Price Indexes and Inflation Review: Unemployment and Production Unemployment Up  Employment Down  Production Down Unemployment Down  Employment Up  Production Up Nominal GDP for 2014=Sum of the market values of all final goods and services produced in the United States during 2014 Real GDP for 2014=Sum of the market values of all final goods and services produced in the United States during 2014 evaluated at base year (2009) prices Review: A Way to Measure Production How many final goods and services does the economy produce? Nominal GDP increases when:Production (Q’s) increaseand/or prices (P’s) increase Problem: We only want to measure changes in production (Q’s), not changes in prices (P’s). Solution: Keep prices (P’s) constant.

Nominal GDP for 2014=Sum of the market values of all final goods and services produced in the United States during 2014 Real GDP for 2014=Sum of the market values of all final goods and services produced in the United States during 2014 evaluated at base year (2009) prices Price Indexes GDP Price Deflator Hypothetical Questions: What if prices were unchanged since 2009? GDP Price Deflator 100 What if prices had doubled since 2009?200 What if prices had tripled since 2009?300 Since the base year (2009) prices have risen by about 8 percent on average. For the economy as a whole, what is the “average” price? GDP Price DeflatorConsumer Price Index (CPI)

108.3  RateChange in the of =Price Index expressed Inflationas a percentage Year GDP Price Deflator 2009 = Rate of Inflation in 2014=== 1.5%

How Social Security Unfairly Calculates the Cost of Living for Retirees 8:38 am ET Oct 20, 2015 DAVID BLANCHETT: Retirees got some bad news recently when it comes to Social Security: Their Social Security benefits won’t increase in The reason, according to the Department of Labor’s announcement on Oct. 15, was that living expenses were 0.4% lower in the third quarter from a year before, primarily because of lower gas prices.. The Labor Department uses the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W, to measure inflation’s effects on Social Security beneficiaries’ costs. A cost- of-living increase for the following year’s benefits is determined by the average monthly CPI-W value in the third quarter of the current year.. Consumer Price Index (CPI) First, the Bureau of Labor Statistics decides upon the market basket of goods that is purchased by the typical American household: Second, the Bureau of labor statistics calculates how much this market basket would have cost in the base year and how much it costs now. Third, it calculates the ratio of the costs and by convention multiplies the ratio by 100. The result is the CPI: CPI for September 2015 = Cost of the Market Basket in September 2015 Cost of the Market Basket in Base Year × 100 x pounds of chickeny pounds of beefz gallons of gasolinen cans of beer

YearJanFebMarAprMayJunJulAugSepOctNovDec Increase inChange in Purchasing Power: Nominal Per CapitaIncrease inChange in Real Per Capita Disposable Income (%)CPI (%)Disposable Income (%) Consumer Price Index (CPI) CPI for September 2015 = Cost of the Market Basket in September 2015 Cost of the Market Basket in Base Year The Effects of Inflation: Purchasing Power  RateChange in the of =Price Index expressed Inflationas a percentage   100 =   100 = = .2% × 100 Market Basket: “Basket” of Goods consumed by the typical American household.

Does the CPI Overstate or Understate the Effect of Inflation? Substitution Smith household In September 2013, the Smith household was using all its income to purchase the typical market basket of goods; During the next year the household’s income rose by 1.7 percent, an amount just equal to the increase in the CPI. Could the Smiths continue to consume the typical market basket of goods? If so, the Smiths would be just as well off. Would the Smiths continue to consume the typical market basket of goods? The Smiths would be better off. Yes No Quality Improvements and New Products CPIGround Beef ($/lb)Turkey ($/lb) Sept Sept Percent change1.7%17.1%  13.2% Personal computers Cell phones

Atypical Households Percent of Income Spent Urban WorkersElderly Food and beverages15.70%12.80% Housing39.20%44.50% Apparel3.60%2.40% Transportation18.70%14.50% Medical care5.60%11.30% Recreation5.50%5.30% Price of Gasoline ($/gal) September September Elderly

2.4% $3 Net Increase of Purchasing Power  $5 of Interest Inflation and Interest Rates: Nominal and Real Interest Rates The Effects of Inflation: Purchasing Power RealNominal Interest =Interest  Rate (r)Rate (i) Inflation Rate (  ) Save $100 for a year Nominal Interest Rate = 5% Inflation Rate = 2% Real Interest Rate = 3%   $2 Erosion of Purchasing Power Year Nominal Interest Rate (i) 5.2% 3.1% Inflation Rate (  ) 2.8% 3.8% Real Interest Rate (r)  0.7% Nominal Interest Rates: The interest rate that the bank advertises. Question: What is the opportunity cost of holding cash? Answer: Nominal interest rate %1.6%  1.5% Question: What does opportunity cost refer to?

Equilibrium: Quantity Demanded = Quantity Supplied Aggregate Demand (AD) Curve P Q D S P* Q* Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were _____, given that everything else relevant to the demand for beer remains the same? Market supply curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were _____, given that everything else relevant to the supply of beer remains the same? P Q SP Q D If P =.50 If P = 1.00 If P = 1.50 If P = 2.00 If P =.50 If P = 1.00 If P = 1.50 If P = Review: Market for a Good Question: Why is the demand curve downward sloping? Question: Why is the supply curve downward sloping?

Equilibrium: Goods and Services Purchased Equals Goods and Services Produced  (%) G&S AD AS AD Question: How many final goods and services would be purchased if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? AS Question: How many final goods and services would be produced if the inflation rate (  ) were _______ percent, given that all other factors relevant to supply remained the same?  (%) G&S AS  (%) G&S AD If  = 1.0 If  = 2.0 If  = 3.0 If  = 4.0 If  = 1.0 If  = 2.0 If  = 3.0 If  = Aggregate Demand/Aggregate Supply Model

Aggregate Demand/Aggregate Supply Equilibrium Goods and services (G&S) purchased Goods and services (G&S) produced =  AD  AS =  (%) G&S AD AS Goods and services (G&S) purchased  AD Goods and services purchased by households CC Goods and services purchased by firms II Goods and services purchased by governments GG =++ =++  C + I + G =  GDP Real GDP for 2014=Sum of the market values of all final goods and services produced in the United States during 2014 evaluated at base year (2009) prices NB: To keep our analysis more straightforward we are ignoring net exports for now.

 (%) G&S AD AS AD Question: How many final goods and services would be purchased if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? AS Question: How many final goods and services would be produced if the inflation rate (  ) were _______ percent, given that all other factors relevant to supply remained the same? Summary: Aggregate Demand/Aggregate Supply Model Goods and services (G&S) purchased Goods and services (G&S) produced  AD  AS  C + I + G  GDP Equilibrium

AD Question: How many final goods and services would be purchased if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same?  (%) G&S AD If  = 1.0 If  = 2.0 If  = 3.0 If  = Aggregate Demand Curve Question: Why is the aggregate demand (AD) curve downward sloping? Inflation rate (  ) increases  Fewer goods and services purchased  The aggregate demand (AD) curve is downward sloping. The Federal Reserve Board (Fed)

The Real Interest Rate: The Federal Reserve Board’s (Fed’s) Throttle on the Economy Real interest rate (r) increases  Loans become more costly  Households and firm purchase fewer goods and services  In the entire economy fewer goods and services (G&S) purchased Real interest rate (r) decreases  Loans become less costly  Households and firm purchase more goods and services  In the entire economy more goods and services (G&S) purchased  Economy “slows down”  Economy “speeds up” Fed’s Goal: Use its throttle, the real interest rate, to stabilize the economy. When the inflation rate (  ) increases the Fed “slows down” the economy by increasing the real interest rate (r). When the inflation rate (  ) decreases the Fed “speeds up” the economy by decreasing the real interest rate (r). Taylor Principle

The Federal Reserve Board and the Taylor Principle When the inflation rate (  ) increases the Fed “slows down” the economy by increasing the real interest rate (r). When the inflation rate (  ) decreases the Fed “speeds up” the economy by decreasing the real interest rate (r). Inflation rate (  ) increases  Real interest rate (r) increases  Loans become more costly  Households and firm purchase fewer goods and services  Economy “slows down” Inflation rate (  ) decreases  Real interest rate (r) decreases  Loans become less costly  Households and firm purchase more goods and services  Economy “speeds up” Taylor principle  Economy stabilizes Taylor Principle Fed’s Goal: Use its throttle, the real interest rate, to stabilize the economy.  In the entire economy fewer goods and services (G&S) purchased  In the entire economy more goods and services (G&S) purchased

When the inflation rate (  ) increases the Fed “slows down” the economy by increasing the real interest rate (r). If  = When the inflation rate (  ) decreases the Fed “speeds up” the economy by decreasing the real interest rate (r). FP  (%) r (%) Taylor Principle and the Fed Policy (FP) Curve If  = FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? % %1.0%  r = 1.0% Consumption Purchases (C) Investment Purchases (I) 1, , ,  r = 3.0%  r = 5.0% Taylor Principle The Fed policy (FP) curve is upward sloping to stabilize the economy.  If  =1.0%If  =2.0%If  =3.0%

FP  (%) r (%) AD  (%) G&S AD Question: How many final goods and services would be purchased, if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? Deriving the Aggregate Demand (AD) Curve If  = 2, ,750 2,250 FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? If  = % 2, %1.0% ,7502,  r = 1.0% Consumption Purchases (C) Investment Purchases (I) Government Purchases (G) Goods and Services Purchased (G&S) 1, ,250 1, ,000 1, ,750  r = 3.0%  r = 5.0% The Fed policy (FP) curve is upward sloping to stabilize the economy. The aggregate demand (AD) curve reflects the goods and services purchased. The aggregate demand (AD) curve is downward sloping.  If  =1.0%If  =2.0%If  =3.0%

FP  (%) r (%) AD  (%) G&S AD Question: How many final goods and services would be purchased, if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? Summary of the Fed Policy (FP) and the Aggregate Demand (AD) Curves FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? Inflation rate (  ) increases Real interest rate (r) increases Loans become more costly Households and firms purchase less Fewer goods and services purchased   Taylor principle (FP curve)  C and I decrease  AD = C + I + G decreases