Sherif Khalifa. Sherif Khalifa () Inflation 1 / 33
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1 Sherif Khalifa Sherif Khalifa () Inflation 1 / 33
2 "The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists" Ernest Hemingway. Sherif Khalifa () Inflation 2 / 33
3 Definition The consumer price index CPI is a measure of a weighted average of prices of a fixed basket of goods and services typically purchased by consumers. The Consumer Price Index is a measure of the overall price of goods and services. The Consumer Price Index is used to calculate the cost of living over time. The Consumer Price Index provides guidance over consumer purchasing power. When the index increases, a consumer has to spend more to maintain the same living standards. When the index decreases, a consumer has to spend less to maintain the same living standards. Sherif Khalifa () Inflation 3 / 33
4 Fix the basket by determining which goods and services are most important to the typical consumer. Hot Dogs Burgers 4 2 Sherif Khalifa () Inflation 4 / 33
5 Find the prices of the goods and services in the basket for each point in time. Year Hot Dogs Burgers 2013 $1 $ $2 $ $3 $4 Sherif Khalifa () Inflation 5 / 33
6 Compute the cost of the basket in each point in time. Year Hot Dogs Burgers Basket Cost 2013 $1x4=$4 $2x2=$4 $ $2x4=$8 $3x2=$6 $ $3x4=$12 $4x2=$8 $20 Sherif Khalifa () Inflation 6 / 33
7 Choose a base year and compute the consumer price index. CPI = CPI 2013 = CPI 2014 = CPI 2015 = Cost of basket in current year X 100 Cost of basket in base year ( ) 8 x100 = ( ) 14 x100 = ( ) 20 x100 = Sherif Khalifa () Inflation 7 / 33
8 Definition The inflation rate is the percentage change in the price level. Definition Inflation is an increase in the overall level of prices. Deflation is a decrease in the overall level of prices. Hyperinflation is an extraordinarily high rate of inflation. Inflation rate = Inflation = Inflation = Final CPI Initial CPI ( Initial ) CPI = 75% 100 ( ) = 43% 175 Sherif Khalifa () Inflation 8 / 33
9 6% 6% 6% 15% 4% 4% Housing 42% Transportation Food & Beverages Medical care Recreation Education and communication Apparel 17% Other Sherif Khalifa () Inflation 9 / 33
10 Sherif Khalifa () Inflation 10 / 33
11 Sherif Khalifa () Inflation 11 / 33
12 Substitution Bias When prices change from one period to another, they do not change proportionately. Consumers buy less of the items whose prices have increased more. Consumers buy more of the items whose prices have increased less or have decreased. Consumers substitute towards the items that have become less expensive. The consumer price index ignores the possibility of consumer substitution. Sherif Khalifa () Inflation 12 / 33
13 New Goods When a new item is introduced, consumers have more variety from which to choose. Greater variety of consumer items makes each dollar more valuable. This decreases the cost of maintaining the same level of well being. New items are not included in the calculation of the consumer price index. Sherif Khalifa () Inflation 13 / 33
14 Quality Change If the quality of a good deteriorates from one year to another, the value of a dollar decreases. You are getting a worse good for the same amount of money even if the price of the good stays the same. If the quality of a good improves from one year to another, the value of a dollar increases. You are getting a better good for the same amount of money even if the price of the good stays the same. Changes in quality poses a problem because quality is hard to quantify. Sherif Khalifa () Inflation 14 / 33
15 GDP Deflator = [ ] Nominal GDP X 100 Real GDP Policy makers monitor the GDP Deflator and the CPI to gauge the change in prices. The GDP deflator reflects the prices of all goods and services produced domestically. The CPI reflects the prices of all goods and services bought by typical consumers. The GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. The CPI compares the price of a fixed basket of goods and services to the price of the same basket in the base year. Sherif Khalifa () Inflation 15 / 33
16 Percent 15 Percent 15 per Year per Year CPI CPI GDP GDP deflator deflator Sherif Khalifa () Inflation 16 / 33
17 The consumer price index can be used to compare dollar amounts at different periods of time. Price level today Amount in Today s $ = Amount in year T $x Price level in year T Sherif Khalifa () Inflation 17 / 33
18 Year CPI Professor salary $24,000 Today 180 $50,000 Amount in Today s $ = $24, 000X = $48, 000 Sherif Khalifa () Inflation 18 / 33
19 Year CPI Athlete Salary $80,000 Today 195 $950,000 Amount in Today s $ = $80, 000X 195 = $1, 026, Sherif Khalifa () Inflation 19 / 33
20 The Consumer Price Index can be used to determine changes in purchasing power. If the increase in income is higher than the increase in spending, purchasing power increases. If the increase in spending is higher than the increase in income, purchasing power decreases. Sherif Khalifa () Inflation 20 / 33
21 Consumers consume 100 hot dogs and 200 burgers. Year Price Price of Hot dogs of Burgers 2014 $1 $ $2 $4 CPI 2014 = CPI 2015 = Inflation = (100X $1) + (200X $3) X 100 = 100 (100X $1) + (200X $3) (100X $2) + (200X $4) X 100 = 142 (100X $1) + (200X $3) = 42% 100 Sherif Khalifa () Inflation 21 / 33
22 The percentage change in the price of hotdogs reflects the percentage change in the income of hotdog producers Percentage change in the price of hotdogs = 100% Hotdog producers are better off because the increase in their income is higher than the increase in their spending. The percentage change in the price of burgers reflects the percentage change in the income of burger producers Percentage change in the price of Burgers = 33% Burger producers are worse off because the increase in their spending is higher than the increase in their income. Sherif Khalifa () Inflation 22 / 33
23 Year News Paper Wage 1950 $0.15 $3.23/hour Today $0.75 $14.32/hour Percentage Change in the price = = 400% Percentage Change in the wage = = 343% 3.23 The worker s purchasing power in terms of news paper decreased. Sherif Khalifa () Inflation 23 / 33
24 Costs of Inflation Definition Inflation tax, or seignorage, is the revenue the government raises by creating money. When tax revenue is inadequate and ability to borrow is limited. A government may print money to cover its budget deficit. Excessive increase in the money supply causes inflation. Inflation causes the dollars in your wallet to be less valuable. The inflation tax is a tax on everyone who holds money. Sherif Khalifa () Inflation 24 / 33
25 Costs of Inflation Definition Shoeleather costs are the resources wasted when inflation encourages people to decrease their money holdings. Because inflation erodes the value of money, one can avoid the inflation tax by holding less money. We go to the bank more often to keep more of our wealth in an interest-bearing account and less in our wallet. Making more frequent trips to the bank causes your shoes to wear out more quickly. The actual cost is the time and convenience you sacrifice to keep less money on hand. Shoeleather costs include the time and transaction costs of more frequent bank withdrawals. Sherif Khalifa () Inflation 25 / 33
26 Costs of Inflation Definition Menu costs are the costs of price adjustments due to inflation. Firms change prices infrequently because there are costs of changing prices. Menu costs include the cost of deciding on new prices, and of printing new price lists and catalogs. Menu costs include the cost of sending the new price lists and catalogs to dealers and customers. Menu costs include the cost of advertising the new prices, and of dealing with customer annoyance over price changes. Sherif Khalifa () Inflation 26 / 33
27 Costs of Inflation Inflation changes the yardstick we use to measure transactions. Inflation erodes the real value of money which is the unit of account. These changes in the yardstick causes confusion and inconvenience. Complicates long-run planning and the comparison of dollar amounts over time. Sherif Khalifa () Inflation 27 / 33
28 Costs of Inflation Lawmakers often fail to take inflation into account when writing tax laws. Taxes are based on nominal income, and are not adjusted for inflation. Inflation causes people to pay more taxes even when their real incomes do not increase. Sherif Khalifa () Inflation 28 / 33
29 Costs of Inflation Definition Nominal interest rate is the interest rate announced without correction for the effects of inflation. Definition Real interest rate is the interest rate corrected for the effects of inflation. Real interest rate = Nominal interest rate Inflation rate r = i π Sherif Khalifa () Inflation 29 / 33
30 Costs of Inflation Interest Rates (percent (percent per per year) year) Interest Rates Nominal Nominal interest interest rate rate Real Real interest interest rate rate Sherif Khalifa () Inflation 30 / 33
31 Costs of Inflation Before tax r = Before tax i π After tax r = After tax i π After tax i = i (1 t) Sherif Khalifa () Inflation 31 / 33
32 Costs of Inflation A B Before tax Nominal Interest Rate 4 12 Inflation Rate 0 8 Before tax Real Interest Rate 4 4 A B Before tax Nominal Interest Rate % tax rate 1 3 After tax Nominal Interest Rate 3 9 Inflation Rate 0 8 After tax Real Interest Rate 3 1 Sherif Khalifa () Inflation 32 / 33
33 Costs of Inflation Loan agreements specify a nominal interest rate, based on the rate of inflation expected at the time of the agreement. If inflation turns out higher than expected, the debtor wins and the creditor loses because the repayment is lower than anticipated. Higher-than-expected inflation transfers purchasing power from creditors to debtors. If inflation turns out lower than expected, the creditor wins and the debtor loses because the repayment is higher than anticipated. Lower-than-expected inflation transfers purchasing power from debtors to creditors. Inflation arbitrarily redistributes wealth among individuals. Sherif Khalifa () Inflation 33 / 33
Sherif Khalifa. Sherif Khalifa () Inflation 1 / 30
Sherif Khalifa Sherif Khalifa () Inflation 1 / 30 "The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a premanent ruin.
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