ECON 201 1st Edition Lecture 24Outline of Last 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 rateOutline of Current Lecture I. Example Problem: Real and Nominal Interest RatesII. Three Problems with the CPIa. Substitution biasb. Introduction of new goodsc. Unmeasured quality changeIII. Building Inflation into the SystemIV. The Costs of Inflationa. Definition of inflation fallacyV. Hyperinflationa. Definition of hyperinflationCurrent LectureI. Example Problem: Real and Nominal Interest RatesThis problem was the first clicker question from class today. If you deposit $1,000 for one year and the nominal interest rate is 9% and the inflation rate is 3.5%, what is the real interest rate?The real interest rate is the nominal interest rate minus the inflation rate. Here, the real interest rate is 9% - 3.5% = 5.5%. This means that the purchasing power of the $1,000 deposit has grown5.5%, or $55. If we could predict the inflation rate in a market, we could probably avoid negativereal interest rates. II. ThreeProblems with the CPIThere are multiple problems with the CPI, and the first of these have to do with the problems in measuring the cost of living. The first problem is substitution bias. There are a lot of items in thebasket, and everyday people change their minds when purchasing goods. For a lot of things, youknow the value of the substitute (the same or similar good at a lower price). However, the basket never changes, so when you substitute you are technically avoiding inflation. This means 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.that the basket is not entirely accurate about how much inflation a person absorbs. The second problem is introduction of new goods. Once again, the basket never changes. New goods then do not make it into the basket. Another problem is unmeasured quality change. Because products are constantly improving, the price increases; if you really purchase a new product, this does not count as inflation. Yet again, because it is always in the basket it never changes. These problems overstate inflation. The balance sheet does make adjustments, but the CPI still likely overstates inflation by about 0.5% per year. They do update the basket from time to time, as they try to maintain it and serve everyone. They are as consistent as they can be, but ideally the best we can do is try to figure out how to keep it the same over time. III.Building Inflation into the SystemBy using social security and COLAs, we are building inflation into the system. In the past, prices would roller coaster but overall stay fairly constant. In the last half of the 20th century though, we saw a definite increase in overall prices. IV. The Costs of InflationThe inflation fallacy is the belief that inflation erodes the consumers’ purchasing power. This is false because the bigger cost of inflation is that it erodes real incomes. Inflation itself is a general increase in the prices of things people buy and sell (such as their labor). Inflation causes nominal wage and CPI to parallel each other. However, there are still costs of inflation. Menu costs is best demonstrated by using the example of a restaurant. When you have anything you have to change in a restaurant, you have to reprint all the menus. This is a “menu” cost, i.e. reprinting and republishing literature with changes. Another cost of inflation is the misallocationof resources from relative-price variability, in that all prices rise at the same time (also known as“blurred price signals”). Confusion and inconvenience is a cost of inflation because inflation changes the “yardstick” which complicates long-range planning and the comparison of dollar amounts over time. Finally, tax distortion is a cost of inflation although it has a big caveat: everything is worse when there is unexpected inflation. To the extent that you can predict it, youcan plan for it and build it in. But when you have unexpected inflation, then there are disastrousconsequences. In the 70s, many savings and loans were destroyed because inflation was many times more than it was predicted to be. V. HyperinflationHyperinflation is generally defined as inflation exceeding 50% per month. This is because prices rise when the government prints too much money. This happened to Germany after WWII; too much money was printed, chasing too few goods. Excessive growth in the money supply always causes hyperinflation. After WWI, other countries pinned all the prices and costs for reparationson war-torn areas on the losing countries. The countries couldn’t pay for it. The result was inflation. Currency bottomed completely out, and we had wanton, horrible inflation. They kept printing money to pay, so the economy fell apart and lost productivity all because they had too much money. Ultimately, this set the stage for Hitler as he helped rebuild the economy. At the end of WWII, the winners paid for the rebuilding of Europe. This happened in Zimbabwe as well;large government budget deficits led to the creation of large quantities of money and high inflation