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THE CHANGE IN PRICES OVER TIME Inflation and Deflation.

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1 THE CHANGE IN PRICES OVER TIME Inflation and Deflation

2 The Big Mac Index : A market basket with only a Big Mac in it. Mmm…? It’s based on the average price of a Big Mac in America: $4.20 When I lived in Egypt I could get a Big Mac for about $2. …but of course there were much more delicious things to eat. Source: The Economist (2012)

3 Purchasing Power Parity (PPP) How far does your dollar go? When we talk about inflation, PPP refers to changes in how far your dollar goes over time.

4 Remember our lost $20 bill? Why is this a terrible investment plan?

5 Prices change over time, and that’s okay. You will probably make more than your grandparents did, but does your dollar go farther?

6 Prices change over time, and that’s okay. You will probably make more than your grandparents did, but does your dollar go farther? Real Wage = Wage Rate ÷ Price Level  (Remember that price level is the average price of all goods and services in an economy)

7 Prices change over time, and that’s okay. You will probably make more than your grandparents did, but does your dollar go farther? Real Wage = Wage Rate ÷ Price Level  (Remember that price level is the average price of all goods and services in an economy) Real Income = Income ÷ Price Level

8 Inflation Rate Calculation, Again Price index in year 2 – price index in year 1 *100 Price index in year 1

9 The Costs of Inflation Shoe Leather Costs Menu Costs Unit-of-Account Costs

10 Inflation and Interest Rates Nominal Interest Rate:  The interest rate in today’s dollars. (In Year ‘X’ dollars) Real Interest Rate:  Nominal Interest – Inflation Rate

11 Find the real interest rate. Nominal interest rate: 10% Inflation rate: 6% Real interest rate: ___?___

12 THINK ABOUT NOMINAL VS. REAL RATES. Does inflation hurt everyone?

13 Imagine. The year is You just took out a $10,000 five year loan at 10% interest. How much will you have to pay in 2012?

14 Fast forward to Good news! Over the past five years, the price level has risen at a rate of 7%! How much do you “really” have to pay on your $10,000 loan?

15 So, inflation is good for debtors. How does the bank feel at the end of the 5 years?

16 Winners and Losers from Inflation This happens because most loans (debts) are expressed in nominal interest rates. Inflation causes the “real” rate of interest to change. Winners = _____?______ Losers = _____?_____

17 So, who wins from deflation? Winners = _____?______ Losers = _____?_____

18 Inflation Target Policy makers try to keep inflation at about 3% It takes a recession to cure severe inflation.  That’s a massive opportunity cost.  U.S. in P. 81 Planet Money on the Brazilian Hyperinflation:


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