Lecture Outline – InflationA. Defining and Measuring Inflation1. What is inflation?a. situation in which the economy;s average price level is rising2. What is the inflation rate? How is the inflation rate calculated? a. % change in the price level from the previous periodb. Inflation = p2- p1/ p1 x 100c. What has been the average inflation rate in the US since 1950? 1. 3.7%d. What was the average inflation rate in the US between 2000 and 2010?1. 2.5%e. Has the inflation rate in the US been relatively stable since 1950?1. No it varies and goes up and downf. What is hyperinflation? Which countries have experienced hyperin-flation?1. Extremely high rates of inflation3. Inflation is measured from an index. What is an index?a.4. There are 3 different price indexes. What are they and how do they differ?5. Consumer Price Index, GDP deflator, Producer Price Indexa. Consumer price index: measure of overall cost of the goods and services bought by a typical consumer. Used to moni-tor change in the cost of living over time1. Fix the “basket” The bureau of Labor Statistics (BLS) sur-veys consumers to determine that’s in the typical con-sumer’s ‘shopping basket’2. Find the prices. The BLS collects data on the prices of all the goods in the basket3. Compute the basket’s cost. Use the prices to compute thetotal cost of the basket14. chose a bas year and compute the index5. 100 x cost of basket in current year/ cost in base year6. Compute inflation rate: Inflation rate = CPI this year - CPI last year/ CPI last year x 100%6. Why is it difficult to measure the CPI accurately? By roughly how muchis the CPI overstated annually?a. When CPI rises, the family has to spend more money to maintain the same standard of livingb. Included in CPI: housing, transportation, food and bever-ages, education and communication, medical care, recreation, apparel, other goods and services c. Substitution Bias: over time some prices rise faster than others and consumers will substitute towards goods that will be-come relatively cheaper. CPI does not account for this. CPI over-states the cost of livingd. Introduction of new goods offers more choices which makes each dollar more valuable.e. Many product prices decrease in the years after they are introduced. Price decreases are not included in CPIf. Unmeasured Quality change/ Improvements in the quality of goods in the basket increase the value of each dollar. Paying more for the same good.g. CPI overstates the cost of living by .5-1% per yearh. Important because the Social Security payments will in-crease at the same rate as the inflation rate. SS are higher than they need to be. People to receive SS are generally Senior Citi-zens. They have a different basket because they spend so much on medical care and little on educationi. GDP deflator is a measure of the overall level of prices1. GDP deflator = nominal GDP/real GDP x 1002. Imported consumer goods: included in CPI. Excluded from GDP deflator3. Capital goods: excluded from CPI. Indcluded in GDP defla-tor if they are produced domestically24. The basket: CPI uses fixed basket. GDP uses basket of cur-rently produced goods & services. Matters is different prices are changing by different amounts.5. They each measure differnt thingsProducer Price Index (PPI): The average price received by producersIncludes intermediate goods as well as final goodsPPI’s exist for different industries.7. What is a “real price?” a. Price of a good that has been corrected for inflation.b. Why do we care about real prices?1. Real prices allow us to compare prices over time2. Give an idea of how our purchasing power changes over timec. Explain how to convert a nominal price into a real price (see the ap-pendix for chapter 29).1. Price level in 2005/ price level in 19312. Take old price and multiply by current year’s cpi. Then di-vide by current CPI3. After correcting for inflation, gas was more expensive in 1981.B. The Quantity Theory of Money1. What is quantity theory of money (i.e. quantity equation)? a. Explain what each side of the quantity equation represents.b. What does each piece of the quantity equation represent?2. List at least 3 things that affect the velocity of money.3. Under the assumption that real GDP is fixed by the real factors of pro-duction and the velocity of money is stable, what causes inflation? a. Use the quantity equation to explain the cause of inflation.b. What are the “real factors of production?”4. Rewrite the quantity equation in terms of growth rates.a. What is the relationship between the growth rate of the money sup-ply and the inflation rate? Use the quantity equation to explain your answer. 3b. What assumptions are being made to show the relationship be-tween the growth rate of the money supply and the inflation rate? Are these assumptions realistic?c. Is there evidence to support the relationship between the level of the money supply and the price level?d. Is there evidence to support the relationship between the growth rate of the money supply and the inflation rate?e. What does it mean when we say that “inflation is always and every-where a monetary phenomenon?”5. Explain how each of the following will affect the price level? a. All else equal, an increase in the velocity of money.b. All else equal, a decrease in the velocity of money.c. All else equal, an increase in real GDP.d. All else equal, a decrease in real GDP.6. What is deflation? What is disinflation?7. What does this mean? “In the long run, money is neutral.”8. Explain why money is “not neutral” in the short run.a. Why does an increase in the money supply temporarily increase real GDP?b. Why does a decrease in the money supply temporarily decrease real GDP?c. What is a real wage?C. The Costs of Inflation1. What is price confusion and money illusion? Give an example of eacha. How does the economy respond when prices are difficult to inter-pret?b. What happens to the allocation of resources when prices are diffi-cult to interpret?2. Explain why inflation acts as a tax.3. What is the difference between a nominal return (i.e. nominal interest rate) and a real return (i.e. real interest rate)?a. How does inflation affect the real return that lender’s receive?b. How does inflation affect the real return that borrower’s pay?4c. Explain why an unexpected increase in the inflation rate transfers wealth from lenders to borrowers.d. Explain why an unexpected decrease in the inflation rate