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THE CHANGE IN PRICES OVER TIME Inflation and Deflation

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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)

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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.

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

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

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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)

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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

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

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

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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

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

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

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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?

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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?

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

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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 = _____?_____

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

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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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