EQ: What is Price Level Stability? EQ: What is Inflation? EQ: Why is Inflation Bad? EQ: How is Price Level Stability Measured?

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1 EQ: What is Price Level Stability? EQ: How is Price Level Stability Measured? First let s consider What is Price Level? In an economy, the price level is the overall price of all goods and services. Basically, it is a single price that includes the price of bread, milk, cable TV, gas, cars, insurance, etc. In macroeconomics, we do not talk about the price of one thing changing, we discuss the prices of all things changing. Price level stability is a condition in which the price level remains relatively unchanging in an economy. That is, a condition in which the overall prices of goods and services remain relatively unchanging. Relatively unchanged means that if other things change (like incomes), overall prices will change proportionally (same % in the same direction). Example: If family incomes increase by 5%, then the price level will remain stable if overall prices increase by 5%. Most people do not discuss the stability of the price level in an economy. Price Level Stability is the goal, but the way we determine whether we are achieving the goal is by examining Inflation. The way we measure Price Level Stability is by calculating the Inflation Rate in an economy. The Consumer Price Index is the specific measure used for calculating inflation and the inflation rate. We will now examine these concepts. EQ: What is Inflation? Inflation is a sustained rise in the general price level within an economy. Too many dollars chasing too few goods When the amount of money spent in an economy increases faster than the number of goods produced within that economy. Inflation happens when people increase prices of resources without increasing the values of those resources. Wage raises for workers who do the same thing they have always done with no increase in productivity. Raising the price of an dozen eggs or gallon of milk. Inflation is the erosion of purchasing power of money. $1 today can buy more than $1 next year. Why consumers don t like inflation: Nobody likes it when they have to pay more for stuff enough said. Prices usually increase before people get pay increases at their jobs, so they have less power to buy the things they want. Why businesses don t like inflation: Changing prices is a pain in the butt. Marketing people have to meet to set the new price. New menus and signs have to be printed. Also, they have to pay more for factors of production without really getting more out of those factors.

2 Why investors/savers don t like inflation: If $1 today is more valuable than $1 in a year, then when you save money, it loses value the longer you have it. That is one reason savers get interest when they put it in the bank. If interest earned on saved/invested money is not higher than inflation, then money is being lost. If the inflation rate is 5% and interest earned is 4%, then money saved is losing 1% of its purchasing power every year (4% - 5% = -1%). To make things worse, you have to pay income tax on the 4% interest that you earned. So, not only did your money lose value overall, you also had to pay the government for the income you earned. Why leaders don t like inflation: Government leaders don t like inflation because consumers and businesses hate it. When the populace is highly concerned about inflation, it is something that will affect leaders. What economists don t like about inflation: Inflation makes people behave irrationally and that freaks economists out. Economists like to predict what will happen (remember relationships among factors) Price increases make people upset and people who are upset can t understand that when their pay goes up, prices have to go up so that businesses can pay for those pay raises. Why economists don t mind inflation: Remember that money is a medium of exchange and has no real consumption value itself. Many economists refer to money as a veil it is simply a system used to price things and shouldn t influence the real economy. If the price of everything goes up 5%, including wages, then everyone can buy exactly what they have always been able to buy. So, why the freak-out? EQ: How Do I Calculate the Inflation Rate? The inflation rate is the proportionate rate of increase in the general price level per year. That is, it is the approximate increase in the price of goods & services while holding the value of money constant. Let s say that everything has a price of $1. After a year, everything now has a price of $1.03. This is a 3% increase in the price of everything. We would say that the inflation rate is 3%.

3 EQ: How Do I Calculate the Inflation Rate? As noted earlier, the Consumer Price Index (CPI) is used as a measure of the inflation rate. The CPI sums the prices of a "basket" of goods and services consumed by the average household. It is the total price of milk, bread, meat, a TV, gasoline, butter, etc. all bought by households. It is reported both monthly and yearly. Page 4-3 in the textbook shows U.S. CPI from 1913 to 2007 As prices of goods and services increase, the CPI increases, representing an increase in the price level. You can calculate the inflation rate by comparing the CPI from one year to the CPI from another year. EQ: How Do I Calculate the Inflation Rate? Calculating the % annual inflation rate: The formula is: Change in the CPI during the time period divided by the CPI at the starting point of the time period. Inflation Rate (Year 2) = Example: CPI Year2 CPI Year1 CPI Year1 CPI in 2006 was & CPI in 2007 was Change in CPI during 2007 was = 5.7 The inflation rate for 2007 = 5.7 / = = 2.83% EQ: What is the Difference between Inflation makes it difficult to see what is really happening in the economy. For example: It s hard to tell if more stuff was produced in the economy than previous years. Year 1: 1,000 cars x $20,000 each = $20 million Year 2: 975 cars x $21,025 each = $20.5 million Revenues make it look like more cars were sold in Year 2, but we can see that fewer cars were sold at a higher price per car. It s hard to tell how much of a return savers and investors earn on their money. $1,000 saved x 4% interest = $40 $1,000 saved x 3% inflation = $30 Actual interest earned is $10 because there was $40 interest earned minus $30 lost in purchasing power. EQ: What is the Difference between Because the value of what a dollar can purchase changes over time, we distinguish between: How much money consumers pay out in total dollars. This is referred to as Nominal. How much actual consumer satisfaction is provided. This is referred to as Real. Avatar vs. Gone with the Wind : Even though U.S. consumers spent $667 million on Avatar, the movie only provided consumer satisfaction to Americans 88 million times. Even though U.S. consumers only spent $198 million on Gone with the Wind, the movie provided consumer satisfaction to Americans 202 million times. In the Real economy, Gone with the Wind wins!

4 EQ: What is the Difference between In macroeconomics, the words Nominal and Real are used regularly. Nominal means a value that is unadjusted (not adjusted) for changes in the price level. It is basically a measure of an economic value in prices that are current to the time of purchase. Real means a value that is adjusted for changes in the price level. It is basically a value that has been converted as if there were no inflation at all. EQ: What is a Nominal Price Change? Remember that nominal means an economic value in prices current to the time of purchase. So, a nominal price is the price of a good or service that you see on the menu or the price tag (the price that shows on a receipt). It is the price of a product including inflation. A nominal price change is simply an increase or decrease in how much a person has to pay to buy something. EQ: What is a Nominal Price Change? Remember the market graph with the Supply & Demand curves? The y-axis represents Market Price This is the nominal price If you recall, anytime either the Supply curve or the Demand curve shifts, Price changes. Anything that causes a change in Demand will cause a nominal price change. Anything that changes consumers incomes, preferences for a product, or the number of buyers in a market. Anything that causes a change in Supply will cause a nominal price change. Anything that increases or decreases costs of production will change supply (business taxes, wages, rent, etc.) Price S D EQ: What is a Relative Price Change? A relative price is the price of a good or service in comparison to the price of another good or service. It is a ratio of how many units of one good you could potentially buy if you give up one unit of another good. Example: Let s say you can buy a normal DVD for $20 (nominal price) or a Blu-Ray DVD for $40 (nominal price). The relative price of a DVD to a Blu-Ray DVD is 2:1. A relative price change is a situation in which the nominal price of one good or service changes more greatly or in a different direction than the nominal price change of another product. Example 1: If the nominal price of milk increases by 10% while the nominal price of bread increases by 5%, then the relative price of milk is higher when compared to bread. Example 2: If the nominal price of gas decreases by 5% and the nominal price of bottled water increases by 5%, then the relative price of gas is lower when compared to bottled water.

5 EQ: What is a Relative Price Change? Relative price changes are caused by disproportional nominal price changes across multiple markets. Basically, this means one of the following: The supply or demand curve increases in one market and decreases in another market (this is disproportional). The supply or demand curve increases/decreases in one market but does not change in another market. The supply or demand curve increases/decreases greatly in one market but increases/decreases mildly in another market. Usually not caused by changes in income, since changes in income are likely to simultaneously increase demand in most markets. That is, if incomes increase by 5%, then the price of all products will likely increase by 5% to compensate for the increased wages to workers (i.e., no change in relative price since all changes were equal).