policy makers) § Going from 7% inflation to 2% inflation § Disinflation is good for the economy § Referred to as price stability Deflation § Negative inflation rate § Prices falling § Deflation is bad for the economy § Creates incentive to delay spending on durable goods and capital investments

HYPERINFLATION Inflation gone wild Government wild with the printing press