- Inflation = the sustained general rise in the price levelo (Deflation = the sustained general fall in the price level)o Nominal vs. real Nominal: price tag, current dollars, paycheck amount Real: constant dollars, adjusted for inflationo General observations Frequently you hear people worrying about inflation and how it erodes (lessens)the purchasing power of the consumer- There are 3 possibilities:o Inflation reduces the real wage (this one seems the most logical)o Inflation doesn’t change the real wageo Inflation increases the real wage- E.g. your nominal income is $40,000/year, and projected inflation is 10%o If your nominal income increases by less than 10%, you are worse offo If your nominal income increases by 10%, you stay the sameo If your nominal income increases by more than 10%, your purchasing power increases Unanticipated inflation creates winners and losers: it is distributive- E.g. you have a fixed rate loan. If inflation occurs the buyer is better off because $1,000/month (for example) is worth less (has less purchasing power)o Unanticipated inflation creates winners and losers it is redistributive E.g. If you can anticipate construction on the route you drive to work, you can adjust your schedule so you can get to work on timeVs. If you can’t anticipate traffic on your way to work, there may still be some, and you may be late to work E.g. If you sign a contract with someone to lend them money and you can anticipate the inflation rate, both you and the borrower will be satisfied.Vs. if the inflation rate is much higher than anticipated, the borrower is better off (because the money they’re giving the lender has less purchasing power thanexpected)- Measuring Price level & inflationo We use an index An index is a series of numbers used to track a variable’s rise or fall over time Index # = (value of measure in CY/value of measure in BY)*(scale factor)- CY = current year- BY = base year- The scale factor is usually 1 or 100 *The index number of the base year is always equal to the scale factor E.g. Year Value Index #, BY = Yr 1 Index #, BY = Yr 41 80 (80/80)*100 = 100 (80/140)*100 = 57.142 100 (100/80)*100 = 125 (100/140)*100 = 71.433 120 (120/80)*100 = 150 (120/140)*100 = 85.714 140 (140/80)*100 = 175 (140/140)*100 = 100- *BY choice affects index numbers- *BY index number always = the scale factor (using the same information as above):Year Annual % rate of change, BY = Yr 1 Annual % rate of change, BY = Yr 41 -- --2 [(125-100)/100]*100% = 25% [(71.43-57.14)/57.14]*100% = 25%3 [(150-125)/125]*100% = 20% [(85.71-71.43)/71.43]*100% = 20%4 [(175-150)/150]*100% = 16.67% [(100-85.71)/85.71]*100% = 16.67%- *% rate of change does NOT depend on the choice of BYo CPI is the consumer price index; it measures the cost of goods bought by the typical consumero To calculate CPI: Fix the basket (fix the quantities of items that will be priced). The goal is to measure what’s happening to overall prices- (vs. GDP, which measured production. For real GDP prices were held constant.) Find the prices of each good in the basket at each point in time Compute the basket’s cost (Qs = fixed, Ps vary) Choose the BY & compute the index- The index number (CPI) for year n =[price of basket in year n/price of basket in BY]*scale factor Use the index number to compute the inflation rate- Inflation rate in year n = [(CPIYr n – CPIYr n-1)/ CPIYr n-1]*100% - (This is simply the % change formula: [(new – old)/old]*100%)o E.g. Basket: 3 watches, 2 pens, 1 hamburger Data: Year Price of watches Price of pens Price of hamburger1 $20 $2 $52 $20 $3 $63 $25 $3 $74 $30 $4 $8 Basket’s cost: Year Cost of Basket1 3($20)+ 2($2) + 1($5) = $692 3($20)+ 2($3) + 1($6) = $723 3($25)+ 2($3) + 1($7) = $884 3($30)+ 2($4) + 1($8) = $106 CPI:Year CPI, BY = Yr 1 CPI, BY = Yr 41 (69/69)*100 = 100 (69/106)*100 = 65.092 (72/69)*100 = 104.35 (72/106)*100 = 67.923 (88/69)*100 = 127.54 (88/106)*100 = 83.024 (106/69)*100 = 153.62 (106/106)*100 = 100 Use CPI to compute inflation rate from the previous yearYear Rate of inflation (using CPI w/BY = Yr 1)1 --2 [(104.35 – 100)/100]*100% = 4.35%3 [(127.54 – 104.35)/104.35]*100% = 22.22%4 [(153.62 – 127.54)/127.54]*100% = 20.45%- The rate of inflation is the same using CPI w/BY = Yr 4o Issues with CPI Substitution bias- CPI doesn’t allow for substitution; you use the exact same products when calculating CPI (even though consumers often substitute items when the things they usually buy are expensive)- This leads to an overstatement of inflation (because in reality the basketyou consume costs less than what the CPI says) Innovation over time- It’s hard for CPI to adjust for innovation- As innovation occurs the dollar has more purchasing power (e.g. computers cost a lot more when they first became popular than they donow, because innovation has increased over time)- Costs of inflationo Shoe-leather costs You “wear out your shoes” spending time hunting for deals You want to buy items now because the value of the dollar is being eroded, so you have more purchasing power nowo Menu costs You must constantly “update the menu at your restaurant” because prices become dated and must increase as inflation occurs It is “expensive to reprint the menu” (re-pricing items costs time and effort)o Unit of account costs Because inflation causes prices to rise, the dollar becomes a less reliable unit of measuremento E.g. Joe loans Helen $100 due at the end of the year. Joe charges 10% interest on the loan for the year. Suppose inflation is 10%. How much will Helen pay Joe at the end of the year?- Total payment = amount borrowed + interest on the loan = $100 + 0.1*($100) = principle amount + interest = $100*(1 + 0.1) = $110 What is the purchasing power of this nominal payment using the base year’s dollars?- Real value = [(nominal value)/(price index)]*(scale factor) = [$110/1.1]*1 = $100 (price index accounts for 10% interest)- Fisher Equation: Real interest rate = nominal interest rate – expected inflation rate( = 10% - 10% = 0 )o The nominal interest rate must be larger than the expected inflation rate for the real interest rate to be positive Suppose Joe wants the real interest rate to be 10%, what will the nominal interest rate be?- Using fisher equation: 10% = nominal interest rate – 10%Nominal
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