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PSU ECON 104 - Calculating CPI and income

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Econ 104 1st EditionLecture 11Outline of Last Lecture I. Consumer Price IndexII. Disinflation, Deflation, inflation III. How to calculate CPIOutline of Current Lecture I. Calculating inflation rateII. Purchasing powerIII. Consequences of inflation IV. Real vs Nominal IncomeV. Inflation interest ratesCurrent LectureI. Calculating Inflation Rate using CPIa. From previous example where 2012 CPI was 200 and 2011 Inflation Rate was 175i. (New CPI-Old CPI)/Old CPI X 100 = Inflation Rateii. (200-175)/175 X 100 = 14.28 %II. Consumer Price index derives from a survey of 14,000 households by the Bureau of Labor Statisticsa. 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 transportationIII. How does inflation affect purchasing power?a. As CPI increases, the amount of goods and services the dollar can buy decreasesi. 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 downb. Some workers receive a cost of living allowance (COLA) which automatically raises the wage when CPI risesc. First let’s look back: Babe Ruth’s Salary in 1932 = $80,000i. How much do you think his salary would be in 20141. How much would he have to make today to have the same purchasing power as he did in 19322. 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 Dataiii. CPI1932 = 12.9 CPI2014 = 236.71. Take the ratio of the (New CPI to Old CPI) a. 236.7/12.9 =18.35 b. Now multiply this number by $80,000i. $80,000 X 18.35 = $1,467,9072. Find the Inflation (π) from 1932 through 2014IV. Consequences of inflation a. Real IncomeyearX= (Nominal IncomeYearX/ CPI YearX/100)b. Nominal Income: income received in today’s dollarsc. Real income: income adjusted for changes in the CPI i. Shows increase in purchasing powerii. Also reflects increase in your standard of livingV. EXAMPLE: Suppose you made $40,000 in 2011 and you received a 10% salary increase in 2012Year Nominal Income ($) CPI Real Income2011 40,000 225 17,7772012 44,000 230 19,130a. Real income in 2011: (40,000)(225/100) = 17,777b. Real income in 2012: (44,000)(230,100) = 19,130c. 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 2015i. Find out if you are better off. Look up the inflation forecast for 20151. 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 oila. Because these prices are so volatile 5. CPI change estimated for 2015 is 1.1% ii. % change Real income = % change Nominal Income - %change CPI1. With a 2% salary increase and a inflation forecasta. 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 incomeea. 2.2% - 1.1% = .9% 4. You are better off because the percentage change in your income is higher than the rate of inflationa. Your purchasing power has increasedc. 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 CPI1. -2% = 2% - 4% ii. Your standard of living has decreased iii. When inflation is unanticipated it is the worst1. 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 is4%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 fallsb. Real income = (Nominal income)/ (CPI/100)c. %Change real income = %nominal income - %change CPId. Inflation hurts the most when it is unanticipated i. Happened especially in the 1970’s1. Caught everyone by surprise, even the forecastersIX. Inflation and Interest Rates a. The interest rate is the i. Cost of borrowing and the return to lending1. When you lend, you are essentially lending to the government if you buya US government bondb. Real versus nominal interest ratesi. Nominal Interest Rate (i) : the stated interest rate on a loan, saving account, certificate of deposit (CD)1. It is observable2. (i) = r + inflation a. If you don’t known what inflation is going to be then i. (i) = r + inflationeii. 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 +


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