1. The monetary system, prices, and inflation Outline 1.What is a monetary system? 2.Index numbers 3.The Consumer Price Index (CPI) 4.The CPI and the Inflation Rate 5.Adjusting the money (nominal) wage for inflation using the CPI 6.The Costs of Inflation 7.Is the CPI accurate? 8.Consequences of overstating inflation

2. The monetary system The monetary systems establishes two things: 1.The unit of value (or account) 2.The medium of exchange

3. In England, the pound is our unit of value. The price of bus fare, dry cleaning, soft drinks, and GDP is expressed in pounds.

4. In the U.S., the dollar serves as the unit of value and medium of exchange. If you want to by goods and services here, you need dollars. Recall that GDP in 1999 was 9.256 trillion dollars

5. This Note Is Legal Tender For All Debts, Public and Private Fiat Money: Anything which serves as a means of payment by government declaration You are willing to accept money not because it is “backed” by precious metals; but rather because you know it is generally acceptable in exchange

6. Index numbers An index is a series of numbers used to track a variable’s rise or fall over time. Index numbers are meaningful in a relative sense—by comparing one period’s index number with that of another period. In general, an index number is calculated as: Value of the measure in the current period Value of the measure in the base period  100

7. Example: Violent Acts on TV We select the year 1996 as our base year, or benchmark period. In that year, there were 10,433 violent acts on TV. Thus, our index for the current year would be calculated as follows Number of violent acts in the current year 10,433  100 If there were 14,534 acts in 2000, then: Thus, TV violence increased by 39.3 percent between 1996 and 2000.

8. Inflation is a sustained increase in the prices of goods and services (or the cost of living). To measure inflation, we look at changes in the price of a market basket of goods or services households typically purchase with their income Time prices

9. 4 We use the CPI to measure changes in the cost of living experienced by households. 4 The CPI is the “narrow” price index in that the market basket used to construct it includes items purchased by households. 4 Bureau of Labor Statistics economic assistants check the prices of 80,000 items in 30 metropolitan areas each month. 4 The inflation rate is simply the percentage change in the CPI from one period to the next.  1982-84 is the base period The Consumer Price Index (CPI)

10. The BLS now revises the market basket every 2 years

11. Source: www.bls.gov

13. On average, the prices of goods and services in the CPI market basket increased by 3.7 % from 1999 to 2000 To compute the 2000 inflation rate Inflation 2000 = [(CPI 2000  CPI 1999 ) –1]  100 Thus we have: Inflation 2000 = [(174.5  168.3) –1]  100 = 3.7 percent

15. Inflation in selected countries, May 1999 to May 2000 Source: The Economist

16. The inflation myth Inflation cannot by itself decrease average real income. Inflation can shift purchasing power from some groups to others

17. Inflation in not an equal opportunity villain. That is, inflation arbitrarily, and unfairly, redistributes real income

18. The race to stay ahead of inflation Inflation erodes the purchasing power of income and sets off a race to stay ahead of the cost of living. Teachers, fireman, truck drivers, nurses, accountants, plumbers, social security recipients, and others strive to increase their incomes so as not to suffer a decrease in their standard of living. Some groups do better than others.

19. Ave. Income of Seattle Transit Employees The question is: were we better off in 2000 in terms of real purchasing power?

20. Are Seattle transit employees any better off, at least based on these figures?

21. Why are we smiling? Because our social security benefits are indexed to the CPI Why doesn’t Congress index the minimum wage to the CPI?

22. Source: U.S. Department of Labor Value of the Federal Minimum Wage

23. Unexpected inflation redistributes real income from lenders to borrowers Repayments schedules for most debt contracts are fixed in nominal or money terms—that is, debts are not indexed to inflation. Inflation erodes the real value of repayments. Savings & Loan institutions lost money on long term mortgages in the70s and 80s.

24. We bought this house in 1957 for $19,000. We financed the house on a 30 year mortgage note at 3.5 percent interest. Can you guess what our monthly payment was? Answer: $85.32

26. The Boskin Commission reported to Congress in 1996 that the CPI over-estimated the actual inflation rate in recent years by an average of about 1.4%. Many economists challenge the Boskin findings; however, most agree that inflation is overstated by the CPI

27. Sources of bias in the CPI The substitution bias : People tend to substitute relatively cheaper items in place of those that have become relatively more expensive. Growth of discounting : People react to higher retail prices by shopping at the “big box” high volume discount retailers such as Wal-Mart and Home Depot. Also, internet shopping for airline tickets, hotels, and other items allows people to stretch their spending power. New Technologies : New items such as cellular phones, pagers, and PCs enter the CPI market basket with a lag. The prices of these items has fallen as their popularity has risen. Quality bias : For example, the CPI does not fully adjust for the fact car prices rise because of new features such as air bags and antilock brakes. Another example: the cost of hospitalization.

28. Changes in real income over time are not measured properly. Private contracts are distorted. Increase in government outlays

29. This table indicates the average real wage decreased by about 10 percent between ’75 and ’95. But if the CPI has an upward bias of 1.1 percent per year, then the real wage actually increased by 11 percent during this period Source: Department of Labor

30. We have a three-year contract with our hourly employees that is indexed to the CPI

31. Federal outlays indexed to the CPI include: Benefits of 44 million social security recipients Food stamps received by 22 million Benefits received by 4 million retired military personnel and civil servants (or surviving spouses).