Inflation and the Business Cycle

Inflation and the Business Cycle
Module 14-15

Chapter Checklist When you have completed your study of this chapter, you will be able to Explain what the Consumer Price Index (CPI) is and how it is calculated. 1 Explain the limitations of the CPI as a measure of the cost of living. 2 Adjust money values for inflation and calculate real wage rates and real interest rates. 3

Inflation Deflation Inflation
An upward movement in the average level of prices Deflation A downward movement in the average level of prices

Purchasing Power Inflation
The value of money for buying goods and services Varies with prices and income Disposable Income *During inflation purchasing power of a dollar falls *During deflation purchasing power of a dollar rises

Nominal Value Real Value Inflation Price expressed in today’s dollars
Varies with the rate of inflation Value expressed in purchasing power which varies with inflation

Inflation Question Is a 30 second ad during the Super Bowl really 85 times more expensive today ($4.25 million) compared to 1967 ($50,000)?

Inflation Answer Depends on what has happened to the price level and the size of the audience during this time Prices: Fourfold increase Audience: Doubled

Inflation Analysis Adjusting for viewership and inflation the cost per viewer is less than four times what it was in not 25 times.

Inflation Inflation- Measured by computing a price index which is defined as the cost of a market basket today, expressed as a percentage of the cost of that market basket in some starting or base year. In the base year the price index is always equal to 100. Inflation is measured by the rise in a price index. Base year chosen as a point of reference for comparison.

THE CONSUMER PRICE INDEX
Consumer Price Index (CPI) A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services (final products).

Reference Base Year (Period)
Inflation Market Basket Representative bundle of goods and services Reference Base Year (Period) The point of reference for comparison of prices in other year. A period for which the CPI is defined to equal 100. Currently, the reference base period is 19821984.

In May 2005, the CPI was The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 94.4 percent higher in May 2005 than it was on the average during 19821984. In April 2005, the CPI was The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services decreased by 0.2 of a percentage point in May 2005.

Constructing the CPI Three stages: Selecting the CPI basket Conducting the monthly price survey Calculating the CPI

Figure below shows the CPI basket. This shopping cart is filled with the items that an average household buys. Ask your students to make an estimate of their own baskets and compare them with the BLS basket.

The Monthly Price Survey Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas. BECAUSE the CPI measures price changes, it is IMPORTANT that the prices recorded refer to exactly the same items and quantity. Surveying college textbook prices might capture the students’ attention. (See the IM for a detailed discussion).

Calculating the CPI The CPI calculation has three steps: Find the cost of the CPI basket at base period prices. Find the cost of the CPI basket at current period prices. Calculate the CPI for the base period and the current period.

Note- Always use the same quantity to determine the CPI for each year. The only thing that is changing is the price.

Cost of CPI basket at current period prices Cost of CPI basket at base period prices x 100 CPI = For 2000, the CPI is: = 100 $50 x 100 The CPI for the base period is always 100. Always!!! For 2003, the CPI is: = 140 $70 $50 x 100 Once we determine the CPI for these years we can now determine the inflation for these years!

Formula for the Rate of Inflation
Measuring Inflation Inflation rate The percentage change in the price level from one year to the next. CPI in current year  CPI in previous year CPI in previous year x 100 Inflation rate = Emphasize the distinction between the price level and the inflation rate. Do some calculations and have the students do some too. Inflation rate = = 40% percent 140  100 100 x 100 This means there has been a 40% increase in inflation between the previous year and current year. But that is easy because you are working from the base year. Try this!

Formula for the Rate of Inflation
Measuring Inflation Inflation rate- CPI for 2002 is 120 and CPI for 2003 is 140 What is the rate of inflation between 2002 and 2003? CPI in current year  CPI in previous year CPI in previous year x 100 Inflation rate = Emphasize the distinction between the price level and the inflation rate. Do some calculations and have the students do some too. Inflation rate = = 16.7 percent 140  120 120 x 100 This means there has been a 16.7% increase in inflation between the previous year and current year. 20

Dollar Figures from Different Times
In 1931, Babe Ruth made $80,000. What is his salary equal to in 2007 dollars. Need to know the CPI in 1931 and in 2007. CPI in 1931 is 15.2 CPI in 2007 is 207 Formula to convert dollar amounts from different times. Amount in today’s dollars Amount in old dollars CPI today CPI in past = X

In 1931, Babe Ruth made $80,000. What is his salary equal to in 2007 dollars. Need to know the CPI in 1931 and in 2007. CPI in 1931 is 15.2 CPI in 2007 is 207 Formula to convert dollar amounts from different times. 207 15.2 Amount in today’s dollars $80,000 X = Answer is $1,089,474

In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.

In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.

THE CPI AND THE COST OF LIVING
Cost of living index A measure of changes in the amount of money that people would need to spend to achieve a given standard of living. The CPI does not measure the cost of living because It does not measure all the components of the cost of living Some components are not measured exactly So the CPI is possibly a biased measure.

Sources of Bias (Discrepancies) in the CPI The potential sources of bias in the CPI are Goods Evolve/New Good Bias Quality Differences Consumer substitutes Outlet substitution bias The IM contains a detailed explanation of how you might illustrate substitution bias.

New Goods Bias What if the market basket base year was from 1912? New goods do a better job than the old goods that they replace, but cost more. The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate. Quality Change Bias Better cars and televisions cost more than the versions they replace. A price rise that is a payment for improved quality is not inflation but might get measured as inflation.

Commodity Substitution Bias If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. The CPI basket doesn’t change to allow for the effects of substitution between goods. Outlet Substitution Bias If prices rise more rapidly, people use discount stores more frequently. The CPI basket doesn’t change to allow for the effects of outlet substitution.

The Magnitude of the Bias The Boskin Commission estimated the bias to be 1.1 percentage points per year. If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year. To reduce the bias, the BLS has decided to increase the frequency of its Consumer Expenditure Survey and revise the CPI basket every two years. When the BLS revises the CPI basket, the reference base period does not change.

High Rates of Inflation Impose Economic Costs
Cost to Consumers High Rates of Inflation Impose Economic Costs Shoe-Leather Costs Purchasing power of money eroding Discourages people from holding money in bank accounts or wallets Many trips to the ATM/bank Menu Costs Most items we buy have a listed price Changing a listed price has a real cost Businesses update prices intermittently Unit-of-Account Costs Role of the dollar as a basis for contracts and calculation of the tax system Makes money a less reliable unit of measurement The IM contains a detailed explanation of how you might illustrate substitution bias.

Decreasing Value of the Dollar Since 1970
It takes more dollars to purchase fewer items. Purchasing power is decreasing—we purchase less with more dollars. 1985 Today

Real World Price Indexes
Inflation Real World Price Indexes Producer Price Index (PPI) A statistical measure of a weighted average or prices of commodities that firms purchase from other firms. Generally for non-retail markets Used as a leading indicator of the CPI PPI’s for: Food materials Intermediate goods Finished goods

Real World Price Indexes
Inflation Real World Price Indexes GDP Deflator A price index measuring the changes in prices of all new goods and services produced in the economy Broadest measure Not based on a fixed market basket, but a survey of a wide variety of goods.

The GDP Deflator: A Better Measure?
In principle, the GDP deflator is not subject to the biases of the CPI because it uses the price change and the public response to those price changes in the basket of goods and services produced in the current year and the preceding year. In practice, the GDP deflator suffers from some of the CPI’s problems because the Commerce Department does not directly measure the physical quantities of all the goods and services that are produced.

The Consumer Price Index versus the GDP Deflator
The Consumer Price Index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)... …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

The two measures of the inflation rate fluctuate together, but the CPI measure rises more rapidly than the GDP deflator measure. But the price levels get farther apart. Both measures probably overstate the inflation rate.

Inflationary Periods in U.S. History

NOMINAL AND REAL VALUES
Nominal and Real Values in Macroeconomics Macroeconomics makes a big issue of the distinction between nominal values and real values: Nominal GDP and real GDP Nominal wage rate and real wage rate Nominal interest rate and real interest rate

Just because you get an increase in the nominal value, doesn’t mean you are better off than you were before. We will need to deflate nominal values by the price index to calculate real values for anything- Wages, Income, GDP, etc…

Formula for Real Values
Nominal Real = X 100 __________________ Price Index * The price index can be the CPI, PPI, or the GDP Deflator.

Nominal and Real Wage Rates Nominal wage rate The average hourly wage rate measured in current dollars. Real wage rate The average hourly wage rate measured in the dollars of a given reference base year. Reflects inflation! Use the US President example to emphasize the difficulty of holding relevant factors constant to calculate a real wage.

What is the nominal hourly wage of $14.28 in 2002 worth in dollars. CPI is To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100. That is, Nominal wage rate in 2002 CPI in 2002 x 100 Real wage rate in 2002 = Real wage rate in June 2002 = = $7.93 $14.28 179.9 x 100 So the $14.28 in the nominal hourly wage in 2002 is worth $7.93 in 19821984 dollars.

22.3 NOMINAL AND REAL VALUES
Figure 22.4 shows nominal and real wage rates: 1975–2005. The nominal wage rate has increased every year since 1975. The real wage rate increased briefly during the late 1970s, decreased through the mid-1990s, and then increased slightly.

Nominal and Real Income
Example: 2002- Nominal income is $40,000 2003- Nominal Income is $41,000 2002- CPI 181.6 2003- CPI 185 Q. 1- What is my real income for each year? Q. 2- Did my purchasing power increase in 2003? Am I better off in 2003?

2002 Real Income= $40,000/181.6 x 100= $22,026 2003 Real Income= $41,000/185 x 100= $22,162 Real income has increased by $136. You are better off in 2003 than in 2002.

What if your income only increased to $40,500 in 2003. Calculate: 1) Real income for each year. 2) Did your purchasing power increase in 2003?

2002 Real Income= $40,000/181.6 x 100= $22,026 2003 Real Income= $40,500/185 x 100= $21,891 Real income has decreased by $135. So even though your nominal income has increased by $500, your real income has decreased by $135.

Inflation Anticipated Versus Unanticipated Inflation The effects of inflation on individuals depends upon which type of inflation exists.

Anticipated Inflation
The rate of inflation that the majority of individuals believe will occur. If the rate of inflation is 10% and that is what the majority expected, then inflation was fully anticipated.

Unanticipated Inflation
Inflation that comes as a surprise to individuals in the economy. If people expected an inflation rate of 5% and the actual rate of inflation was 10%, then 5% of the actual inflation rate was unanticipated inflation. This is the inflation that wreaks havoc on the economy! Unanticipated inflation hurts many people. When inflation is anticipated some of these people (lenders) are able to protect themselves. All of this is important when dealing with interest rates!

22.3 NOMINAL AND REAL VALUES
Nominal and Real Interest Rates Nominal interest rate The percentage return on a loan expressed in todays dollars. Real interest rate The percentage return on a loan, calculated by purchasing power—the nominal interest rate adjusted for the effects of inflation. Real interest rate = Nominal interest rate – Inflation rate

Inflation/Interest Rates
Real Interest Rate Home Mortgage Nominal Interest Rate 15% Increase in the price of housing of 25% (inflation) Real Rate = 15% - 25% = -10% Real interest rate = Nominal interest rate – Inflation rate

Inflation/Interest Rates
Real Interest Rate Home Mortgage Nominal Interest Rate 6.5% Increase in the price of housing of 2% Real Rate = 6.5% - 2% = 4.5% Question Which scenario is the best for the lender? the borrower?

Does Inflation Necessarily Hurt Everyone?
All of this is extremely important with borrowers and creditors. Banks must anticipate the inflation rate to cover all loans. Try to increase interest rates with the rate of inflation. This is not an exact science. Creditors/lenders must make sure that the nominal rate of interest is greater than anticipated inflation. It is the unanticipated inflation they can not predict. Creditor gains if real interest rate is positive. Debtor gains if real rate of interest is negative Unanticipated inflation is the key!! Higher unanticipated inflation helps borrowers/hurts creditors.

Does Inflation Necessarily Hurt Everyone?
Nom. Int. Rate - Infl. Rate = Real Int. Rate 10% 5% 5% creditor wins 10% 10% 0% draw 10% 15% -5% debtor wins In the past inflation and nominal interest have risen and fallen together.

Effects of Inflation Creditors (Lenders) Lose: Net creditors are individuals or businesses that have more savings than debt. A net creditor receives interest and, therefore, receives a reduced real interest return when there is unanticipated inflation. Debtors (borrowers) Win: Net debtors are individuals or businesses that have more debt than savings. A net debtor pays interest, and therefore, pays a lower real interest rate when there is unanticipated inflation. A fixed rate of interest helps a debtor in the long term. Paying back a loan with less purchasing power during times of inflation.

Figure shows real and nominal interest rates: 1965–2005. During the 1970s, the real interest rate became negative. The nominal interest rate increased during the high-inflation 1980s.

Protecting Against Inflation
Cost-of-living adjustments (COLAs) Clauses in contracts that allow for increases in specified nominal values to take account of changes in the cost of living ARMS- Banks offer “Adjustable Rate Mortgages” that adjust the interest rate to keep up with changes in inflation

Types of Inflation Demand- Pull Inflation- More dollars chasing less goods. An increase in aggregate demand. Often results for too much money in the economy. Cost-Push Inflation- Inflation due to an increase in production/ input costs. Results in a decrease of aggregate supply.

Consumer Demand-Pull Inflation Shift of Demand curve PL S P2 P1 D1 D
GDP Q

Producer Cost-Push Inflation Shift of Supply curve PL P1 P S1 D S GDP
Q

Double Digit Inflation Hyperinflation
Types of Inflation Double Digit Inflation Hyperinflation Stagflation- High inflation and unemployment. Worst possible economic situation.

Changing Inflation and Unemployment: Business Fluctuations
The ups and downs in economy wide economic activity National income Employment Prices

The Typical Course of Business Fluctuations
Four faces, measured by “Trough to Trough”. Phase 1 is Expansion. Avg. expansion 2 ½ years, contraction 1 ½ years.

Expansion Peak Contraction Trough

Recession A period of time during which the rate of growth of business activity is consistently less than its long-term trend or is negative Depression An extremely severe recession

National Business Activity, 1880 to Present

Causes of Changes in the Business Cycle
External Factors Internal Factors International Relations OPEC, war New Discoveries Resources, technology and innovation Social/Political Changes Immigration, shift in attitudes, political party Weather Capital investment Inventories Aggregate demand Government spending and the fluctuating money supply

Predicting Business Cycles
The WOW Factor WEATHER OIL WAR

Leading Indicators Coincident Indicators Come before a change in a phase of the cycle Building permits issued Orders for capital goods Orders for consumer goods Price of raw materials Stock prices Change as you move into a phase Personal income Sales volume Industrial production levels

Lagging Indicators- Months after a cycle has changed Use of credit Number and size of business income

Working-age population
Unemployment X 100 Labor force participation rate = Working-age population x 100 Labor force

Price Indexes/Inflation
CPI Market Basket Fixed Quantity X Prices of G/S= CPI Market Basket Consumer Price Index Cost of CPI basket at current period prices Cost of CPI basket at base period prices x 100 CPI = Rate of Inflation CPI in current year  CPI in previous year CPI in previous year x 100 Inflation Rate =

Formula to convert dollar amounts from different times. Amount in today’s dollars = Amount in old dollars X CPI today CPI in past

Nominal and Real (Income or Wages)
Real Income: Nominal Income current year X 100 CPI (Index) Nominal Income: Real Income X CPI (Index) 100

Inflation and Interest
Nom. Int. Rate - Infl. Rate = Real Int. Rate OR Real Int. Rate + Infl. Rate = Nominal Int. Rate

GDP Deflator used as a price index for all goods and services
Price Indexes GDP Deflator used as a price index for all goods and services in the economy. Price of good in current year X 100 Price of good in base year Nominal GDP X 100 Real GDP

Real GDP- Two ways to determine
Real Values Real GDP- Two ways to determine 2) Price of good in base year X Quantity of good in current year *More of this in Mod 15

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