Prices and Inflation Price Indexes and Inflation GDP Deflator Inflation and Interest Rates Misconceptions about Inflation Costs of Inflation

Price Indexes and Inflation The “aggregate” price level is aggregation of the prices of a large number of goods and services in the economy. A price index measures the aggregate price level relative to a base year. The consumer price index (CPI) measures the cost of buying a fixed basket of consumer goods (which matter to a typical urban household) relative to the cost in a fixed base year.

CPI for current year = (x 100 to get percentages) Example: CPI for an individual consumer The fixed basket of goods for the entire economy includes the total quantity of each good produced in the base year.

The CPI and True Inflation The CPI has several biases: (1)Quality Bias Improvement (2)New Product Bias (3)Substitution Bias

The GDP deflator is a price index that measures the prices of all goods and services produced in an economy: GDP Deflator (P) =  Example: Apples and the Deflator  Example: GDP and the Price Index

Any real quantity (GDP, apples, wages) can be computed using the GDP deflator (P): Decomposition of Growth Rates:  Example: Growth Rates of GDP

The inflation rate is the percent change in the price index: P1 = price index for Year 1 P2 = price index for Year 2 Inflation Rate between Year 1 and Year 2

Two Measures of Inflation

Inflation Rates Around the World: Current:US0.5% (CPI) UK1.25% Japan-0.7% 1980sIsrael370% Argentina1,110% Bolivia8000%  German Hyperinflation (Jan 1922-Dec 1923)

Inflation and Interest Rates Nominal Interest Rate – rate that the dollar value of a loan (or bank account) grows over time. Real Interest Rate – rate that the purchasing power of a loan (or bank account) grows over time. Real Interest rate = Nominal Interest Rate - Inflation Rate

Example: Interest Rates and Music CDs. Economic decisions (borrowing and lending) should be based upon the real interest rate. Fisher Effect – If inflation can be anticipated, then nominal interest rates and inflation tend to move together.

Figure 7.4 Inflation and the nominal interest rate in the United States, 1960–2003

Misconceptions About Inflation Inflation and Purchasing Power  Fact or Fiction: “Inflation is evil because it erodes my purchasing power.”  Fact: Inflation does imply higher overall prices and lower purchasing power per dollar.  Fiction: Inflation always steels the purchasing power of hard earned wages.  Need to consider the purchasing power of wages or the real wage: Real Wage = Nominal Wage/P

Truth: Inflation does not systematically erode the purchasing power of wages.

FIGURE 5: Rates of Change of Wages and Prices in the U.S. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Percentage Change in Prices Prices Year Wages Percentage Change in Wages

Real Wage Rates: 1960 – 1998

Inflation and Relative Prices  Aggregate prices – measures economy-wide price level.  Relative prices – the price of one good relative to another. Example: textbook = $100 and car = $20,000, then price of car = 200 textbooks.

Inflation does not imply prices of all goods increase by same amount. There are winners and losers. Example: Pure Inflation versus Real World

True Costs of Inflation Shoe Leather Costs Inflation (anticipated) increases nominal interest rates and forces people to pay the costs of better money management.  Redistribution of Wealth Unexpected inflation redistributes wealth from lenders to borrowers.  Inflation and Tax System Taxes are based on nominal rather than real incomes.