- HW # 3 is due the Wednesday after spring break- Chapters 10 and 11 are due after break---------------------------------------------------------------------------------------------------------------------------------- Issues with CPIo 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 basket you consume costs less than what the CPI says)o Innovation over time It’s hard for CPI to adjust for innovation As innovation occurs the dollar has more purchasing power (e.g. computers costa lot more when they first became popular than they do now, 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 interest rate = 20%o GDP deflator vs. CPI Each is an index of price and they have similar values GDP deflator has fixed prices CPI has fixed quantities- Macroeconomic goals (3 basic ones)o Economic growth If the population is fixed, the standard of living will rise with economic growth (more GDP/capita) If the population is growing, there must be economic growth to at least maintain the standard of living, if not increase it The U.S. is about 10th in the world rankings for GDP/capita and is 3rd in economicgrowth rateo Full employment (we want everyone to be employed to fully utilize our resources)o Stable prices (low shoe-leather
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