ECON 204 1st Edition Lecture 5 Outline of Last Lecture IX. Expanding on UnemploymentA. Why does long run unemployment matter?Outline of Current LectureX. InflationA. Who wins and loses relative to inflationCurrent LectureX. InflationCPI = consumer price indexCPI measures the cost of the market basket for a typical urban American family.CPI is the most common measure of aggregate price level.Generally the majority of a household CPI is made up of housing.A market basket is a fixed list of goods and their prices. The most common type are consumer market baskets, which include all the goods a household purchases.Aggregate price level: a measure of the overall level of prices in the economy.To measure the aggregate price level economists calculate the cost of purchasing a market basket.The price level changes over time.Real income: income divided by the price levelReal wage: wage rate divided by the price levelInflation rate: percentage increase in the overall level of prices per yearΠ (inflation) = ((P2 – P1)/P1)x100 P1= prices during first year (base year)P2= prices from second yearThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.Producer price index: similar to CPI for good purchased by firms (households have a very different market basket than firms)GDP deflator: measures the price level of all new produced final goods and services in an economy.High rates of inflation impose significant economic costs:1. Shoe-leather costs: the increased cost of transactions caused by inflation. Must spend money quickly because it is losing value quickly.2. Menu cost: the real cost of changing a listed price. Ex: It costs Target to change alltheir prices to keep up with inflation/new prices.3. Unit-of-account costs: arise from the way inflation makes money a less reliable unit of measurement.4. Managerial costs of money (not in textbook): spending more time determining when to go to the bank (for example to get a loan) etc. A. Who wins and loses relative to inflationInflation changes the dollar repayment of a loan- the loan contract is stated in nominal terms. The nominal interest rate: interest rate expressed in dollar terms.Real interest rate: nominal interest rate minus the rate of inflation.r (real interest )= i (nominal interest) – Π (inflation)The lender loses when inflation rises and the borrower wins. It also works visa versa, when inflation decreases the lender benefits and borrower loses. Example: banks and homeowners, banks do not like inflation because the money they lent out is losing value. (note: this is why inflation becomes political- banks oppose it)Inflation and unemployment are counter-cyclical.Disinflation versus deflationDisinflation: process of bringing inflation rate down. Is very costly so policy makers try to prevent inflation from becoming excessive in the first place.Deflation: a negative rate of inflation.Note: people wait to buy things when they know it will be cheaper tomorrow, that leads to no consumption and the economy comes to a