Econ 104 1st Edition Exam 2 Study Guide Lectures 10 17 Lecture 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 four a The CPI is a statistical estimate constructed using the prices of a sample of II III 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 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 increasing as fast as they were in some previous time period 1 The inflation rate is less than 0 but prices are still rising b 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 0 ii 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 Calculate CPI i CPI Cost of Basket in Current Year Cost of Basket in Base Year X 100 Lecture 11 How 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 CPI i New CPI Old CPI Old CPI X 100 Inflation Rate 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 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 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 More Consequences of Inflation i change Real income change Nominal Income change CPI ii 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 VI 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 VII 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 Lecture 12 Who does better a borrower or a lender What are the parts of a business cycle I II III The interest rate is the a Cost of borrowing and the return to lending Real vs Nominal a Nominal interest rate i the stated interest rate on a loan saving account certicifate of deposit CD i Is observable b Real interest Rate i Is not obersavable c Expected interest rate i r expected inflation Unanticipated inflation is it better for the borrower or the saver a Borrower IV V Summary a Interest rate shrinks income as interest rises real income falls i Inflation hurts when it is unexpected b Base year CPI is always 100 c Nominal interest rates can never be negative d Real interest rates can be positive or negative i Negative when inflation is rising e When r 0 lenders and savers both lose i Interest earnings do not keep up with inflation f When r 0 borrowers win i They pay back less than real terms g Conclude i r 0 1 You are more likely to spend ii r 0 1 You are more likely to save Business Cycle a Alternating periods of economic growth and contraction which can be measured in changes in real GDP b Has four cycles i Expansion 1 Production employment and income are increasing Spending by firms and households increases ii Peak 1 the expansion ends iii Recession 1 Production employment and income are decreasing Spending by firms and households decreases iv Trough 1 The recession ends c One Cycle Peak to peak Lecture 13 Procyclical Countercyclical Acyclical Lagging Coincident Leading I NBER National Bureau of Economic Research a A business cycle dating committee announces when recessions begin when they end b Takes time to gather and analyze economic date i 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 recession i 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 output II Challenges confronting policy makers and businesses in forecasting the business cycle a No two business cycles are alike the vary in length and depth b Real GDP comes out only quarterly at the end of the first month after the quarter ends III Business Cycle Indicators a Policymakers and businesses rely on business cycle indicators i Are released more frequently than real GDP daily or monthly ii Lead lag or are coincident indicators of the real GDP cycle iii Still predicting recessions and inflationary booms is difficult b Also have cycles but they may differ in timing and direction i Direction An economic variable can be 1