Chapter 5 Part 2 Inflation

Transcription

1 Chapter 5 Part 2 Inflation Price Level, Inflation, and Deflation The price level is the average level of prices in the economy. Inflation is a persistently rising price level. Deflation is a persistently falling price level. We are interested in the price level because we want to 1. Measure the inflation rate or the deflation rate 2. Distinguish between money values and real values of economic variables. From the Price Level to the Inflation Rate Inflation rate - percentage increase in the overall price level. hyperinflation A period of very rapid increases in the inflation rate. deflation A decrease in the overall price level. dis-inflation a decrease in the inflation rate. 1

2 Price Level, Inflation, and Deflation Why Inflation is a Problem Low, steady, and anticipated inflation or deflation is not a problem. Unpredictable or unanticipated inflation is a problem because it Changes the distribution on income Shifts purchasing power At its worst, inflation becomes hyperinflation: 20, 30+ percent per month inflation rate that is so rapid that workers are paid twice a day because money loses its value so quickly. A few examples of hyperinflation country period CPI Inflation % per year CPI Inflation % per month Israel % 28% Brazil % Bolivia % Ukraine % Argentina % 225% Dem. Republic of Congo / Zaire % Angola % Peru % Zimbabwe % 440% How to Measure the Price Level The Consumer Price Index - CPI The CPI, measures the average of the prices paid by consumers for a fixed basket of goods and services. The CPI is defined to equal 100 for the reference base period. Currently, the reference base period is That is, for the average of the 36 months from January 1982 through December 1984, the CPI equals

3 How to Measure the Price Level The Consumer Price Index - CPI In November 2016, the CPI was This number tells us that the average of the prices paid by consumers for a fixed basket of goods was percent higher in November 2016 than it was during the base period. How the CPI is Calculated Three steps: Selecting the CPI basket Conducting a monthly price survey Calculating the CPI The CPI Basket Housing is the largest component: 41.4%. Transportation and food and beverages are the next largest components: 31.3%. All other components account for 27.3 percent of the basket. 3

4 How the CPI is Calculated The Monthly Price Survey Every month, BLS employees check the prices of the 80,000 goods in the CPI basket in 30 metropolitan areas. Calculating the CPI 1. Find the cost of the CPI basket at base-period prices. 2. Find the cost of the CPI basket at current-period prices. 3. Calculate the CPI for the current period. Example for How the CPI is Calculated Assume a simple economy where people consume only oranges and haircuts and the CPI basket is 10 oranges and 5 haircuts. Suppose the prices in the base period (here its assume to be 2014) are $1.00 and $8.00. The cost of the CPI basket in the base period is $50. How the CPI is Calculated Part (b) of Table 5.1 shows the prices of the basket in 2015 $2.00 and $ Oranges doubled in price and haircuts increased by 25%. The cost of the CPI basket at current-period prices is $70. 4

5 How the CPI is Calculated The CPI is calculated using the formula: Cost of basket at current period prices CPI = Cost of basket at base period prices 100 Using the numbers for the simple example, CPI = $70 X 100 = 140 $50 Prices increased by 40 percent. Price Level, Inflation, and Deflation Measuring the Inflation Rate The major purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The inflation formula is: CPI this year CPI last year Inflation rate =( ) X 100 CPI last year Consumer Price Index, December, selected years, Year Rate of Inflation

6 U.S. Annual Inflation Rate, During some periods experienced double-digit inflation. For the last two decades the U.S. inflation rate has been very low. Price Level, Inflation, and Deflation The CPI is not a perfect measure of the price level and can overstate the true inflation rate for four reasons: New goods bias Quality change bias Commodity substitution bias Outlet substitution bias Magnitude and Consequences of CPI Bias Estimated CPI overstates inflation by 1 percentage point a year. Increases government outlays (close to a third of federal government outlays are linked to the CPI). A bias of 1 percentage point over a decade adds up to aboubt $1 trillion of additional expenditure. 6

7 Price Level, Inflation, and Deflation Alternative Price Indexes Alternative measures of the price level are Chained CPI (Skip) GDP deflator Personal consumption expenditure deflator Price Level, Inflation, and Deflation GDP Deflator - includes the prices of all final goods and services (C,I,G, net exports)that are counted in GDP. The GDP deflator equals: (Nominal GDP Real GDP) 100 Personal Consumption Expenditure Deflator - The PCE deflator includes only the prices of C included in GDP The PCE deflator equals: (Nominal consumption expenditure Real consumption expenditure) 100 In Tables 4.3(b) and (c) from chapter 4, we calculated nominal GDP (NGDP) and real GDP (RGDP) for The GDP deflator for 2014 is calculated as GDP Deflator = NGDP 2014 x100 RGDP 2014 GDP Deflator = 300 x 100 = What is the value of the GDP Deflator in 2009, the base year? GDP Deflator 7

8 Now You Try It P Q P Q P Q good A $ $31 1,000 $36 1,050 good B $ $ $ Compute nominal GDP in each year Compute real GDP in each year using 2009 as the base year. Calculation of Nominal and Real GDP Nominal GDP multiply Ps & Qs from same year 2009: $46,200 = $ $ : $51,400 = $31 x $102 x : $58,300 = $36 x $100 x 205 Real GDP multiply each year s Qs by 2005 Ps 2009: $46,200 = $30 x $100 x : $50,000 = $30 x $100 x : $52,000 = $ $ GDP Deflator GDP Deflator = NGDP RGDP x 100 8

9 Exercise Nominal GDP Real GDP GDP deflator inflation rate 2009 $46,200 $46,200 n.a ,400 50, ,300 52,000 Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2009 to 2010, and from 2010 to CPI vs. GDP Deflator The GDP price index measures the prices of all final goods and services that are included in U.S. GDP The CPI measures the prices of all goods and services bought by U.S. households including used goods and imports 28 CPI vs. GDP Deflator Prices of capital goods (Investment): included in GDP deflator (if produced domestically) excluded from CPI Prices of imported consumer goods: included in CPI excluded from GDP deflator The basket of goods: CPI: fixed GDP deflator: changes every year 9

10 Core Inflation The figure shows the CPI inflation rate. The core inflation rate is the CPI inflation rate excluding the volatile elements (of food and fuel). The core inflation rate attempts to reveal the underlying inflation trend. Price Level, Inflation, and Deflation The Real Variables in Macroeconomics We use a price index to deflate nominal variables to find their real values. For example, Real wage = (Nominal wage CPI) 100 Real GDP = (Nominal GDP GDP Deflator) 100 Note: the real interest rate is different. How the CPI Is Used When comparing dollar values over time - We do not care about the number of dollars, but about their purchasing power Translate nominal values into real values Nominal Value Real Value= Price Index

11 Nominal and Real Weekly Earnings (December of Each Year) 2014 $ $