1. Defining & Calculating Inflation AP Macroeconomics

2. Inflation Deflation An increase in the price level of goods & services A decrease in the price level of goods & services

3. Federal vs. NJ (Minimum Wage) Fed $7.25 Effective: 7/24/09 NJ $7.25 Effective: 7/24/09

4. Causes of Inflation Demand-Pull Inflation Cost-Push Inflation Increases in the supply of money circulating in the economy

5. When the economy starts recovering…there will be a fear of inflation…why?

6. Price Indexes Are used to measure the overall price level Examples: Consumer Price Index Producer Price Index GDP Deflator

7. CPI Consumer Price Index Measures the change in prices urban Americans pay for a fixed basket of goods and services The CPI is among the key indicators that the Federal Reserve Board monitors for signs of inflation, so the CPI can offer clues about the direction of interest rates

8. FYI: What’s in the CPI’s Basket? 16% Food and beverages 17% Transportation Medical care 6% Recreation 6% Apparel 4% Other goods and services 4% 41% Housing 6% Education and communication Copyright©2004 South-Western

10. CPI "headline" CPI –80,000 consumer items in a wide range of categories, like apparel, medical care, and transportation. "core" CPI –Computation that excludes the somewhat volatile food and energy sectors.

11. CPI vs. Core CPI

12. CPI vs. PPI

13. Choose a base year and compute the index: –Designate one year as the base year, making it the benchmark against which other years are compared. –Compute the index (price of the basket in current year) (price in the base year) How the Consumer Price Index Is Calculated X 100

14. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00$7.00$9.00 Cassettes 406.005.004.00 Soda601.502.002.50 Total - - - - Calculate spending for Base Year, Year 1, and Year 2 Use Q x P

15. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00 $150 $7.00 $210 $9.00 $270 Cassettes 406.00 240 5.00 200 4.00 160 Soda601.50 90 2.00 120 2.50 150 Total - - $480 - $530 - $580 What is the total cost of buying all the items in year 2?

16. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00 $150 $7.00 $210 $9.00 $270 Cassettes 406.00 240 5.00 200 4.00 160 Soda601.50 90 2.00 120 2.50 150 Total - - $480 - $530 - $580 What is the CPI for Year 2? Year 2 Total Spending $580 Base Year Total Spending $480 X 100

17. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00 $150 $7.00 $210 $9.00 $270 Cassettes 406.00 240 5.00 200 4.00 160 Soda601.50 90 2.00 120 2.50 150 Total - - $480 - $530 - $580 What is the percentage increase in prices from the base year to Year 2? (Year 2 Total Spending – Base Year Total Spending) Base Year Total Spending X 100

18. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00 $150 $7.00 $210 $9.00 $270 Cassettes 406.00 240 5.00 200 4.00 160 Soda601.50 90 2.00 120 2.50 150 Total - - $480 - $530 - $580 What is the percentage increase in prices from the base year to Year 2? ($580-$480) $480 X 100 = 20.8%

19. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00 $150 $7.00 $210 $9.00 $270 Cassettes 406.00 240 5.00 200 4.00 160 Soda601.50 90 2.00 120 2.50 150 Total - - $480 - $530 - $580 In August 2000 the CPI was 172.8, and in August 2001 the CPI was 177.50. What was the percentage change in prices for this 12 month period? (Year 2 CPI – Year 1 CPI) (Year 1 CPI) X 100

20. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00 $150 $7.00 $210 $9.00 $270 Cassettes 406.00 240 5.00 200 4.00 160 Soda601.50 90 2.00 120 2.50 150 Total - - $480 - $530 - $580 In August 2000 the CPI was 172.8, and in August 2001 the CPI was 177.50. What was the percentage change in prices for this 12 month period? (177.50 – 172.8) (172.8) X 100 = 2.7%

21. Workbook Activity 11, Part B Quantity Bought in Base Year Unit Price in Base Year Spending in Base Year Unit Price in Year 1 Spending in Year 1 Unit Price in Year 2 Spending in Year 2 Whole Pizza 30$5.00 $150 $7.00 $210 $9.00 $270 Cassettes 406.00 240 5.00 200 4.00 160 Soda601.50 90 2.00 120 2.50 150 Total - - $480 - $530 - $580 You’ve just calculated the inflation rate!

22. The Inflation Rate ( π %) –The inflation rate is calculated as follows: How the Consumer Price Index Is Calculated

23. Practice Problem Step 1 – Survey consumers to determine a fixed basket of goods Step 2 – Find the price of each good in year Step 3 – Compute the cost of the basket of goods in each year Step 4 – Choose one year as a base year (2001) and compute the consumer price index in each year Step 5 – Use the consumer price index to compute the inflation rate from previous year

24. Practice Problem… Suppose that a typical consumer buys the following items in 2009 and 2010. 2009 per2010 per CommodityQuantityUnit PriceUnit Price Box of Twinkies5 units$6.00$5.00 Batteries2 units$7.00$9.00 Movie Tickets3 units$12.00$19.00 Which of the following can be concluded about the consumer price index (CPI) for this individual from 2009 to 2010? A. It decreased by 25%. B. It decreased by 20%. C. It increased by 20%. D. It increased by 25%. E. It remained unchanged.

25. Problems in Measuring the Cost of Living The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. Three reasons: 1. substitution bias 2. introduction of new goods 3. unmeasured quality changes

26. Substitution Bias –The basket does not change to reflect consumer reaction to changes in relative prices. Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution. Problems in Measuring the Cost of Living

27. Introduction of New Goods –The basket does not reflect the change in purchasing power brought on by the introduction of new products. New products result in greater variety, which in turn makes each dollar more valuable. Consumers need fewer dollars to maintain any given standard of living. Problems in Measuring the Cost of Living

28. Unmeasured Quality Changes –If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. –If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. –The BLS tries to adjust the price for constant quality, but such differences are hard to measure. Problems in Measuring the Cost of Living

29. The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. –The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. –The CPI overstates inflation by about 1 percentage point per year. Problems in Measuring the Cost of Living

30. GDP Deflator

31. The GDP Deflator versus the Consumer Price Index Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. There are few important differences between the indexes that can cause them to diverge.

32. Key Differences 1. The GDP deflator measures a changing basket of commodities while CPI always indicates the price of a fixed representative basket. 2. GDP deflator frequently changes weights while CPI is revised very infrequently. 3. CPI will consider imported goods because they are still considered as consumer goods while GDP deflator will only contain prices of domestic goods.

33. Two Measures of Inflation 1965 Percent per Year 15 CPI GDP deflator 10 5 0 1970197519801985199020001995 Copyright©2004 South-Western

34. Real (r%) and Nominal Interest (i%) Rates Interest represents a payment in the future for a transfer of money in the past. The nominal interest (i%) rate is the interest rate usually reported and not corrected for inflation ( π %). –It is the interest rate that a bank pays. The real interest rate (r%) is the nominal interest rate that is corrected for the effects of inflation ( π %).

35. You borrowed $1,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation r% = i% - π % r% = 15% - 10% r% = 5% Real (r%) and Nominal Interest (i%) Rates

36. Real and Nominal Interest Rates 1965 Interest Rates (percent per year) 15 Real interest rate 10 5 0 –5 1970197519801985199019952000 Nominal interest rate Copyright©2004 South-Western

37. Medical Care costs…

41. Vocabulary COLA – Cost of living adjustment Disinflation – is the process of bringing the inflation rate down Expected Inflation: gets priced into the market without shock Unexpected Inflation: acts as a source of volatility to the markets Note: Do not confuse with hyperinflation and stagflation!

42. Hyperinflation: Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless.

44. Stagflation Stagflation is defined as slow economic growth occurring simultaneously with high rates of inflation

45. Winners and Losers Explain: “Inflation hurts lenders and helps borrowers.” Explain: “People on fixed income are hurt by inflation.” Explain: “I am always ahead of the game, my annual raise is always above inflation.” Note: Do not confuse expected inflation with unexpected inflation!