ECON 2133 1st Edition Lecture 3 Current LectureA. Inflation: percentage growth rate at a price level- What happens when prices goes up and quality goes up?- Inflation means general price level increase only, very hard to do!- Use Consumer Price Index: measures costs of livingBLS constructs “Household budget” and includes 600+ different goodsTrack price of all goods that are consistent and create a market basket of goods that the regular household consumesThen create a weighted household budget:a. Housing (most expensive) at 40% of budgetb. Utilities at 10% of budgetc. Food at 25% of budgetd. Until they break it down to 100% total of various categories of 600+ goods and services that bureau of labor tracksAdd all this up and see how much it costs.. let’s say 10k as of last year then now it costs 11k - Over that one year inflation was 10% or 1000/10k dollars Measuring inflation by tracking change of price of items that make up household budget in cost of living Does not perfectly measure inflation- CPI has biases:Statistical “mis-measurements” of inflation by the CPI1. Quality bias: CPI overstates the harm of inflation as it assumes quality is constant over time. 2. Substitution bias: Market basket constant even if relative prices change. CPI overstates inflations harm! (says it’s hurting you more than what it is because people will substitute away from expensive to cheaper goods)3. Walmart bias: Walmart brings lower prices, without doubt. Because all 600+ goods are not bought at Walmart so the overall price level is higher than it could be! CPI overstates inflation. CPI mis measures inflation & averages anywhere from 0-2.5% annual error. Due to quality and substitution bias that CPI tries to correct for but doesn’t always get it done in timely fashion.B. Indexation: tying a variable’s movements to changes in CPI. - 100% indexation is going to imply no change in a variable’s real valueEx) If CPI goes up 10%, then the variable goes up 10%. Social security payments need to match CPI and are 100% indexed to CPI because we don’t want standard of living to change for our senior citizens. These 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.Income tax system with different incomes, they are indexed to CPI and adjusted to CPI. So you don’t pay greater taxes because of inflation. It shouldn’t kick you into higher tax brackets since 1986. Two components for raises: merit but also cost of living adjustment (which is from change of CPI)C. Fisher Equation: - Nominal interest rate = real inflation adjusted interest rate + rate of inflation - In 2008/2009 Cars were being sold with 0% inflation with 2% inflation which gives -2%. So GM is paying you 2% a year to get loan and buy a