Inflation Highlights Defining inflation and its cousins Inflation defined as a sustained increase in the general, or average, price level a few items going up in price does not define inflation even during periods of inflation, some items will fall in price Deflation not particularly common in the U.S. we experienced significant deflation during the Great Depression Japan has struggled with deflation since the 1990 s defined as a sustained decrease in the general price level actually sounds rather nice, but isn t can be a symptom of a serious problem in the economy Disinflation defined a a decrease in the rate of inflation it doesn t mean that prices are falling it means that they aren t rising as quickly pretty common phenomenon Why is inflation bad news? Inflation can erode purchasing power as prices of goods and services rise, the purchasing power of a given amount of money declines purchasing power refers to the quantity of goods and services that a given amount of money will buy if we have inflation this year, a $20 bill in your pocket will buy fewer goods at the end of the year than it did at the beginning of the year Does inflation reduce the purchasing power of your wage/income? that depends on whether your income remains constant there is a tendency for wages to rise when the prices of goods and services rise after all, one can think of the wage rate as the price of labor somewhat of a horse race
we need to distinguish between nominal and real wages/income Nominal income simply the number of dollars that you receive inflation doesn t directly change your nominal income Real wage/income defined as the purchasing power of your nominal wage/income inflation certainy can affect your real wage/income if prices of goods and services increase faster than nominal wages/income, then real wages/income decline over the long term, nominal wages have risen faster than prices of goods and services, so real wages have risen for most people more recently though, real wages have stagnated or fallen for some groups Other problems with inflation damages individuals on fixed incomes, often retirees or pensioners o cost of living adjustments (COLAs) can be used to offset the effects of inflation o COLA's must be accurate to neutralize effects may reduce real wealth, depending on the form in which that wealth is held o gold and real estate are sometimes used as hedges against inflation may decrease exports and increase imports, worsening trade deficits has the potential to cause bracket creep, pushing individuals into higher tax brackets despite having no additional real income high rates of inflation disrupt shopping/productive behavior, increasing transaction costs increases the risk associated with borrowing and lending, arbitrarily redistributing income o reduces lending activity and therefore economic activity
Understanding lending The goal of the lender is to get back more purchasing power than they loaned out. Since dollars loaned out aren t paid back until a later point in time, their purchasing power is reduced if inflation occurs. Lenders, and borrowers, take this into account. Nominal rate of interest percentage by which the money the borrower pays back exceeds that which he borrowed Real rate of interest percentage increase in the purchasing power that the lender receives real rate of interest = nominal rate of interest rate of inflation Effects of inflation on lending and borrowing on fixed rate loans volatile interst rates increase the risk associated with borrowing and lending unexpectedly high rates of inflation benefit the borrower unexpectedly low rates benefit the lender most people are risk averse, so more risk = less borrowing and lending borrowing and lending fund economic production and consumption less borrowing and lending = less economic activity Types of inflation Creeping inflation a relatively low, stable, nonaccelerating rate of inflation something akin to a low fever annoying, but relatively easy to adjust for with COLAs, etc. Galloping inflation a higher, but still usually stable and nonaccelerating rate of inflation not something we have much tolerance for in the U.S. Hyperinflation a very high and accelerating rate of inflation often in the 1,000 s of percent each year, sometimes much higher Brazil, Germany during the Weimar Republic, Russia, Turkey, and many other countries have experienced hyperinflation Zimbabwe is the current champ with a rate that exceed 8 octillion percent by some reports
simple cause, direct result of increasing the money supply too rapidly, printing money U.S. hasn t experienced hyperinflation because elected officials do not control the printing presses, and thus cannot succumb to temptation Often leads to the collapse of the financial system New currency is developed or dollarization takes place Measuring inflation Price Indices measured by using a variety of price indices: CPI, PPI, GDP deflator all track the relative cost of goods an services with respect to some base year differ largely in which goods they track, and how they are used Consumer Price Index CPI focused on how understanding how inflation affects your average consumer tracks a market basket of final goods and services that consumers typically buy goods included in the basket and their prices are determined by surveys of consumers and retailers prices include taxes divided into catergories: Food and Beverages, Housing, Apparel, Transportation, Medical Care, Recreation, Education, Other Goods and Services most commonly reported version of the CPI is the CPI U which is designed to track the effects of inflation on urban consumers o its base period is 1982 84 a chained version of the CPI also exists, C CPI U o its based period is 1999 numerous sub indices exist for the CPI Producer Price Index PPI focused on how inflation affects producers tracks a market basket of intermediate goods, raw materials, and final goods and services that firms typically purchase does not include taxes
GDP deflator Broadest measure of inflation Captures the change in all final goods and services Calculating price indices Steps for calculating any fixed basket index 1) Select a base year, serves as a benchmark for comparison 2) Select a representative market basket of goods 3) Calculate price index for current year using the following formula CPI = cost of the representative market basket in current year x 100 cost of the representative market basket in base year Example: Calculate the CPI for 1994 using a base year of 1987 CPI87(1994) = cost of representative market basket in 1994 x 100 cost of representative market basket in 1987 *** Remember the CPI for the base year always equals 100 *** Comparing current prices to base year prices CPI 92 (1998) = 117 on average, prices of goods and services in the basket rose 17 percent between 1992 and 1998 CPI 70 (1981) = 205 on average prices of goods and services in the basket rose 105 percent between 1970 and 1981 CPI 30 (1933) = 71 on average, prices of goods and services in the basket fell 29 percent between 1930 and 1933 Comparing prices from two different years when neither is the base year CPIs both need to have same base year you must calculate percentage change in the CPI to get percentage change in prices use the following formula (use other formulas at your own risk)
years go in chronological order Percent change in prices = CPI(Year 2) CPI(Year 1) x 100 CPI(Year1) Example: Calculate the change in prices between 1975 and 1985 using the data in the table to the right. Year CPI 1975 52.1 1980 77.8 1985 105.5 1990 127.4 % change in prices = 105.5 52.1 x 100 = 102.50% Between 75 and 85 52.1 Converting dollar values in one year into equivalent dollar values in another year can be used with salaries, box office receipts, candy bar prices, etc equivalent = same purchasing power use the following formula Equivalent Dollar value in Year Y = Dollar Value(Year X) x CPI(Year Y) CPI(Year X) Example: In 1982, E.T. was released and earned $434,949,459 at the box office in the U.S. In 2009, Avatar was released and earned $760,505,847 at the box office in the U.S. In real terms, which one earned more money? (For argument s sake, pretend each film earned all of its revenue in the year it was released.) The CPI for 1982 was 94.3, while the CPI for 2009 was 211.143 One approach: Convert E.T. s earnings into an equivalent amount in 2009. Equivalent of E.T. s earnings in 2009 = $434,949,459 x 211.143 = $973,876,284.60 94.3 Conclusion: By this measure E.T. gives Avatar a bad case of the blues.
Converting Nominal GDP to Real GDP major use of the GDP Deflator Example use the GDP deflator to convert NGDP(1994) to RGDP(1994) Real GDP87(1994) = Nominal GDP(1994) x 100 GDP deflator87(1994) Other uses of price indices Indexing tax brackets for inflation Developing cost of living adjustments(colas) for o Social Security o Medicare o Labor contracts Problems with price indices Fixed basket indices are more of a cost of goods measure than a cost of living measure Collecting data is always an issues Sampling errors Consumption pattend changes change the market basket new goods are developed old goods disappear existing goods undergo quality improvements tastes and preferences change over time CPI potentially overstates the effects of inflation Sometimes thought of as the upper limit of inflation o Fails to fully account for changes in quality o Systematically misses the price drops of newly introduced products o May not fully account for shopping at discount outlets o Fails to account for the ability of households to substitute goods and services based on changes in relative prices May understate the effects of inflation on seniors seniors devote a much higher percentage of the income to medicine and medical care this has typical risen faster other prices of other goods and services
their basket may actually be going up faster than the CPI U basket