1. The Price Level and Inflation CHAPTER 1 Chapter 6 - continued

2. Measuring Price Level and Inflation Price Level - average of the prices of all good and services in the economy Price Index – a measure of the price level 2

3. 3 of 25 Index in General Index - A series of numbers used to track a variable’s rise or fall over time An index number is calculated as: It’s the value of a measure in the current period relative to the base period

4. Example: Index Number for House Prices YearHouse PriceIndex of House Price 1$105,000100.00 2$110,000104.76 3$125,000119.05 4$135,000128.57 4 http://research.stlouisfed.org/fred2/series/SPCS20RSA Note: $110,000/$105,000 = 1.0476 $135,000/$105,000 = 1.2857 The convention is to multiply by 100. Which year is the base period?

5. The Consumer Price Index Consumer Price Index (CPI) – An index of the cost over time of a market basket of goods purchased by a typical household CPI includes – the part of GDP that consumers purchase as final users – household purchases of used goods such as used cars or used computers – household purchases of imports 5

6. The Consumer Price Index CPI does not include – Goods and services purchased by anyone other than consumers – Prices of assets, such as stocks, bonds, and homes CPI market basket – The collection of goods and services that the typical consumer buys 6

7. Broad Categories and Relative Importance in the CPI, December 2010 7

8. 8 of 25 (1)define a market basket (2) determine how much it would cost to purchase the market basket in the current year and in the base year (3) divide the dollar cost of purchasing the market basket in the current year by the dollar cost of purchasing the market basket in the base year (4) multiply the quotient by 100. Calculating the Consumer Price Index

9. 9

10. 10 Calculating the Consumer Price Index Market Basket using 2011 as the Base Year

11. 11 CPI in 2012 using 2011 as the based period

12. Consumer Price Index, December, selected years, 1970–2010 12 1983 = 100

13. Text Example: Results of Student Expenditure Survey, 1983 13

14. 14 Prices in 2013

15. 15 Cost of 1983 Student Bundle in 2013 Prices

16. Consumer price index Student price index (SPI) 16 2013

17. From Price Index to Inflation Rate Inflation rate – Percentage change in the price level from one period to the next Deflation – A decrease in the price level from one period to the next 17

18. Consumer Price Index, December, selected years, 1970–2010 18 YearRate of Inflation 2006 2007 2008 2009 2010

19. Consumer Price Index: 1940 - 2014 19

20. The Rate of Inflation Using the Consumer Price Index, 1950–2014 20

21. Three Ways the CPI Is Used (1) As a policy target; (2) To index payments; (3) To translate from nominal to real values (1) Policy target – One macroeconomic goal is stable prices (2) Index payments – A payment, such as Social Security retirement income, is periodically adjusted by the CPI.. 21

22. (3) Translate from Nominal to Real Values Nominal wage – Number of dollars you earn Real wage – Purchasing power of your wage 22 Three Way the CPI Is Used

23. Nominal and Real Weekly Earnings (December of Each Year) 23 http://www.bls.gov/news.release/wkyeng.t01.htm 2014 $796 236.2 $337

24. How the CPI Is Used When comparing dollar values over time – We care not about the number of dollars, but about their purchasing power – Translate nominal values into real values 24

25. The Costs of Inflation The inflation myth – “Inflation, by making goods and services more expensive, erodes the average purchasing power of income in the economy” Inflation does not directly decrease the average real income in the economy – because people’s income increase during inflations. Prices and income tend to rise together. Not really hurt. 25

26. The CPI and Average Hourly Earnings, 1965-2009 1965 = 100 Hourly wage in May 2009 dollars $0 $5 $10 $15 $20 0 100 200 300 400 500 600 700 800 900 1965197019751980198519901995200020052010 CPI (1965 = 100) Nominal average hourly earnings, (1965 = 100) Real average hourly earnings in 2009 dollars, right scale

27. The Costs of Inflation But, Inflation changes the distribution of income. – People living on fixed incomes are particularly hurt by inflation. – And the poor have not fared so well. Welfare benefits are relatively fixed and have not kept pace with inflation.

28. Benefits Indexed to Inflation To address the distribution problem, benefits received by many retired workers, including social security, are fully indexed to inflation. – when prices rise, benefits rise. If inflation is correctly anticipated – a nd if both parties take it into account, then inflation will not redistribute purchasing power

29. Nominal interest rate The actual interest rate borrower’s pay and lender’s earn from making a loan Nominal interest rate = Real interest rate + Expected inflation rate Real interest rate The nominal interest rate adjusted for inflation. Real interest rate = Nominal interest rate - Expected inflation rate Interest Rates and Inflation

30. 30 of 25 Example: I borrow $100 from a lender and agree to pay $105 after one year: Loan amount = $100 Interest payment = $5 Nominal Interest rate = $5/ $100 = 5% The lender now has $105 Suppose inflation is 2%. What cost $100 a year earlier now cost $102. The lender’s purchasing power increases by $3 not $5. The real interest rate is 5% - %2 = 3% Real Interest rate = Nominal interest rate - inflation

31. Real vs. Nominal Interest Rates If the actual rate of inflation = expected rate of inflation Inflation does not lead to redistribution If the actual rate of inflation < expected rate of inflation Lenders gain and borrowers lose If the actual rate of inflation > expected rate of inflation Lenders lose and borrowers gain 31

32. Question Confusing real and nominal interest rates In 1980, mortgage rates were 12% with 10% inflation In 2013,mortgage rate were 4% with 1% inflation Which is a better bargain? 32

33. Is the CPI Accurate? Sources of bias in CPI – Substitution bias – New technologies – Changes in quality – Growth in discounting 33

34. Is the CPI Accurate? Substitution bias – Quantity is fixed New technology – CPI: as new products are introduced, CPI overstates inflation Changes in quality –CPI: fails to fully account for quality improvements in the goods and services in its market basket Overestimates the price of the basket of goods and services 34

35. Is the CPI Accurate? Growth in discounting – CPI: does not recognize that a new discount outlet lowers the prices on many items – As discount outlets expand into new areas, the CPI overstates the inflation rate Food, electronic appliances, clothing, and other items sold there 35

36. Is the CPI Accurate? Consequences of CPI bias – Errors in calculating real wages – Errors in indexing Retirement benefits, wages, interest payments, or federal tax brackets 36

37. The Controversy Over Indexing Social Security Benefits Social Security system – Benefits to about 60 million retired workers in U.S. – One of the largest and most expensive of all federal government programs More than $770 billion in 2012 Estimated to grow to $1,400 billion in 2023 Payments are indexed to CPI 37

38. The Controversy … Because the CPI overstate inflation – Nominal payment rises by more than the actual rise in the price level – Benefits payments in real terms increase over time –Purchasing power is automatically shifted toward those who are indexed and away from the rest of society 38

39. Indexing and “Overindexing” Social Security Benefits 39