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Measuring the Price Level and Inflation

Measuring the Price Level and Inflation. Introduction. What Do You Think? Could you retire in thirty years if you have $100 million?. The Consumer Price Index: Measuring the Price Level. Consumer Price Index (CPI)

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Measuring the Price Level and Inflation

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  1. Measuring the Price Level and Inflation

  2. Introduction • What Do You Think? • Could you retire in thirty years if you have $100 million? Chapter 19: Measuring the Price Level and Inflation

  3. The Consumer Price Index: Measuring the Price Level • Consumer Price Index (CPI) • For any period, measures the cost in that period of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed year, called the base year Chapter 19: Measuring the Price Level and Inflation

  4. Monthly Household Budget of the Typical Family in 1995 (Base Year) Constructing a Hypothetical CPI Cost (in 1995) Item Rent, two-bedroom apartment $500 Hamburgers (60 at $2.00 each) 120 Movie tickets (10 at $6.00 each) 60 Total expenditure $680 Chapter 19: Measuring the Price Level and Inflation

  5. Cost of Reproducing the 1995 (Base-Year) Basket of Goods and Services in Year 2000 Constructing a Hypothetical CPI Cost (in 2000) Cost (in 1995) Item Rent, two-bedroom apartment $630 $500 Hamburgers (60 at $2.00 each) 150 120 Movie tickets (10 at $6.00 each) 7060 Total expenditure $850 $680 Chapter 19: Measuring the Price Level and Inflation

  6. The Consumer Price Index: Measuring the Price Level • Constructing the CPI • Bureau of Labor Statistics (BLS) • Pick a base year • Conduct the consumer expenditure survey to determine the base-year basket of goods and services • Measure the current prices of the base-year basket Chapter 19: Measuring the Price Level and Inflation

  7. Cost of Reproducing the 1995 (Base-Year) Basket of Goods and Services in Year 2000 Constructing a Hypothetical CPI Cost (in 2000) Cost (in 1995) Item Rent, two-bedroom apartment $630 $500 Hamburgers (60 at $2.00 each) 150 120 Movie tickets (10 at $6.00 each) 7060 Total expenditure $850 $680 • The CPI in year 2000 = $850/$680 = 1.25 • Base year = 1.00 • The cost of living increased by 25% from 1995 to 2000 Chapter 19: Measuring the Price Level and Inflation

  8. The Consumer Price Index: Measuring the Price Level • Constructing the CPI • The CPI for a given period measures the cost of living for that period relative to the base year Chapter 19: Measuring the Price Level and Inflation

  9. The Consumer Price Index: Measuring the Price Level • Constructing the CPI • The CPI is a price index. • Price Index • A measure of the average price of a given class of goods or services relative to the price of the same goods and services in a base year Chapter 19: Measuring the Price Level and Inflation

  10. Inflation • CPI • Measures the average level of prices relative to prices in the base year • Inflation • Measures how fast the average price level is changing over time Chapter 19: Measuring the Price Level and Inflation

  11. Inflation • Rate of Inflation • The annual percentage rate of change in the price level Chapter 19: Measuring the Price Level and Inflation

  12. Calculating InflationRates: 1972 - 1976 Year CPI 1972 0.418 1973 0.444 1974 0.493 1975 0.538 1976 0.569 Chapter 19: Measuring the Price Level and Inflation

  13. Calculating InflationRates: 1929 - 1933 Year CPI 1929 0.171 1930 0.167 1931 0.152 1932 0.137 1933 0.130 Chapter 19: Measuring the Price Level and Inflation

  14. Inflation • Deflation • A situation in which the prices of most goods and services are falling over time so that inflation is negative Chapter 19: Measuring the Price Level and Inflation

  15. Adjusting for Inflation • Deflating a Nominal Quantity • 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 Chapter 19: Measuring the Price Level and Inflation

  16. Adjusting for Inflation • Deflating a Nominal Quantity • Deflating (a nominal quantity) • A process of dividing a nominal quantity by a price index (such as the CPI) to express the quantity in real terms Chapter 19: Measuring the Price Level and Inflation

  17. Nominal family income Real family income = Nominal family income/CPI CPI 1995 $20,000 1.00 $20,000/1.00 = $20,000 2000 $22,000 1.25 $22,000/1.25 = $17,600 Comparing the Real Values of a Family’s Income in 1995 and 2000 Year Chapter 19: Measuring the Price Level and Inflation

  18. Adjusting for Inflation • Example • Home run hitters drive Cadillacs • 1930 Babe Ruth’s salary was $80,000 • 1998 Mark McGwire’s salary was $8.3 million • CPI (1982 - 84 = 100) • 1930 = 0.167 • 1998 = 1.64 • Babe Ruth’s real salary = $80,000/0.167 = $479,000 • Mark McGwire’s real salary = $8.3 million/1.64 = $5.06 million Chapter 19: Measuring the Price Level and Inflation

  19. Adjusting for Inflation • 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 (dollar) wage by the CPI for that period Chapter 19: Measuring the Price Level and Inflation

  20. Nominal Wages CPI (1982 - 84 = 100) Real Wage 1970 $3.23 0.388 $3.23/0.388 = $8.32 1990 $10.01 1.307 $10.01/1.307 = $7.66 Adjusting for Inflation • Real Wages of U.S. Production Workers • An example: Chapter 19: Measuring the Price Level and Inflation

  21. Nominal and Real Wages for Production Workers’ 1960 - 2001 Chapter 19: Measuring the Price Level and Inflation

  22. Adjusting for Inflation • Indexing • The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index • Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation Chapter 19: Measuring the Price Level and Inflation

  23. Adjusting for Inflation • Indexing to Maintain Buying Power • An example: Social Security Payment Inflation 2000 $1,000/month 2000 - 2005 = 20% 2005 $1,200/month indexed to inflation Chapter 19: Measuring the Price Level and Inflation

  24. Adjusting for Inflation • Example • An indexed labor contract • Contract specifics • 1st year wage = $12/hr • Real wage will rise 2 percent in the 2nd and 3rd year • CPI: Year 1 = 1.00; Year 2 = 1.05; Year 3 = 1.10 • Year 2 wage = w2/1.05 = $12 x 1.02 = $12.24 • W2 = $12.24 X 1.05 = $12.85 • Year 3 wage = w3/1.10 = 12.24 x 1.02 = $12.48 • W3 = $12.48 X 1.10 = $13.73 Chapter 19: Measuring the Price Level and Inflation

  25. Adjusting for Inflation • Economic Naturalist • Every few years there is a well-publicized battle in Congress over whether the minimum wage should be raised. • Why do these heated debates recur so regularly? Chapter 19: Measuring the Price Level and Inflation

  26. Does the CPI Measure“True” Inflation? • 1996 report by the Boskin Commission estimated that the CPI overstates inflation by as much as 1 to 2 percentage points a year. • Overstating Inflation • Would unnecessarily increase government spending • Underestimate the improvements in the standard of living Chapter 19: Measuring the Price Level and Inflation

  27. Does the CPI Measure“True” Inflation? • Two Causes of the CPI Overestimation of Inflation • Quality adjustment bias • Substitution bias Chapter 19: Measuring the Price Level and Inflation

  28. Does the CPI Measure“True” Inflation? • Substitution Bias -- An Example • Assume 1995 CPI basket • Inflation: 1995 - 2000 = $300/$200 = 1.50 or 50% Items Expenditure 1995 Prices 2000 Prices Coffee (50 cups at $1/cup) $50 $2/cup = $100 Tea (50 cups at $1/cup) $50 $1/cup = $50 Scones (100 at $1 each) $100 $1.50/cup = $150 Total $200 $300 Chapter 19: Measuring the Price Level and Inflation

  29. Does the CPI Measure“True” Inflation? • Substitution Bias -- An Example • Assume 1995 CPI basket • Inflation: 1995 - 2000 w/substitution = $250/$200 = 25% Item (2000 w/substitution) Expenditure Coffee (0 cups at $2/cup) $0.00 Tea (100 cups at $1/cup) 100.00 Scones (100 at $1.50 each) 150.00 Total $250.00 Chapter 19: Measuring the Price Level and Inflation

  30. Does the CPI Measure“True” Inflation? • Economic Naturalist • Why is inflation in the health care sector apparently high? Chapter 19: Measuring the Price Level and Inflation

  31. The Costs of Inflation:Not What You Think • 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 Chapter 19: Measuring the Price Level and Inflation

  32. The Costs of Inflation:Not What You Think • Observations • Changes in relative price do not necessarily imply a significant amount of inflation. • Inflation can be high without affecting relative prices. Chapter 19: Measuring the Price Level and Inflation

  33. The Costs of Inflation:Not What You Think • Observations • To counteract relative price changes, government policy would have to affect the market for specific goods. • To counteract inflation, the government must use monetary and fiscal policy. Chapter 19: Measuring the Price Level and Inflation

  34. The Costs of Inflation:Not What You Think • The Price Level, Relative Prices, and Inflation CPI % change in oil prices Inflation Relative price of oil 2000 1.20 2001 1.32 2002 1.40 8% (2000 - 2001) 10% -2% 8% (2001 - 2002) 6% +2% Chapter 19: Measuring the Price Level and Inflation

  35. The True Costs of Inflation • “Shoe-Leather” Costs • The use of resources to economize on holding cash during periods of high inflation Chapter 19: Measuring the Price Level and Inflation

  36. The True Costs of Inflation • “Shoe-Leather Costs at Woodrow’s Hardware • Need $5,000 cash/day • May withdraw $25,000 on Monday or $5,000/day • Cost of a withdraw = $4/trip Chapter 19: Measuring the Price Level and Inflation

  37. The True Costs of Inflation • “Shoe-Leather Costs at Woodrow’s Hardware • Zero inflation • Withdraw $25,000 • Shoe-leather cost = $4/week Chapter 19: Measuring the Price Level and Inflation

  38. The True Costs of Inflation • “Shoe-Leather Costs at Woodrow’s Hardware • 10% inflation • Withdraws $25,000 • Average cash holding/day = $15,000 • Cost of holding cash = $15,000 x 10% = $1,500 Chapter 19: Measuring the Price Level and Inflation

  39. The True Costs of Inflation • “Shoe-Leather Costs at Woodrow’s Hardware • 10% inflation • Withdraws $5,000 daily • Average cash holding/day = $5,000 • Cost of holding cash = $5,000 x 10% = $500 • Shoe-leather cost = $4/trip x 200 trips (50 wks) = $800 • Benefit of $1,000 > cost of $800 Chapter 19: Measuring the Price Level and Inflation

  40. The True Costs of Inflation • “Noise” in the Price System • Inflation obscures the information transmitted by prices and reduces the efficiency of the market system Chapter 19: Measuring the Price Level and Inflation

  41. The True Costs of Inflation • Distortions of the Tax System • Inflation, Indexation, and --- • Bracket creep • Capital depreciation allowance Chapter 19: Measuring the Price Level and Inflation

  42. The True Costs of Inflation • Observation • Inflation may distort the incentives provided by the tax system for people to work, save, and invest and reduce economic growth. Chapter 19: Measuring the Price Level and Inflation

  43. The True Costs of Inflation • Unexpected Redistribution of Wealth • From workers to employers if wages are not indexed to inflation • From lenders to borrowers Chapter 19: Measuring the Price Level and Inflation

  44. The True Costs of Inflation • Interference with Long-Run Planning • Retirement planning • Investment and business strategies Chapter 19: Measuring the Price Level and Inflation

  45. Hyperinflation • Economic Naturalist • How costly is high inflation? Chapter 19: Measuring the Price Level and Inflation

  46. Hyperinflation • Economic Naturalist • Fischer, Sahay, and Vegh examined 133 market economies 1960 - 96 • 45 episodes of high inflation (100% +) in 25 countries • Real GDP/person fell by an average of 1.6%/yr • Real consumption/ person fell by an average of 1.3%/yr • Real investment/person fell by an average of 3.3%/yr Chapter 19: Measuring the Price Level and Inflation

  47. Inflation and Interest Rates • Nominal Interest Rate (market interest rate) • The annual percentage increase in the nominal value of a financial asset Chapter 19: Measuring the Price Level and Inflation

  48. Inflation and Interest Rates • Real Interest Rate • The annual percentage increase in the purchasing power of a financial asset • The real interest rate on any asset equals the nominal interest rate on that asset minus the inflation rate Chapter 19: Measuring the Price Level and Inflation

  49. Inflation and Interest Rates • Inflation and the Real Interest Rate Chapter 19: Measuring the Price Level and Inflation

  50. Inflation and Interest Rates Year Real Interest = Nominal Interest - Inflation 1970 0.80 6.5 5.7 1975 -3.3 5.8 9.1 1980 -2.0 11.5 13.5 1985 3.9 7.5 3.6 1990 2.1 7.5 5.4 1995 2.7 5.5 2.8 2000 2.2 4.7 2.5 Chapter 19: Measuring the Price Level and Inflation

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