1. MBMC Measuring the Price Level and Inflation

2. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 2 Introduction What Do You Think? Could you retire in thirty years if you have $1 million at that point?

3. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 3 The Consumer Price Index: Measuring the Price Level Consumer Price Index (CPI) For any period, CPI measures the cost in that period of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed benchmark year, called the base year

4. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 4 The Consumer Price Index: Measuring the Price Level Constructing the CPI CPI for current year = 100 x current cost of the base-year basket -------------------------------------------------------. base-year cost of the base-year basket The CPI is a price index.

5. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 5 Cost of Reproducing the 1995 (Base-Year) Basket of Goods and Services in Year 2000 Item Cost in 1995 Rent, two-bedroom apartment$630$500 60 Hamburgers150120 10 Movie tickets 7060 Total expenditure$850$680 Cost in 2000 Expenditures of a Hypothetical Household CPI for 2000 = 100x($850/$680) = 125 CPI for 1995 = 100x($680/$680) = 100 Living cost rose by 25% from 1995 to 2000.

6. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 6 Inflation CPI Measures the average level of prices relative to prices in the base year Inflation Measures how fast the average price level is changing over time Inflation Rate Is the percentage change in the price level

7. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 7 Calculating Inflation Rates: 1972 - 1976 YearCPI 19720.418 19730.444 19740.493 19750.538 19760.569

8. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 8 Calculating Inflation Rates: 1929 - 1933 YearCPI 19290.171 19300.167 19310.152 19320.137 19330.130

9. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 9 Inflation Deflation A situation in which the prices of most goods and services are falling over time so that inflation rate is negative

10. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 10 Adjusting for Inflation Deflating a Nominal Quantity Nominal Quantity  A quantity that is measured in terms of its current dollar value Real Quantity  A quantity that is measured in physical terms -- for example, in terms of quantities of goods and services

11. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 11 Adjusting for Inflation Deflating a Nominal Quantity A process of dividing a nominal quantity by a price index (such as the CPI) to express the quantity in real terms

12. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 12 Comparing the Real Values of a Family’s Income in 1995 and 2000 Year Real family income = Nominal family income/CPI 1995$20,0001.00$20,000/1.00 = $20,000 2000$22,0001.25$22,000/1.25 = $17,600 Nominal family income CPI What deflating does here is to transform the $22,000 nominal income of year 2000 into a real quantity that is comparable to year 1995’s income $20,000. The last column of the table above shows that in real terms, the family’s income dropped by 12%, though in nominal terms, it went up by 10%.

13. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 13 Adjusting for Inflation Example: Home run hitters drive Cadillacs  1930 Babe Ruth’s salary was $80,000  1998 Mark McGwire’s salary was $8.3 million Who was earning more?  CPI (1982 - 84 = 1.00) o1930 = 0.167 o1998 = 1.64 oBabe Ruth’s real salary = $80,000/0.167 = $479,000 oMark McGwire’s real salary = $8.3 million/1.64 = $5.06 million

14. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 14 Adjusting for Inflation Real Wage The wage paid to workers measured in terms of real purchasing power The real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period

15. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 15 Adjusting for Inflation Real Wages of U.S. Production Workers Nominal WagesCPI (1982 - 84 = 1.00)Real Wage 1970$3.230.388$3.23/0.388 = $8.32 1990$10.011.307$10.01/1.307 = $7.66

16. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 16 Nominal and Real Wages for Production Workers’ 1960 - 2001

17. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 17 Adjusting for Inflation Indexing The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation

18. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 18 Adjusting for Inflation Indexing to Maintain Buying Power An example: Social Security PaymentInflation 2000$1,000/month2000 - 2005 = 20% 2005$????/month if indexed to inflation

19. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 19 Adjusting for Inflation Economic Naturalist Every few years there is a well-publicized battle in Congress over whether the minimum wage should be raised. Why do these heated debates recur so regularly?

20. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 20 Does the CPI Measure “True” Inflation? 1996 report by the Boskin Commission estimated that the CPI overstates inflation by as much as 1 to 2 percentage points a year. Overstating Inflation Would unnecessarily increase government spending Underestimate the improvements in the standard of living

21. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 21 Does the CPI Measure “True” Inflation? Two Causes of the CPI Overestimation of Inflation Quality adjustment bias Substitution bias

22. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 22 Items (quantities) Expenditure by 1995 Prices by 2000 Prices Does the CPI Measure “True” Inflation? Coffee (50 cups) $1/cup = $50 $2/cup = $100 Tea (50 cups) $1/cup = $50 $1/cup = $50 Scones (100) $1each= $100 $1.50ea. = $150 Total $200 $300 Inflation 1995 ~ 2000 = $300/$200 – 1 = 50% Substitution Bias -- An Example A consumer likes coffee and tea equally well

23. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 23 Item (Yr. 2000 quantity w/substitution) Expenditure Does the CPI Measure “True” Inflation? Coffee (0 cups at $2/cup) $0.00 Tea (100 cups at $1/cup) $100.00 Scones (100 at $1.50 each) $150.00 Total $250.00  Inflation 1995 ~ 2000 w/substitution = $250/$200 –1 = 25% Substitution Bias -- An Example

24. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 24 Does the CPI Measure “True” Inflation? Economic Naturalist Why is inflation in the health care sector apparently high?

25. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 25 The Costs of Inflation: Not What You Think Price Level A measure of the overall level of prices at a particular point in time as measured by a price index such as the CPI Relative Price The price of a specific good or service in comparison to the prices of other goods and services

26. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 26 The Costs of Inflation: Not What You Think Observations Changes in relative price do not necessarily imply a significant amount of inflation. Inflation can be high without affecting relative prices.

27. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 27 The Costs of Inflation: Not What You Think Observations To counteract relative price changes, government policy would have to affect the market for specific goods. To counteract inflation, the government must use monetary and fiscal policy.

28. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 28 CPI% change in oil pricesInflationRelative price of oil 20001.20 20011.32 20021.40 The Costs of Inflation: Not What You Think The Price Level, Relative Prices, and Inflation 8% (2000 ~2001)10%-2% 8% (2001 ~ 2002)6%+2%

29. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 29 The True Costs of Inflation “Shoe-Leather” Costs The use of resources to economize on holding cash during periods of high inflation

30. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 30 The True Costs of Inflation Shoe-Leather Costs at Woodrow’s Hardware Need $5,000 cash/day May withdraw $25,000 on Monday or $5,000/day Cost of a withdraw = $4/trip

31. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 31 The True Costs of Inflation Shoe-Leather Costs at Woodrow’s Hardware When there is no inflation,  Withdraw $25,000 every Monday  Shoe-leather cost = $4/week or $200/year (if assuming 50 weeks/year)

32. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 32 The True Costs of Inflation Shoe-Leather Costs at Woodrow’s Hardware With 10% inflation per year,  If withdrawing $25,000 every Monday, oAverage cash holding/day = $15,000 oCost of holding cash = $15,000 x 10% = $1,500/year oShoe-leather cost = $200/year

33. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 33 The True Costs of Inflation Shoe-Leather Costs at Woodrow’s Hardware With 10% inflation a year,  If withdrawing $5,000 daily, instead of $25,000 every Monday oAverage cash holding/day = $5,000 oCost of holding cash = $5,000 x 10% = $500/year oShoe-leather cost = $4/trip x 250 trips (50 wks) = $1000/year Marginal Benefit of going daily = $1,000 saved on costing of holding cash Marginal Cost of going daily = $800 increase in shoe- leather cost So the choice is to bank daily, which increases the shoe- leather cost

34. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 34 The True Costs of Inflation “Noise” in the Price System With high inflation, producers have greater difficulty telling whether the changes in the prices of their goods or services are changes in relative prices or just a reflection of the general price inflation. As such, high inflation obscures the information transmitted by prices and reduces the efficiency of the market system

35. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 35 The True Costs of Inflation Distortions of the Tax System Inflation, Indexation, and ---  Bracket creep  Capital depreciation allowance

36. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 36 The True Costs of Inflation Observation Inflation may distort the incentives provided by the tax system for people to work, save, and invest and reduce economic growth.

37. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 37 The True Costs of Inflation Unexpected Redistribution of Wealth From workers to employers if wages are not indexed to inflation From lenders to borrowers

38. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 38 The True Costs of Inflation Interference with Long-Run Planning Retirement planning Investment and business strategies

39. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 39 Hyperinflation Cost of Hyperinflation Fischer, Sahay, and Vegh examined 133 market economies 1960 - 96  45 episodes of high inflation (100% +) in 25 countries oReal GDP/person fell by an average of 1.6%/yr oReal consumption/ person fell by an average of 1.3%/yr oReal investment/person fell by an average of 3.3%/yr

40. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 40 Inflation and Interest Rates Nominal (market) Interest Rate The annual percentage increase in the nominal value of a financial asset Real Interest Rate The annual percentage increase in the purchasing power of a financial asset. It equals the nominal interest rate on that asset minus the inflation rate.

41. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 41 Inflation and Interest Rates Inflation and the Real Interest Rate

42. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 42 Inflation and Interest Rates YearReal Interest = Nominal Interest - Inflation 19700.806.55.7 1975-3.35.89.1 1980-2.011.513.5 19853.97.53.6 19902.17.55.4 19952.75.52.8 20002.24.72.5

43. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 43 The Real Interest Rate in the United States, 1960 - 2001

44. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 44 Inflation and Interest Rates Fisher-Effect The tendency for nominal interest rates to be high when inflation is high and low when inflation is low

45. MBMC Chapter 6: Measuring the Price Level and Inflation Slide 45 Inflation and Interest Rates in the United States, 1960 - 2001