Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Measuring the Price Level and Inflation
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Value of Money Value of money depends upon the prices of goods and services Rapid and ongoing increases in the prices of most goods and services can radically reduce the buying power of a given amount of money
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Problems of Inflation Makes comparisons of economic conditions over time difficult Creates uncertainty about the future How much should I save for retirement? Imposes many costs on an economy
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Measuring Inflation Consumer Price Index, CPI It measures, for any time period, the cost of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed year The fixed year is called the base year It uses a constant basket of goods and services It is collected by the BLS
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide CPI Measures changes in prices of a typical market basket Is used to eliminate the effects of inflation from economic data
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Inflation Rate of inflation The annual percentage rate of change in the price level, as measured, for example, by the CPI A measure of how fast the average price level is changing over time
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Deflation Deflation A situation in which the prices of most goods and services are falling over time so that inflation is negative
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Adjusting for Inflation 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 Deflating The process of dividing a nominal quantity by a price index to express the quantity in real terms
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Real Wage 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 wage by the CPI for that period
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig. 7.1 Nominal and Real Wages for Production Workers,
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Indexing Indexing The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index Prevents the purchasing power of the nominal quantity from being eroded by inflation (e.g., a Social Security payment)
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Accuracy of CPI Changes in the CPI are important Directly impacts government budgets Study shows CPI overstates inflation between 1 - 2% a year Costing federal government billions of dollars more than necessary every year Underestimating of true living standard
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Reasons for Overstatement of Inflation Quality adjustment bias: statistics do not account for the fact that The quality of goods and services change over time New goods appear Substitution bias CPI uses a fixed market basket Consumers seek out cheaper substitutes when prices rise
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Price Level vs. Relative Price 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 If the price of oil decreases by 10% and all other prices decrease by 3%, then the relative price of oil decreases (i.e. oil is cheaper relatively) Serious misunderstanding by the public The remedies are different
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Costs of Inflation Reduces efficiency of the economy “Shoe-leather” costs More frequent trips to the bank Inflation raises the cost of holding cash “Noise” in the price system Difficult to interpret information conveyed by prices Relative price change or inflation? Distortions of the tax system Many provisions in the tax codes are not indexed Causes bracket creep Causes paying more than initially intended
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Costs of Inflation Reduces efficiency of the economy Unexpected redistribution of wealth Inflation higher than expected Under contracts, wage earners are hurt to the benefit of employers Hurts creditors to the benefit of debtors Interference with long-run planning Difficult to forecast prices over long periods
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Hyperinflation Hyperinflation A situation in which the inflation rate is “extremely” high Experienced by Several Latin American countries Israel Transition economies like Russia Confederacy of U.S Magnifies the costs of inflation
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Real Interest Rate Real interest rate (i.e., real rate of return) The annual percentage increase in the purchasing power of a financial asset Equals the nominal interest rate on that asset minus the inflation rate Financial investors and lenders do best when the real (not the nominal) interest rate is high Increasing purchasing power
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Nominal Interest Rate Nominal interest rate (i.e., the market interest rate) The annual percentage increase in the nominal value of a financial asset
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Real vs. Nominal r = real interest rate i = nominal, market, interest rate = inflation rate
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig. 7.2 The Real Interest Rate in the United States,
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Lenders vs. Borrowers Unexpected inflation Hurt creditors, aids borrowers reduces the value of the dollars with which the debts are repaid For a given nominal interest rate, the higher the inflation rate (higher than expected), the lower the real interest rate the lender receives
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Inflation and Interest Rates Economists have noticed that During periods of high inflation Interest rates are high as well During periods of low inflation Interest rates are low as well
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig. 7.3 Inflation and Interest Rates in the United State,
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fisher Effect Fisher effect The tendency for nominal interest rates to be high when inflation is high and low when inflation is low If inflation has been high recently Lenders anticipate that it will continue to be high Lenders raise the nominal interest rate so that the real rate of return is not affected