MBMC Measuring the Price Level and Inflation. MBMC Copyright c 2004 by The McGraw-Hill Companies,...

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

Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Introduction

What Do You Think?Could you retire in thirty years if you have

$100 million?


MB MC


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


MB MC


Monthly Household Budget of the Typical Family in 1995 (Base Year)

Item Cost (in 1995)

Rent, two-bedroom apartment $500

Hamburgers (60 at $2.00 each) 120

Movie tickets (10 at $6.00 each) 60

Total expenditure $680

Constructing a Hypothetical CPI


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

Hamburgers (60 at $2.00 each) 150 120

Movie tickets (10 at $6.00 each) 70 60

Total expenditure $850 $680

Cost (in 2000)


%25680

170

680

680 - 850 Living of Cost


MB MC



Constructing the CPIBureau of Labor Statistics (BLS)

Pick a base yearConduct the consumer expenditure survey to

determine the base-year basket of goods and services

Measure the current prices of the base-year basket

yearbase in services and goods of basket year-base of Cost

yearcurrent in services and goods of basket year-base of Cost CPI


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

Hamburgers (60 at $2.00 each) 150 120

Movie tickets (10 at $6.00 each) 70 60

Total expenditure $850 $680

Cost (in 2000)


•The CPI in year 2000 = $850/$680 = 1.25•Base year = 1.00•The cost of living increased by 25% from 1995 to 2000


MB MC



Constructing the CPIThe CPI for a given period measures the

cost of living for that period relative to the base year


MB MC



Constructing the CPIThe CPI is a price index.

Price IndexA 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


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


MB MC


Inflation

Rate of InflationThe annual percentage rate of change in

the price level


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


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


MB MC


Inflation

DeflationA situation in which the prices of most

goods and services are falling over time so that inflation is negative


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


MB MC



Deflating a Nominal QuantityDeflating (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


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


MB MC



ExampleHome run hitters drive Cadillacs

1930 Babe Ruth’s salary was $80,0001998 Mark McGwire’s salary was $8.3 millionCPI (1982 - 84 = 100)

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


MB MC



Real WageThe wage paid to workers measured in

terms of real purchasing powerThe real wage for any given period is

calculated by dividing the nominal (dollar) wage by the CPI for that period


MB MC



Real Wages of U.S. Production WorkersAn example:

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


MB MC


Nominal and Real Wages for Production Workers’ 1960 - 2001


MB MC



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


MB MC



Indexing to Maintain Buying PowerAn example:

Social Security Payment Inflation

2000 $1,000/month 2000 - 2005 = 20%

2005 $1,200/month indexed to inflation


MB MC



Example An indexed labor contract

Contract specifics

o 1st year wage = $12/hr

o 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

o W2 = $12.24 X 1.05 = $12.85

Year 3 wage = w3/1.10 = 12.24 x 1.02 = $12.48

o W3 = $12.48 X 1.10 = $13.73


MB MC



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?


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


MB MC



Two Causes of the CPI Overestimation of InflationQuality adjustment biasSubstitution bias


MB MC


Items Expenditure1995 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

Substitution Bias -- An ExampleAssume 1995 CPI basket

Inflation: 1995 - 2000 = $300/$200 = 1.50 or 50%


MB MC


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

Substitution Bias -- An ExampleAssume 1995 CPI basket

Inflation: 1995 - 2000 w/substitution = $250/$200 = 25%


MB MC



Economic NaturalistWhy is inflation in the health care sector

apparently high?


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


MB MC



ObservationsChanges in relative price do not

necessarily imply a significant amount of inflation.

Inflation can be high without affecting relative prices.


MB MC



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.


MB MC


CPI % change in oil prices Inflation Relative price of oil

2000 1.20

2001 1.32

2002 1.40


The Price Level, Relative Prices, and Inflation

8% (2000 - 2001) 10% -2%

8% (2001 - 2002) 6% +2%


MB MC


The True Costs of Inflation

“Shoe-Leather” CostsThe use of resources to economize on

holding cash during periods of high inflation


MB MC



“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


MB MC



“Shoe-Leather Costs at Woodrow’s HardwareZero inflation

Withdraw $25,000Shoe-leather cost = $4/week


MB MC



“Shoe-Leather Costs at Woodrow’s Hardware10% inflation

Withdraws $25,000o Average cash holding/day = $15,000o Cost of holding cash = $15,000 x 10% = $1,500


MB MC



“Shoe-Leather Costs at Woodrow’s Hardware10% inflation

Withdraws $5,000 dailyo Average cash holding/day = $5,000o Cost of holding cash = $5,000 x 10% = $500o Shoe-leather cost = $4/trip x 200 trips (50 wks) =

$800o Benefit of $1,000 > cost of $800


MB MC



“Noise” in the Price SystemInflation obscures the information

transmitted by prices and reduces the efficiency of the market system


MB MC



Distortions of the Tax SystemInflation, Indexation, and ---

Bracket creepCapital depreciation allowance


MB MC



ObservationInflation may distort the incentives provided

by the tax system for people to work, save, and invest and reduce economic growth.


MB MC



Unexpected Redistribution of WealthFrom workers to employers if wages are

not indexed to inflationFrom lenders to borrowers


MB MC



Interference with Long-Run PlanningRetirement planningInvestment and business strategies


MB MC


Hyperinflation

Economic NaturalistHow costly is high inflation?


MB MC


Hyperinflation

Economic NaturalistFischer, 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


MB MC


Inflation and Interest Rates

Nominal Interest Rate (market interest rate)The annual percentage increase in the

nominal value of a financial asset


MB MC



Real Interest RateThe annual percentage increase in the

purchasing power of a financial assetThe real interest rate on any asset equals

the nominal interest rate on that asset minus the inflation rate


MB MC



Inflation and the Real Interest Rate

)rate( inflation the - )( interst nominal )( Rate Interest Real ir

- ir


MB MC



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


MB MC


The Real Interest Rate in the United States, 1960 - 2001


MB MC



ObservationsUnexpected inflation will benefit borrowers

and hurt lendersExpected inflation may not hurt lenders if

they can adjust the nominal interest rates


MB MC



Fisher-EffectThe tendency for nominal interest rates to

be high when inflation is high and low when inflation is low


MB MC


Inflation and Interest Rates in the United States, 1960 - 2001

MB MC

End ofChapterEnd of

Chapter

MBMC Measuring the Price Level and Inflation. MBMC Copyright c 2004 by The McGraw-Hill Companies,...

Documents

Transcript of MBMC Measuring the Price Level and Inflation. MBMC Copyright c 2004 by The McGraw-Hill Companies,...