Econ 104 1st Edition Lecture 11 Outline of Last Lecture I Consumer Price Index II Disinflation Deflation inflation III How to calculate CPI Outline of Current Lecture I Calculating inflation rate II Purchasing power III Consequences of inflation IV Real vs Nominal Income V Inflation interest rates Current Lecture I Calculating Inflation Rate using CPI a From previous example where 2012 CPI was 200 and 2011 Inflation Rate was 175 i New CPI Old CPI Old CPI X 100 Inflation Rate ii 200 175 175 X 100 14 28 II Consumer Price index derives from a survey of 14 000 households by the Bureau of Labor Statistics a 41 Housing b 18 8 Transportation c 6 8 Education i Recreation is 6 0 1 Oddly close to education 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 d The biggest two are housing and transportation III How does inflation affect purchasing power a As CPI increases the amount of goods and services the dollar can buy decreases i So when there is inflation our money means less ii In the Macro economy we say as prices on average start to rise our purchasing power goes down b Some workers receive a cost of living allowance COLA which automatically raises the wage when CPI rises c First let s look back Babe Ruth s Salary in 1932 80 000 i How much do you think his salary would be in 2014 1 How much would he have to make today to have the same purchasing power as he did in 1932 2 The CPI has been growing ever since so the salary will be higher 3 We are asking about 2014 because we do not have the numbers for 2015 yet given the year is not even over ii We find the 2014 CPI by going to the FRED website 1 FRED Federal Reserve Economic Data iii CPI1932 12 9 CPI2014 236 7 1 Take the ratio of the New CPI to Old CPI a 236 7 12 9 18 35 b Now multiply this number by 80 000 i 80 000 X 18 35 1 467 907 2 Find the Inflation from 1932 through 2014 IV Consequences of inflation a Real IncomeyearX Nominal IncomeYearX CPI YearX 100 b Nominal Income income received in today s dollars c Real income income adjusted for changes in the CPI i Shows increase in purchasing power ii Also reflects increase in your standard of living V EXAMPLE Suppose you made 40 000 in 2011 and you received a 10 salary increase in 2012 Year Nominal Income CPI Real Income 2011 40 000 225 17 777 2012 44 000 230 19 130 a Real income in 2011 40 000 225 100 17 777 b Real income in 2012 44 000 230 100 19 130 c Growth in nominal income change nominal i 10 d Growth in Real income change real i 19 130 17 777 17 777 X 100 7 6 VI More Consequences of Inflation a Inflation shrinks b EXAMPLE Suppose you receive a 2 salary increase in the beginning of 2015 i Find out if you are better off Look up the inflation forecast for 2015 1 Look at the Federal Reserve Bank of Philadelphia website 2 Real GDP will grow at a Rate of 3 2 estimated 3 Headline CPI includes everything everything I the basket 4 Core CPI does not include food and oil a Because these prices are so volatile 5 CPI change estimated for 2015 is 1 1 ii change Real income change Nominal Income change CPI 1 With a 2 salary increase and a inflation forecast a Changing nominal to real by subtracting out inflation 2 Headline inflatione 1 1 a Superscript e means it is and expectation and not actual 3 change real incomee a 2 2 1 1 9 4 You are better off because the percentage change in your income is higher than the rate of inflation a Your purchasing power has increased c EXAMPLE You received a 2 salary increase What if inflation in 2015 actual turns out to be 4 Are you still better off i change Real Change Nominal Change CPI 1 2 2 4 ii Your standard of living has decreased iii When inflation is unanticipated it is the worst 1 Percentage change income was actually less than percentage change in inflation 2 Adjustable rate mortgages are used to count for unanticipated inflation so no one ends up getting an unexpected lesser end of the deal a As inflation rises so does your rate on the mortgage VII Inflation and Americans on Fixed Income a Suppose you are retired and your annual retirement benefits are 30 000 and inflation is 4 b change Real change nominal income Change CPI i In this example with a fixed income your change in nominal income is 0 1 4 0 4 2 Your purchasing power will decline VIII Summary a Inflation shrinks income as inflation rises real income falls b Real income Nominal income CPI 100 c Change real income nominal income change CPI d Inflation hurts the most when it is unanticipated i Happened especially in the 1970 s 1 Caught everyone by surprise even the forecasters IX Inflation and Interest Rates a The interest rate is the i Cost of borrowing and the return to lending 1 When you lend you are essentially lending to the government if you buy a US government bond b Real versus nominal interest rates i Nominal Interest Rate i the stated interest rate on a loan saving account certificate of deposit CD 1 It is observable 2 i r inflation a If you don t known what inflation is going to be then i i r inflatione ii Do not put a little e of the i ii Real interest rate r 1 Is NOT observable a Real interest rate is just solving for r in the equation i i r inflaton