Econ 104 1st EditionExam # 2 Study Guide Lectures: 10 - 17Lecture 10 What is CPI? Disinflation? Deflation? Inflation?I. Consumer Price Index: A measure of the average change over time in the prices of the goods and services purchased by the typical urban family of foura. The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.b. CPI differs from GDP because in CPI the price is the variable with the goods fixed constant while GDP has variable goods with price fixed constant. II. Disinflation vs deflation vs inflation a. Disinflation i. Disinflation is a convenient way of saying that the inflation rate is decelerating: prices are still going up over time, but they’re not increasingas fast as they were in some previous time period.1. The inflation rate is less than 0 but prices are still risingb. Deflation i. When prices deflate, not surprisingly, they drop continuously over time. c. Inflation i. Inflation is a pretty familiar phenomenon for most people; we’re used to seeing prices go up generally over time. 1. Inflation rate is greater than 0ii. People become uncertain about how much prices will go up in the future,and lenders must charge higher and higher rates of interest to preserve their after-inflation return. Inflation can be especially disruptive if the prices are increasing faster than wages. A small amount of inflation is usually perceived as acceptable if it’s not a big surprise.III. Calculate CPI:i. CPI = (Cost of Basket in Current Year)/ (Cost of Basket in Base Year) X 100Lecture 11How do you calculate inflation rate using CPI? How does this affect purchasing power? What is real income and nominal income? How do you find real interest rates?I. Calculating Inflation Rate using CPIi. (New CPI-Old CPI)/Old CPI X 100 = Inflation RateII. 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!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 risesIV. 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. More Consequences of Inflation i. % change Real income = % change Nominal Income - %change CPIii. 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 VI. Summary:a. Inflation shrinks income: as inflation rises, real income fallsb. Real income = (Nominal income)/ (CPI/100)c. %Change real income = %nominal income - %change CPIVII. 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 + inflaton Lecture 12Who does better, a borrower or a lender? What are the parts of a business cycle?I. The interest rate is the a. Cost of borrowing and the return to lending II. Real vs Nominala. Nominal: interest rate (i) the stated interest rate on a loan, saving account, certicifate of deposit (CD)i. Is observableb. Real interest Ratei. Is not obersavable c. Expected interest rate: (i) = r + expected inflation III. Unanticipated inflation: is it better for the borrower or the savera. BorrowerIV. Summary: a. Interest rate shrinks income: as interest rises, real income fallsi. Inflation hurts when it is unexpected b. Base year CPI is always 100c. Nominal interest rates can never be negatived. Real interest rates can be positive or negativei. Negative when inflation is risinge. When r<0 lenders and savers both losei. Interest earnings do not keep up with inflation f. When r<0 borrowers win!i. They pay back less than real terms g. Concludei. r<0 1. You are more likely to spend ii. r>01. You are more likely to saveV. Business Cyclea. Alternating periods of economic growth and contraction, which can be measuredin changes in real GDPb. Has four cycles i. Expansion1. Production, employment, and income are increasing Spending by firms and households increases. ii. Peak1. the expansion endsiii. Recession1. Production, employment, and income are decreasing. Spending byfirms and households decreases.iv. Trough1. The recession endsc. One Cycle: Peak to peak.Lecture 13Procyclical? Countercyclical? Acyclical? Lagging? Coincident? Leading?I. NBER (National Bureau of Economic Research)a. A business cycle dating committee announces when recessions begin & when they endb. Takes time to gather and analyze economic datei. Always wish you had more time or another model to compare it with!c. Economists try and get ahead of the curve to see if there is going to be a recessioni. If they see it coming, there is a very slim (close to 0%) that they will stop it, but they are able to lessen the decline, or try and create more outputII. Challenges confronting policy makers and businesses in forecasting the business cyclea. No two business cycles are alike: the vary in length and depthb. Real GDP comes out only quarterly at the end of the first month after the quarter ends III. Business Cycle Indicatorsa. Policymakers and businesses rely on business cycle indicatorsi. Are released more frequently than real GDP (daily or monthly)ii. Lead, lag or are