November 25, AP Inflation.notebook. Goal #3 Price Stability. What is inflation? Inflation is a general rise in prices.

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1 AP Inflation.notebook Goal #3 Price Stability Country and Time Zimbabwe, 2008 Annual Inflation Rate 79,600,000,000% Time for Prices to Double 24.7 hours What is inflation? Inflation is a general rise in prices. What will inflation do to purchasing power? Note: Any inflation rate above 10% is considered to be "hyperinflation" which is really destabilizing for an economy Purchasing Power will fall! Jan 20 12:13 PM Jan 20 12:22 PM Reduced Purchasing Power It takes $2 to buy what $1 would purchase in It takes $6 to buy what $1 would purchase in Jan 20 12:23 PM What causes inflation? 1. Quantity Theory 2. Demand-Pull 3. Cost-Push Jan 20 12:25 PM Quantity Theory of Money Inflation occurs when government prints too much money. MV=PY Jan 20 12:27 PM M= Money Supply V= Velocity of Money P= Price Level Y= Output Jan 20 12:28 PM 1

2 AP Inflation.notebook Demand-Pull Inflation "Too many dollars chasing too few goods." Essentially, higher demand for products leads to temporary shortages that drive up prices. Cost-Push Inflation -Higher production costs increase prices -Usually due to a negative supply shock EX: Hurricane Katrina destroyed oil refineries decreasing the supply of oil and gas. Companies that needed to use gasoline had to raise their prices to cover fuel costs. Can lead to STAGFLATION - rising prices coupled with FALLING real GDP. Jan 20 12:32 PM Jan 20 12:34 PM The Wage Price Spiral A Perpetual Process: 1.Workers demand raises 2.Owners increase prices to pay for raises 3. High prices cause workers to demand higher raises 4. Owners increase prices to pay for higher raises 5. High prices cause workers to demand higher raises 6. Owners increase prices to pay for higher raises Jan 20 12:36 PM Interest Rates and Inflation Jan 20 12:26 PM Nominal Interest Rate v. Real Interest Rate What is the difference? Jan 20 12:41 PM Jan 20 12:42 PM 2

3 Real Interest Rates The percentage increase in purchasing power that a borrower pays. (adjusted for inflation) Real = nominal interest rate expected inflation Nominal Interest Ratesthe percentage increase in money that the borrower pays not adjusting for inflation. Nominal = Real interest rate + expected inflation Fisher Principal - nominal rate of interest will adjust so that it is equal to real interest rate plus inflation 1. Nominal interest rate is 15%; Rate of inflation is 10%. What is the real interest rate? 2. Nominal interest rate is 6%. The rate of inflation rises unexpectedly to 8%. What is the real interest rate? 3. The nominal interest rate is 10%. The real interest rate is 6%. What is the rate of inflation? 4. Assume you have a loan on a used car at 4%. Determine your real interest rate. Jan 20 12:44 PM Jan 20 12:45 PM Closing: Socrative Exit Ticket How do we measure inflation? 1) Consumer Price Index 2) GDP Deflator Jan 26 5:01 AM Jan 20 12:50 PM Consumer Price Index - most common measurement of inflation - Government tracks the same goods and services over a period of time ("market basket") - % change in prices from year to year is the inflation rate -prices are also usually compared to a base year (usually 1982) To see recent CPI data go to: Jan 20 1:05 PM Jan 26 2:46 PM 3

4 CPI = price of market basket price of market basket in a base year X CPI 2002: 100 CPI 2003: 104 See figuring CPI sheet to see an example of how CPIs are determined. 2. CPI 2005: 98 CPI 2006: CPI 2007: 120 CPI 2015: 135 Jan 20 1:35 PM Jan 20 1:45 PM Problems with CPI: 1. Substitution Bias - as prices rise, people substitute for items not in the market basket Problems with CPI 2. New Products - the basket may not include the newest products people are buying 3. Quality - CPI ignores improvements or declines in quality of products Jan 20 1:48 PM Jan 20 1:48 PM Consumer Price Index GDP Deflator GDP Deflator measures prices of a specific set of goods and services people typically purchase provides a measure of inflation measures prices of ALL goods and services produced domestically GDP Deflator = Nominal GDP Year 1 Real GDP Year 1 X 100 Nominal GDP = (Deflator) X (Real GDP) 100 Jan 20 1:50 PM Jan 20 1:52 PM 4

5 1. In an economy, Real GDP (base year 1996) is $100 billion. Nominal GDP is $150 billion. Calculate the GDP Deflator. 2. In an economy Real GDP (base year 1996) is $125 billion. Nominal GDP is $150 billion. Calculate the GDP Deflator. 3. In an economy Real GDP (base year 1996) is $200 billion and the GDP Deflator is 120. Calculate nominal GDP. Jan 20 1:56 PM Jan 26 2:37 PM 5