Principles of Macroeconomics Chapter 7 The Price Level and Inflation Vocabulary 1 Deflation a decrease in the price level from one period to the next 2 Inflation Rate the percentage change in the price level from one period to the next 3 Real Interest Rate the annual percent increase in a lender s purchasing power 4 Nominal Interest Rate the annual percent increase in a lender s dollars from 5 GDP Price Index an index of the price level for all final goods and services from making a loan making a loan included in GDP 6 Consumer Price Index CPI an index of the cost through time of a market 7 basket of goods purchased by a typical household Indexed Payment a payment that is periodically adjusted in proportion with a price index 8 Price Level the average level of prices in the economy 9 Index a series of numbers used to track a variable s rise or fall over time When the price level rises the value of the dollar its purchasing power falls Introduction Measuring the Price Level and Inflation Index Numbers in General Most measures of the price level are reported in the form of an index a series of numbers each one representing a different period Index Calculation 100 x Value of measure in current period Value of measure in base period o An index will always equal 100 in the base period Index numbers compress and simplify information so that we can see how things are changing at a glance The Consumer Price Index Introduction Price Index CPI Which Items to Include CPI includes The widely used measure of the price level in the United States is the Consumer o Designed to track the prices paid by the typical consumer reported by the Bureau of Labor Statistics BLS o Consumer purchases as final users restaurant meals haircuts o Household purchases of used goods used cards used computers Not part of GDP o Household purchases of imports from other countries French cheese Japanese cars Not part of GDP o Price of housing services rent CPI does not include o Goods and services purchased by anyone other than consumers purchases by businesses government agencies other countries exports o Assets stocks bonds homes How Much Weight for Each Item The CPI s approach is to track the cost of the CPI market basket the collection of goods and services that the typical consumer buys o If the price basket rises by 10 then the price level will rise by the same amount o To determine the CPI market basket the BLS surveys thousands of families every couple of years and records their spending in detail Each good and service in the basket is weighted according to its relative importance in the average family s budget Housing and transportation hold the highest percentages Tracking and Reporting the Price Level CPI 100 x Cost of market basket in current period Cost of market basket in July 1983 o Shows us the changing cost of a basket of goods o Periods before July 1983 100 o July 1983 100 o Periods after July 1983 11 From Price Index to Inflation Rate CPI measure of the price level in the economy o Reported each month seasonally adjusted along with the growth rate rate of inflation Inflation rate measures how fast the price level is changing o More specifically it tells us the percentage change in the price level from one period to the next o Inflation CPI 2 CPI 1 CPI 1 o The annual inflation rate is reported as the percentage change in that month s CPI from its value one year earlier o When the price level rises the inflation rate will be positive When the price level falls we have negative inflation which is called deflation How the CPI is Used o As a Policy Target o To Index Payments o An indexed payment is one that is periodically adjusted so that it rises and falls by the same percentage as a price index o Indexing a payment makes up for any loss of purchasing power causes by inflation o To Translate from Nominal to Real Values o Nominal variables measured in the number of dollars o Real variables adjusted for the change in the dollar s purchasing power Real Variables and Adjustment for Inflation o By focusing on real wage the purchasing power of your wage and not on the nominal wage the number of dollars you earn we can tell what happens to purchasing power o Real wage in any year 100 x Nominal wage in that year CPI in that year Important Provisos about Real Earnings o Why Real Earnings are underestimated o 1 Nonwage benefits employer contributions to retirement accounts and health insurance are not included in the earnings If they were earnings would have risen by more o 2 Changes in the CPI overestimate inflation o When comparing dollar values over time we care not about the number of dollars but about their purchasing power Thus we translate nominal values into real values using the formula o Real value 100 x Nominal value Price Index Real GDP and the GDP Price Index o The BEA calculates real GDP directly by choosing a base year currently 2005 and valuing the quantities of each good produced at the prices it would sell for in the base year The BEA also reports separately a price index called the GDP price index that helps economists track the average price of goods and services included in GDP o CPI vs GDP Price Index o GDP Price index includes some prices that the CPI ignores CPI tracks only the prices of foods bought by American consumers GDP price index includes the prices of goods purchased by the government investment goods purchased by businesses and exports o GDP price index excludes some prices that are part of the CPI GDP price index leaves out used goods and imports CPI includes both used goods and imports as long as its purchased by consumers o The GDP price index measures the prices of all goods and services that are included in U S GDP while CPI measures the prices of all goods and services bought by U S households The Costs of Inflation The Inflation Myth o Myth Inflation erodes the purchasing power of our incomes o Wrong Inflation redistributes purchasing power from buyers to sellers but it does not directly decrease the average real income in the economy o An Example Purchasing Power and Inflation in the 1970s o During the late 1970s the typical American worker saw their real incomes decline What was the cause Dramatic rise in the price of imported oil 3 34 Inflation mechanism The Redistributive Cost of Inflation o How does inflation sometimes redistribute real income An increase in the price level reduces the purchasing power of any payment that is specified in nominal terms o Sellers
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