ECON 201 1st Edition Lecture 23Outline of Last Lecture I. Understanding Appreciation and DepreciationII. Leveragea. Definition of capital requirementb. Definition of credit crunchIII. Analyzing a Real-World Economic ProblemIV. Consumer Price Indexa. Definition of consumer price indexb. Definition of inflation rateV. Example Problem: CPI and Inflation RateOutline of Current Lecture I. Note about the LectureII. Indexationa. Definition of indexationIII. Comparing Prices over TimeIV. Real vs. Nominal Interest Ratesa. Definition of nominal interest rateb. Definition of real interest rateCurrent LectureI. Note about the LectureA large part of this lecture was spent completing clicker questions over the course material we have studied so far; the remaining notes are very brief. II. IndexationThere are three main uses of the CPI: indexation, comparing prices over time, and comparing real and nominal interest rates. Indexation is when a price, wage, or interest rate is automatically adjusted for inflation by law or contract. An example of this is the COLA (cost of living allowances and adjustments) in many multi-year labor contracts. Another example is the adjustment in social security payments and federal income tax brackets. Because these brackets are set, if the income continues increasing due to inflation and exceeds the tax bracket then a larger amount of money will be taken out of the person’s income, known as a bracket creep. This is why it is important to monitor inflation using the CPI.III. Comparing Prices over TimeThese 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.Another use of the CPI is comparing prices over time. The CPI can adjust figures so that they canbe compared. For example, if you find the CPI of two different years – say 1960 and 2010 – and want to compare the cost of a good from 2010 in 1960 dollars, you can do so by using the following formula. Amount ∈today's dollars= Amount∈ year T dollars ×Pricelevel todayPrice level∈ year TThis can be re-written for clarification by using “P1” and “P2” as substitutes. “P1” represents theyear that you want to convert the amount to, while “P2” represents the year that the amount is in. In the example above, 1960 is the year you want to convert the amount to (P1) while 2010 is the year the amount it is. This formula is shown below.$ (P 1)=$ (P 2)×CPI of P 1CPI of P 2Look at the following example problem. The price of a gallon of regular unleaded gas was $1.42 in March of 1981 and $2.50 in August of 2005. The CPI in 1982 was 88.5; the CPI in 2005 was 196.4. What is the cost of the gas from 1981 in 2005 dollars? First, identify the years as either PIor P2. PI is the year you want to convert the amount to – 2005. P2 is the year that the money is in – 1981. Now, plug in the values in the equation above. $(P 1)=$(P 2)×CPI of P 1CPI of P 2$ (P 1)=$ 1.42 ×196.488.5$ (P 1)=$ 3.15So, the price of the gas in 1981 is equal to approximately $3.15 in 2005 dollars.IV. Real vs. Nominal Interest RatesThe third and final use of CPI is that of real and nominal interest rates. The nominal interest rate is the interest rate not corrected for inflation. It is the rate of growth in the dollar (face) value of a deposit or debt. The real interest rate is corrected for inflation, and is the rate of growth in the purchasing power of a deposit or debt. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate.Realinterest rate=nominalinterest rate−inflation
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