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Transcript of MBMC Measuring the Price Level and Inflation. MBMC Chapter 6: Measuring the Price Level and...
MB MC
Measuring the Price Level and Inflation
Measuring the Price Level and Inflation
Chapter 6: Measuring the Price Level and Inflation Slide 2
MB MC
Introduction
What Do You Think?Could you retire in thirty years if you have
$1 million at that point?
Chapter 6: Measuring the Price Level and Inflation Slide 3
MB MC The Consumer Price Index: Measuring the Price Level
Consumer Price Index (CPI)For any period, CPI 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 benchmark year, called the base year
Chapter 6: Measuring the Price Level and Inflation Slide 4
MB MC The Consumer Price Index: Measuring the Price Level
Constructing the CPI CPI for current year = 100 x current cost of the base-year basket
------------------------------------------------------- .
base-year cost of the base-year basket
The CPI is a price index.
Chapter 6: Measuring the Price Level and Inflation Slide 5
MB MC
Cost of Reproducing the 1995 (Base-Year) Basket of Goods and Services in Year 2000
Item Cost in 1995
Rent, two-bedroom apartment $630 $500
60 Hamburgers 150 120
10 Movie tickets 70 60
Total expenditure $850 $680
Cost in 2000
Expenditures of a Hypothetical Household
CPI for 2000 = 100x($850/$680) = 125
CPI for 1995 = 100x($680/$680) = 100
Living cost rose by 25% from 1995 to 2000.
Chapter 6: Measuring the Price Level and Inflation Slide 6
MB MC
Inflation
CPIMeasures the average level of prices
relative to prices in the base year
InflationMeasures how fast the average price level
is changing over time
Inflation RateIs the percentage change in the price level
Chapter 6: Measuring the Price Level and Inflation Slide 7
MB MC Calculating InflationRates: 1972 - 1976
Year CPI
1972 0.418
1973 0.444
1974 0.493
1975 0.538
1976 0.569
6.2% 100 x 0.062 0.418
0.418 - 0.444 '73 - 1972 :rate Inflation
11.0% 100 x 0.110 0.444
0.444 - 0.493 '74 - 1973 :rate Inflation
Chapter 6: Measuring the Price Level and Inflation Slide 8
MB MC Calculating InflationRates: 1929 - 1933
Year CPI
1929 0.171
1930 0.167
1931 0.152
1932 0.137
1933 0.130
2.3%- 100 x 0.023- 0.171
0.171 - 0.167 '30 - 1929 :rate Inflation
9.0%- 100 x 0.090- 0.167
0.167 - 0.152 '31 - 1930 :rate Inflation
Chapter 6: Measuring the Price Level and Inflation Slide 9
MB MC
Inflation
DeflationA situation in which the prices of most
goods and services are falling over time so that inflation rate is negative
Chapter 6: Measuring the Price Level and Inflation Slide 10
MB MC
Adjusting for Inflation
Deflating a Nominal QuantityNominal Quantity
A quantity that is measured in terms of its current dollar value
Real QuantityA quantity that is measured in physical terms --
for example, in terms of quantities of goods and services
Chapter 6: Measuring the Price Level and Inflation Slide 11
MB MC
Adjusting for Inflation
Deflating a Nominal QuantityA process of dividing a nominal quantity by
a price index (such as the CPI) to express the quantity in real terms
Chapter 6: Measuring the Price Level and Inflation Slide 12
MB MC Comparing the Real Values of a Family’s Income in 1995 and 2000
YearReal family income =
Nominal family income/CPI
1995 $20,000 1.00 $20,000/1.00 = $20,000
2000 $22,000 1.25 $22,000/1.25 = $17,600
Nominal family income CPI
What deflating does here is to transform the $22,000 nominal income of year 2000 into a real quantity that is comparable to year 1995’s income $20,000. The last column of the table above shows that in real terms, the family’s income dropped by 12%, though in nominal terms, it went up by 10%.
Chapter 6: Measuring the Price Level and Inflation Slide 13
MB MC
Adjusting for Inflation Example: Home run hitters drive Cadillacs
1930 Babe Ruth’s salary was $80,0001998 Mark McGwire’s salary was $8.3 million
Who was earning more?CPI (1982 - 84 = 1.00)
o 1930 = 0.167o 1998 = 1.64o Babe Ruth’s real salary = $80,000/0.167 = $479,000o Mark McGwire’s real salary = $8.3 million/1.64 = $5.06 million
Chapter 6: Measuring the Price Level and Inflation Slide 14
MB MC
Adjusting for Inflation
Real WageThe 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 6: Measuring the Price Level and Inflation Slide 15
MB MC
Adjusting for Inflation
Real Wages of U.S. Production Workers
Nominal Wages CPI (1982 - 84 = 1.00) Real Wage
1970 $3.23 0.388 $3.23/0.388 = $8.32
1990 $10.01 1.307 $10.01/1.307 = $7.66
Chapter 6: Measuring the Price Level and Inflation Slide 16
MB MC Nominal and Real Wages for Production Workers’ 1960 - 2001
Chapter 6: Measuring the Price Level and Inflation Slide 17
MB MC
Adjusting for Inflation
IndexingThe 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 6: Measuring the Price Level and Inflation Slide 18
MB MC
Adjusting for Inflation
Indexing to Maintain Buying PowerAn example:
Social Security Payment Inflation
2000 $1,000/month 2000 - 2005 = 20%
2005 $????/month if indexed to inflation
Chapter 6: Measuring the Price Level and Inflation Slide 19
MB MC
Adjusting for Inflation
Economic NaturalistEvery 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 6: Measuring the Price Level and Inflation Slide 20
MB MC 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 6: Measuring the Price Level and Inflation Slide 21
MB MC Does the CPI Measure“True” Inflation?
Two Causes of the CPI Overestimation of InflationQuality adjustment biasSubstitution bias
Chapter 6: Measuring the Price Level and Inflation Slide 22
MB MC
Items (quantities) Expenditure by 1995 Prices by 2000 Prices
Does the CPI Measure“True” Inflation?
Coffee (50 cups) $1/cup = $50 $2/cup = $100
Tea (50 cups) $1/cup = $50 $1/cup = $50
Scones (100) $1each= $100 $1.50ea. = $150
Total $200 $300
Inflation 1995 ~ 2000 = $300/$200 – 1 = 50%
Substitution Bias -- An Example
A consumer likes coffee and tea equally well
Chapter 6: Measuring the Price Level and Inflation Slide 23
MB MC
Item (Yr. 2000 quantity w/substitution) Expenditure
Does the CPI Measure“True” Inflation?
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
Inflation 1995 ~ 2000 w/substitution
= $250/$200 –1 = 25%
Substitution Bias -- An Example
Chapter 6: Measuring the Price Level and Inflation Slide 24
MB MC Does the CPI Measure“True” Inflation?
Economic NaturalistWhy is inflation in the health care sector
apparently high?
Chapter 6: Measuring the Price Level and Inflation Slide 25
MB MC The Costs of Inflation:Not What You Think
Price LevelA measure of the overall level of prices at a
particular point in time as measured by a price index such as the CPI
Relative PriceThe price of a specific good or service in
comparison to the prices of other goods and services
Chapter 6: Measuring the Price Level and Inflation Slide 26
MB MC The Costs of Inflation:Not What You Think
ObservationsChanges in relative price do not
necessarily imply a significant amount of inflation.
Inflation can be high without affecting relative prices.
Chapter 6: Measuring the Price Level and Inflation Slide 27
MB MC The Costs of Inflation:Not What You Think
ObservationsTo 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 6: Measuring the Price Level and Inflation Slide 28
MB MC
CPI % change in oil prices Inflation Relative price of oil
2000 1.20
2001 1.32
2002 1.40
The Costs of Inflation:Not What You Think
The Price Level, Relative Prices, and Inflation
8% (2000 ~2001) 10% -2%
8% (2001 ~ 2002) 6% +2%
Chapter 6: Measuring the Price Level and Inflation Slide 29
MB MC
The True Costs of Inflation
“Shoe-Leather” CostsThe use of resources to economize on
holding cash during periods of high inflation
Chapter 6: Measuring the Price Level and Inflation Slide 30
MB MC
The True Costs of Inflation
Shoe-Leather Costs at Woodrow’s HardwareNeed $5,000 cash/dayMay withdraw $25,000 on Monday or
$5,000/dayCost of a withdraw = $4/trip
Chapter 6: Measuring the Price Level and Inflation Slide 31
MB MC
The True Costs of Inflation
Shoe-Leather Costs at Woodrow’s HardwareWhen there is no inflation,
Withdraw $25,000 every MondayShoe-leather cost = $4/week or $200/year
(if assuming 50 weeks/year)
Chapter 6: Measuring the Price Level and Inflation Slide 32
MB MC
The True Costs of Inflation
Shoe-Leather Costs at Woodrow’s HardwareWith 10% inflation per year,
If withdrawing $25,000 every Monday,o Average cash holding/day = $15,000o Cost of holding cash = $15,000 x 10% = $1,500/yearo Shoe-leather cost = $200/year
Chapter 6: Measuring the Price Level and Inflation Slide 33
MB MC
The True Costs of Inflation
Shoe-Leather Costs at Woodrow’s Hardware With 10% inflation a year,
If withdrawing $5,000 daily, instead of $25,000 every Mondayo Average cash holding/day = $5,000o Cost of holding cash = $5,000 x 10% = $500/yearo Shoe-leather cost = $4/trip x 250 trips (50 wks) = $1000/year
Marginal Benefit of going daily = $1,000 saved on costing of holding cash
Marginal Cost of going daily = $800 increase in shoe-leather costSo the choice is to bank daily, which increases the shoe-leather
cost
Chapter 6: Measuring the Price Level and Inflation Slide 34
MB MC
The True Costs of Inflation
“Noise” in the Price System With high inflation, producers have greater
difficulty telling whether the changes in the prices of their goods or services are changes in relative prices or just a reflection of the general price inflation.
As such, high inflation obscures the information transmitted by prices and reduces the efficiency of the market system
Chapter 6: Measuring the Price Level and Inflation Slide 35
MB MC
The True Costs of Inflation
Distortions of the Tax SystemInflation, Indexation, and ---
Bracket creepCapital depreciation allowance
Chapter 6: Measuring the Price Level and Inflation Slide 36
MB MC
The True Costs of Inflation
ObservationInflation may distort the incentives provided
by the tax system for people to work, save, and invest and reduce economic growth.
Chapter 6: Measuring the Price Level and Inflation Slide 37
MB MC
The True Costs of Inflation
Unexpected Redistribution of WealthFrom workers to employers if wages are
not indexed to inflationFrom lenders to borrowers
Chapter 6: Measuring the Price Level and Inflation Slide 38
MB MC
The True Costs of Inflation
Interference with Long-Run PlanningRetirement planningInvestment and business strategies
Chapter 6: Measuring the Price Level and Inflation Slide 39
MB MC
Hyperinflation
Cost of HyperinflationFischer, Sahay, and Vegh examined 133
market economies 1960 - 9645 episodes of high inflation (100% +) in 25
countrieso Real GDP/person fell by an average of 1.6%/yro Real consumption/ person fell by an average of
1.3%/yro Real investment/person fell by an average of 3.3%/yr
Chapter 6: Measuring the Price Level and Inflation Slide 40
MB MC
Inflation and Interest Rates
Nominal (market) Interest Rate
The annual percentage increase in the nominal value of a financial asset
Real Interest RateThe annual percentage increase in the
purchasing power of a financial asset. It
equals the nominal interest rate on that
asset minus the inflation rate.
Chapter 6: Measuring the Price Level and Inflation Slide 41
MB MC
Inflation and Interest Rates
Inflation and the Real Interest Rate
)rate( inflation the - )( interst nominal )( Rate Interest Real ir
- ir
Chapter 6: Measuring the Price Level and Inflation Slide 42
MB MC
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 6: Measuring the Price Level and Inflation Slide 43
MB MC The Real Interest Rate in the United States, 1960 - 2001
Chapter 6: Measuring the Price Level and Inflation Slide 44
MB MC
Inflation and Interest Rates
Fisher-EffectThe tendency for nominal interest rates to
be high when inflation is high and low when inflation is low
Chapter 6: Measuring the Price Level and Inflation Slide 45
MB MC Inflation and Interest Rates in the United States, 1960 - 2001