Price Indexes and InflationReview: Unemployment and Production

Unemployment Up

Employment Down

Production Down

Unemployment Down

Employment Up

Production Up

Nominal GDP for 2014 = Sum of the market values of all final goods and services produced in the United States during 2014

Real GDP for 2014 = Sum of the market values of all final goods and services produced in the United States during 2014 evaluated at base year (2009) prices

2014 2014 2014 2014Auto Auto Beer Beer= P Q + P Q + ... = 17,420

2009 2014 2009 2014Auto Auto Beer Beer= P Q + P Q + ... = 16,090

Review: A Way to Measure Production How many final goods and services does the economy produce?

Nominal GDP increases when: Production (Q’s) increase and/or prices (P’s) increase

Problem: We only want to measure changes in production (Q’s), not changes in prices (P’s).

Solution: Keep prices (P’s) constant.

Nominal GDP for 2014 = Sum of the market values of all final goods and services produced in the United States during 2014

Real GDP for 2014 = Sum of the market values of all final goods and services produced in the United States during 2014 evaluated at base year (2009) prices

2014 2014 2014 2014Auto Auto Beer Beer= P Q + P Q + ... = 17,420

2009 2014 2009 2014Auto Auto Beer Beer= P Q + P Q + ... = 16,090

Price Indexes

GDP Price Deflator

Nominal GDP for 2014GDP Price Deflator for 2014= 100Real GDP for 2014

2014 2014 2014 2014Auto Auto Beer Beer2009 2014 2009 2014Auto Auto Beer Beer

P Q + P Q + ...= ×100P Q + P Q + ...

Hypothetical Questions:

What if prices were unchanged since 2009?

GDP Price Deflator

100What if prices had doubled since 2009? 200What if prices had tripled since 2009? 300

17,420 100 108.3 16,090

Since the base year (2009) prices have risen by about

8 percent on average.

For the economy as a whole, what is the “average” price?

GDP Price Deflator Consumer Price Index (CPI)

108.3 106.7

106.7

1.6106.7

1930 1940 1950 1960 1970 1980 1990 2000 20100

20

40

60

80

100

120

GDP Price Deflator: 1930-20142009 = 100.0

Rate Change in the of = Price Index expressed

Inflation as a percentage

1930 1940 1950 1960 1970 1980 1990 2000 2010-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

GDP Price Deflation Inflation Rate: 1930-2014

YearGDP Price Deflator

2009 = 1002013 106.7

2014 108.3

Rate of Inflation in 2014 == = 1.5%

How Social Security Unfairly Calculates the Cost of Living for Retirees8:38 am ETOct 20, 2015

 DAVID BLANCHETT: Retirees got some bad news recently when it comes to Social Security: Their Social Security benefits won’t increase in 2016. The reason, according to the Department of Labor’s announcement on Oct. 15, was that living expenses were 0.4% lower in the third quarter from a year before, primarily because of lower gas prices....The Labor Department uses the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W, to measure inflation’s effects on Social Security beneficiaries’ costs. A cost-of-living increase for the following year’s benefits is determined by the average monthly CPI-W value in the third quarter of the current year....Consumer Price Index (CPI)

First, the Bureau of Labor Statistics decides upon the market basket of goods that is purchased by the typical American household:

Second, the Bureau of labor statistics calculates how much this market basket would have cost in the base year and how much it costs now.Third, it calculates the ratio of the costs and by convention multiplies the ratio by 100. The result is the CPI:

CPI for September 2015 = Cost of the Market Basket in September 2015

Cost of the Market Basket in Base Year× 100

x pounds of chicken y pounds of beef z gallons of gasoline n cans of beer

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec2013 230.3 232.2 232.8 232.5 232.9 233.5 233.6 233.9 234.1 233.5 233.1 233.02014 233.9 234.8 236.3 237.1 237.9 238.3 238.2 237.9 238.0 237.4 236.2 234.82015 233.7 234.7 236.1 236.6 237.8 238.6 238.6 238.3 237.4

Increase in Change in Purchasing Power:Nominal Per Capita Increase in Change in Real Per Capita

Disposable Income (%) CPI (%) Disposable Income (%)1979-802009-10

Consumer Price Index (CPI)

CPI for September 2015 = Cost of the Market Basket in September 2015

Cost of the Market Basket in Base Year

The Effects of Inflation: Purchasing Power

10.52.8 3.0

1.2

13.51.6

Rate Change in the of = Price Index expressed

Inflation as a percentage237.4 238.0

238.0 100=

.6

238.0 100= = .2%

× 100

Market Basket: “Basket” of Goods consumed by the typical American household.

Does the CPI Overstate or Understate the Effect of Inflation?Substitution

Smith household

In September 2013, the Smith household was using all its income to purchase the typical market basket of goods;During the next year the household’s income rose by 1.7 percent, an amount just equal to the increase in the CPI.

Could the Smiths continue to consume the typical market basket of goods? If so, the Smiths would be just as well off.

Would the Smiths continue to consume the typical market basket of goods?

The Smiths would be better off.

Yes

No

Quality Improvements and New Products

  CPI Ground Beef ($/lb) Turkey ($/lb)Sept 2013 234.1 3.50 1.82Sept 2014 238.0 4.10 1.58Percent change 1.7% 17.1% 13.2%

Personal computers

Cell phones

Atypical Households

Percent of Income SpentUrban

Workers ElderlyFood and beverages 15.70% 12.80%Housing 39.20% 44.50%Apparel 3.60% 2.40%Transportation 18.70% 14.50%Medical care 5.60% 11.30%Recreation 5.50% 5.30%

  Price of Gasoline ($/gal)

September 2014 3.40September 2015 2.40

Elderly

2.4%

$3 Net Increase of Purchasing Power

$5 of

Interest

Inflation and Interest Rates: Nominal and Real Interest Rates

The Effects of Inflation: Purchasing Power

Real NominalInterest = Interest Rate (r) Rate (i)

InflationRate ()

Save $100 for a year

Nominal Interest Rate = 5%

InflationRate = 2%

Real Interest Rate = 3%

$2 Erosion of

Purchasing Power

Year20072008

Nominal Interest Rate (i)

5.2%3.1%

InflationRate ()

2.8%3.8%

Real Interest Rate (r)

0.7%

Nominal Interest Rates: The interest rate that the bank advertises.

Question: What is the opportunity cost of holding cash? Answer: Nominal interest rate.

2014 0.1% 1.6% 1.5%

Question: What does opportunity cost refer to?

Equilibrium:Quantity Demanded = Quantity Supplied

Aggregate Demand (AD) CurveP

QD

S

P*

Q*Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were _____,

given that everything else relevant to the demand for beer remains the same?

Market supply curve: How many cans of beer would firms produce (the quantity

supplied), if the price of beer were _____, given that everything else relevant to the

supply of beer remains the same?P

Q

SP

QD

If P = .50

If P = 1.00

If P = 1.50

If P = 2.00

If P = .50

If P = 1.00

If P = 1.50

If P = 2.00

2.001.501.00.50 2.001.501.00.50

Review: Market for a Good

Question: Why is the demand curve downward sloping?

Question: Why is the supply curve downward sloping?

Equilibrium:Goods and Services Purchased

EqualsGoods and Services Produced

(%)

G&SAD

AS

AD Question: How many final goods and services would be purchased if the inflation rate () were _______ percent, given that all other factors relevant to demand remained

the same?

AS Question: How many final goods and services would be produced if the inflation

rate () were _______ percent, given that all other factors relevant to supply remained the

same? (%)

G&S

AS (%)

G&SAD

If = 1.0

If = 2.0

If = 3.0

If = 4.0

If = 1.0

If = 2.0

If = 3.0

If = 4.0

4.03.02.01.0 4.03.02.01.0

Aggregate Demand/Aggregate Supply Model

Aggregate Demand/Aggregate Supply Equilibrium

Goods and services (G&S) purchased

Goods and services (G&S) produced=

AD

AS=

(%)

G&SAD

AS

Goods and services (G&S) purchased

AD

Goods and services purchased by households

C

Goods and services purchased by

firms

I

Goods and services purchased by governments

G= + +

= + +

C + I + G =

GDP

Real GDP for 2014 = Sum of the market values of all final goods and services produced in the United States during 2014 evaluated at base year (2009) prices

NB: To keep our analysis more straightforward we are ignoring net exports

for now.

(%)

G&SAD

ASAD Question: How many final goods and services

would be purchased if the inflation rate () were

_______ percent, given that all other factors relevant to demand remained the same?

AS Question: How many final goods and services would be produced if the

inflation rate () were _______ percent, given

that all other factors relevant to supply

remained the same?

Summary: Aggregate Demand/Aggregate Supply Model

Goods and services (G&S) purchased

Goods and services (G&S) produced

AD

AS

C + I + G

GDP

Equilibrium

AD Question: How many final goods and services would be purchased if the inflation rate () were _______ percent, given that all other factors relevant to demand remained

the same? (%)

G&SAD

If = 1.0

If = 2.0

If = 3.0

If = 4.0

4.03.02.01.0

Aggregate Demand Curve

Question: Why is the aggregate demand (AD) curve downward

sloping?

Inflation rate () increases

Fewer goods and services purchased

The aggregate demand (AD) curve

is downward sloping.

The Federal Reserve Board (Fed)

The Real Interest Rate: The Federal Reserve Board’s (Fed’s) Throttle on the Economy

Real interest rate (r) increases

Loans become more costly

Households and firm purchase fewer goods and services

In the entire economy fewer goods

and services (G&S) purchased

Real interest rate (r) decreases

Loans become less costly

Households and firm purchase more goods and services

In the entire economy more goods

and services (G&S) purchased

Economy “slows down”

Economy “speeds up”

Fed’s Goal: Use its throttle, the real interest rate, to stabilize the economy.

When the inflation rate () increases the Fed “slows down” the economy by increasing the real interest rate (r).

When the inflation rate () decreases the Fed “speeds up” the economy by decreasing the real interest rate (r).

Taylor Principle

The Federal Reserve Board and the Taylor Principle

When the inflation rate () increases the Fed “slows down” the economy by increasing the real interest rate (r).

When the inflation rate () decreases the Fed “speeds up” the economy by decreasing the real interest rate (r).

Inflation rate () increases

Real interest rate (r) increases

Loans become more costly

Households and firm purchase fewer goods and services

Economy “slows down”

Inflation rate () decreases

Real interest rate (r) decreases

Loans become less costly

Households and firm purchase more goods and services

Economy “speeds up”

Taylor principle

Economy stabilizes

Taylor Principle

Fed’s Goal: Use its throttle, the real interest rate, to stabilize the economy.

In the entire economy fewer goods

and services (G&S) purchased

In the entire economy more goods

and services (G&S) purchased

When the inflation rate () increases the Fed “slows down” the economy by increasing the real interest rate (r).

If =

If =

When the inflation rate () decreases the Fed “speeds up” the economy by decreasing the real interest rate (r).

FP

(%)

r (%)1.0 3.0 5.0

Taylor Principle and the Fed Policy (FP) Curve

If = 2.0

3.0

1.0

FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy?

2.03.0%

3.01.05.0%1.0%4.0

2.0 4.0 6.0

r = 1.0%

Consumption Purchases (C) Investment Purchases (I)

1,530 220

1,300 200

1,070 180

r = 3.0%

r = 5.0%

Taylor Principle

The Fed policy (FP) curve is upward sloping to stabilize

the economy.

If =1.0% If =2.0% If =3.0%

FP

(%)

r (%)AD

(%)

G&S

AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?

1.0 3.0 5.0

Deriving the Aggregate Demand (AD) Curve

If =

2,000

2.0

3.0

1.0

1,750 2,250

FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy?

If =

If =

2.03.0%

2,000

3.01.05.0%1.0%

2.03.01.0

1,7502,2504.0

2.0 4.0 6.0

r = 1.0%

Consumption Purchases (C) Investment Purchases (I)

Government Purchases (G) Goods and Services Purchased (G&S)

1,530 220 500

2,250

1,300 200 500

2,000

1,070 180 500

1,750

r = 3.0%

r = 5.0%

The Fed policy (FP) curve is upward sloping to stabilize the

economy.

The aggregate demand (AD) curve reflects the goods and services

purchased.

The aggregate demand (AD) curve is downward sloping.

If =1.0% If =2.0% If =3.0%

FP

(%)

r (%)AD

(%)

G&S

AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?

Summary of the Fed Policy (FP) and the Aggregate Demand (AD) Curves

FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy?

Inflation rate ()

increases

Real interest rate (r)

increases

Loans become

more costly

Households and firms

purchase less

Fewer goods and services purchased

Taylor principle

(FP curve)

C and I

decrease

AD = C + I + G

decreases