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UB ECO 181 - Chapter 6

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Chapter 6 – Measuring the cost of Living -InflationAfter 1940,U.S. inflation has been _________________ but before 1940 there was significant_________________.Inflation – measures the % change in the ___________________________ in the economy. measured by: _______________: measures cost of purchasing a given market basket in a given year relative to the base year. Cost of basket _______ x 100Formula: Price Index = Cost of basket Inflation rate from year 1 to year 2 = Inflation - If the inflation rate is > 0 then the ________ price of goods in the economy is ______. Deflation - If the inflation rate is <0, then the average price of goods in the economy is ________.Hyper inflation – If inflation rate is_______________Does inflation mean that the price of all goods is rising?Cost of _basket________ Price Index = Cost of basket _______ *1003 Price Indices: (have different ____________)1. ___________________________ - measures the average price of all goods ______________ in the economy.2. ________ Price Index- measures how inflation affects ____________.3. _________ Price Index - measures the change in the price ofa ____________________________________ . ___________ is a leading indicator – meaning that price changes will show up in this index first.Consumer Price Index (CPI) – Measures the price of a _________ of goods consumed bya “typical” ____________. measures the typical consumer’s _________ Used to compute cost of living adjustments (COLAs) in many contracts and in Social Security. Thus if the CPI increases 2.1% these contracts will increase payments___ Computing CPI and inflation rateStep 1. Compute the cost of the basket of goods from the given information for both the current year and the base year.Step 2. Compute the CPI for the necessary years.Step 3. Find the desired inflation rate by computing the percentage change in the CPI for the appropriate years.In class Example Basket is 100 gas, 200 pizzas and 100 soda.Base year is 2013P gas PpizzaPsoda2013 3.75 2.00 1.502014 2.75 2.50 2.00 2015 2.25 3.00 2.50 Cost of Basket in 2013Cost of Basket in 2014Cost of Basket in 2015CPI 2013CPI 2014CPI 2015Inflation 2013- 2014Inflation 2014-2015Problems in Measuring the Cost of Living- The CPI is not a perfect measure of the change in the _____________ because:1. Substitution Bias- When the price of one a good changes, consumers often respondby______________________________________.- The CPI does not allow for this substitution : it is calculated usinga __________ basket of goods and services- The basket has ______ of the expensive goods than are actually being consumed.- This implies that the CPI _______________the increase in the cost of living over time.II. Also does not always include:_____________III. Or allow for changes in __________ (although this has been improved recently)Thus although prices may be rising consumers can buy _____________ goods, buy __________ goods and get better ______________ goods. Thus the CPI is likely to _____________ the effects of inflation. This is important because Social Security payments and many contracts have COLAs tied to the ________. Thus the government is____________ recipients of government transfers.The times of highest inflation were: _____________________. The average inflation rate over the last 60 years is approximately _______.The _____________ is normally higher than the ___________.- CPI is used ________ frequently since it measures the affect of inflation on ________. - However, GDP has a _______ upward bias since the basket _________. Importance of the CPI (and other PIs)I. Allows us to compute________ rate.II. Allows us to compare Dollar Figures from ______________. Suppose we know that the current Federalminimum wage is 7.25 and that in 1964 it was $1.15. How can we compare the two figures?_______________Amount in 2015 $ = Amount in 1964$s *Purchasing power of the minimum wage in 1964 in todays $ = Thus the current minimum wage_____________________In General: _____________Amount in todays $ = Amount in year t $s *Private 4 year 1990 in 2013 prices =Public 4 year 1990 in 2013 prices=Public 2-year 1990 in 2013 prices=III. Correcting variables for inflation: a) ___________________- Can use the CPI to inflation values to ensure that payments allow people to maintain ___________________b) Converting Nominal variables into “Real Variables” – can use a price index to ___________ nominal values to _______ the effects of inflation.Real GDP = Real Wage = Real Interest Rate = Nominal interest is the __________ increase in savings or the ____________ cost of borrowing. ___________ for inflation.Real interest it the increase in the ______________ of your savings or the loss of ______________ when borrowing. _____________ for inflation.For example suppose you deposit 1,000 for 1 year. The bank pays you 4% and the inflation rate is 2%. In a year you will receive $_____ or ____% more money. (ie the nominal rate=____%. But goods will be _____% more expensive. So you will only be able to buy ________% more goods (ie the real rate = ____%)When borrowers and lenders make decisions, they make thembased on the ________________. Lenders prefer __________ real ratesBorrowers prefer ________ real ratesImportant points about the real and nominal interest rates:1. Nominal interest rate is usually _________ than the real interest rate due to __________.2. This does not hold during times of __________.3.The nominal interest rate cannot (normally) go lower than _______. 4.The real interest rate can be ______________ Example: If nominal interest= 3% and inflation= 5%Real interest = _____.Real Rates will be negative if inflation is _____________ than expected.For example suppose you deposit 1,000 for 1 year. The bank pays you 4% and you expect the inflation rate to be 2% while in reality it turns out to be 4%. Expected real return =Actual Real return = If actual inflation > expected, the real rate will be _______________.In this case borrowers pay a _________ than expected real interest, and thus ___________.While lenders receive a ____________ than expected real return and _______________. If alternatively, the inflation is lower than expected:Actual real return = Nominal - _____________.Actual return _________ Expected so ___________ Win and


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