Econ 2203 1st Edition Lecture 7 Current LectureKeyEquationsExamplesDefinitionsImportant InformationOutline- Correcting Economic Variables for the effects of inflation o Dollar figureso Nominal interest rate and Real interest rateInflation rate is the percentage change in the price level from previous period • Price level index: GDP deflator and CPI • GDP deflator is used to calculate inflation rate ��������� ���� = ��� �������� �� ���� 2 − ��� �������� �� ���� 1 ��� �������� �� ���� 1 × 100% In the real world for most cases, CPI is preferred to calculate inflation rate. ��������� ���� = ��� �� ���� 2 − ��� �� ���� 1 ��� �� ���� 1 × 100% Two Measures of U.S. Inflation 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.Correcting the Effects of Inflation • Money today is always worth more than money tomorrow Purchasing power is the number of goods or services that can be purchased with a unit of currency - ($1)o The purchasing power of $1 is 1/2 sandwiches in 2006. ($2 per sandwiches)- $1 is losing value o The purchasing power of $1 is 1/4 sandwiches in 2012. ($4 per sandwiches) - Due to the change of prices, the purchasing power of $1 is changing - What we concern is the amount of goods and services we can exchange not the face value of money Dollar Figures from Different Times President Hoover’s 1931 salary was $75,000 President Obama’s 2009 salary was $400,000 CPI is 214.5 for 2009 and 15.2 for 1931, who is richer? o Nominal term: $400,000 > $75,000 President Obama is richero Real term: It depends on whose salary could buy more goods and serviceso CPI is 214.5 for 2009 and 15.2 for 1931������ �� ���� 1 ′ � ������� = ����� ����� �� ���� 1 ����� ����� �� ���� 2 × ������ �� ���� 2 ′ � �������Salary in 2009 = (CPI in 2009/CPI in 1931) x Salary in 1931Salary in 2009 = (214.5/15.2) x 75,000 = 1 million (President Hoover)400,000 < 1,000,000Another method: CPI Salary1931 15.2 $75,0002009 214.5 ?(15.2x/15.2) = (75,000 x 214.5/15.2)President Hoover’s Salary = 1,058,388400,000 < 1,058,388Question 1: Consternation Corporation paid its production line workers $8.00 an hour last year. If the CPI is 160 now and was 128 last years, the firm should increase the hourly wages of its workers by(128x/128) = (8 x 160/128)X = 10a. $0.25b. $1.60c. $2.00d. $2.56Nominal and Real Interest Rates In 2011, Sally deposited $1,000 in a bank that pays an annual interest rate of 10 percent. She withdrew all her money in 2012. Was she richer? Nominal Interest rate: 10%– Nominal meanings: (Amount of money)Nominal Interest Rates – the interest rates as usually reported without a correction for the effects of inflation • 2012: $1,100 • 2011: $1,000 – Real meanings: (Amount of goods and services)Real Interest Rate – the interest rate corrected for the effects of inflationReal Interest Rate = Nominal Interest Rate – Inflation Rate• 2012: the purchasing power of $1,100 • 2011: the purchasing power of $1,000 Let us assume the price of a DVD was $10 in 2011Money Purchasing power ofall her money2011 $1,000 1002012 $1,100 110How many DVDs in 2012Inflation Rates (In 2012)Price of a DVD (In 2012)Purchasing Power (How many DVDs in 2012?)0% $10 x (1 + 0%) = $10 ($1,100/$10) = 1106% $10 x (1 + 6%) = $10.6 ($1,100/$10.6) = 10410% $10 x (1 +10%) = $11 ($1,100/$11) = 10012% $10 x (1 +12%) = $11.2 ($1,100/$11.2) = 98-2% $10 x (1 – 2%) = $9.8 ($1,100/$9.8) = 112% Change of Purchasing PowerInflation Rates(In 2012)DVDs in 2011 DVDs in 2012 % Change of Purchasing Power0% 100 DVDs 110 DVDs (110-100)/100 x 100% = 10%6% 100 DVDs 104 DVDs (104/100)/100 x 100% = 4%10% 100 DVDs 100 DVDs (100-100)/100 x 100% = 0%12% 100 DVDs 98 DVDs (98-100)/100 x 100% = -2%-2% 100 DVDs 112 DVDs (112-100)/100 x 100% = 12%The Relationship of nominal interest rates, real interest rates, and inflation ratesNominal Interest Rates Inflation Rates Real Interest Rates10% 0% 10%10% 6% 4%10% 10% 0%10% 12% -2%10% -2% 12%If a hamburger was $5 in 2011, what was the purchasing power of her money in 2012? o Nominal interest rate is 10% o CPI (2012) is 129. 6, CPI (2011) is 120 (Inflation rate is 8%) o Real interest rate is 2% Method 1: (Nominal interest rate and inflation rate) – Sally’s money in 2012: Sally had $100 more in her account in 2012 – Price of a hamburger in 2012: $5.51 hamburger cost $0.40 more in 2012. (From $5 to $5.4)– Number of hamburgers Sally could buy in 2012: Sally was able to buy 4 hamburgers more in 2012Method 2: (Real interest rate) – Real interest rate measures percentage change of purchasing power– 2% means Sally could buy 2% more hamburgers in 2012 Summary: • Nominal interest rates tell you how fast the number of dollars in your bank account rises overtime. – Sally had $100 more in her account in 2012 • Real interest rates tells you how fast the purchasing power of your bank account (the amount of goods you are able to buy) rises overtime – Sally was able to buy 4 hamburgers more in 2012 • Inflation rates tell you how fast the price of goods rises overtime – 1 hamburger cost $0.40 more in 2012. (From $5 to $5.4)Real and Nominal Interest RatesSource: U.S. Department of Labor; U.S. Department of TreasurySummary for Chapter 6• Consumer Price Index (CPI) and inflation rate • Difference between GDP deflation and CPI • How to correct effects of inflation? • Nominal interest rate and real interest