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					What about the other evil?
         Inflation and Deflation
• Inflation
  – A sustained increase in the average of all prices of
    goods and services in an economy

• Deflation
  – A sustained decrease in the average of all prices
    of goods and services in an economy
                Runaway Inflation

• In 1923 prices in Germany more than doubled
  every day.
      – No one saved, invested, or made long-run plans.
      – Production came to a halt; unemployment increased
        by a factor of 10.
      – The economy collapsed.
      – Ultimately Hitler came to power.
• Zimbabwe experienced a similar economic
  disaster between 2007 and 2010.

  Inflation…is bad…is bad!
What is inflation?
A continuing rise in the average level of
  prices.(it costs more to purchase the typical
  “bundle” of goods and services that is
  produced or consumed or both.)
Bottom line: Too many $$$$ chasing too few

• The current price of a good is $1.
• If its price doubles every day, what will its
  price be in 10 days? 20 days?
• In 10 days, $512.
• In 20 days, $524,288.

CPI measures average family’s price
       structure purchases
• The CPI is based on what it costs an average
  family to live.
• Just think… Inflation enables us to live in
  more expensive neighborhoods without
  having to move
          Inflation is bad… see???
Shortened Time Horizons
• During the German hyperinflation, workers were paid two
  or three times a day so that they could buy goods in the
  morning before prices increased in the afternoon.
People may be encouraged to withhold resources from the
  production process, hoping to sell them later at higher
Bracket Creep
• Under our progressive tax system, taxes go up when prices
• Savings, investment, and work effort decline.
                Inflation discussion
Notice we said an increase in the Average Level of prices. Not a
change in any specific price…

Statisticians calculate the average then look for changes in the
average. The Consumer Price Index for All Urban Consumers (CPI-
U) decreased 0.4 percent in August, before seasonal adjustment, the
Bureau of Labor Statistics of the U.S. Department of Labor reported
today. The August level of 219.086 (1982-84=100) was 5.4 percent
higher than in August 2007.
 A decline in average prices = deflation.

Relative price means an increase in the price of apples (relative to
other fruits) apples cost more than pears. Buyers switch from one
good to another when their relative prices diverge.
Inflation does not make ALL persons worse off.
                Effects of Inflation

• Some prices rise and some fall.
• Rising prices require you to reallocate your
  purchasing power to ensure that you get the
  most satisfaction per dollar spent.
      – You might reduce buying goods with higher prices
        and increase buying goods with lower prices.
• This can be seen by the difference between
  nominal income and real income.

    Nominal Income vs. Real Income
 What is the difference between nominal income and real
Nominal = income you receive in a particular period
Real income = what you can use for purchasing stuff.
***If you nominal income does not change and there is an
  increase in the average level of prices….. You cannot buy as
  much “stuff.”
If the number of dollars you receive every year is always the
    same, your nominal income doesn’t change- but your real
    income will rise or fall with price changes.
              Another rule:
• If you put your money into savings and
  keep it there rather than spending it, and
  inflation comes along…

• your money in savings will not buy as much
  as it would prior to the wave of inflation
  that hit.
    Uncertainty and Misconception
Money Illusion (feels like they have more than they do)
• Even people whose nominal incomes keep up with
  inflation often feel oppressed by rising prices.
• They feel cheated when they discover that their higher
  nominal wages don’t buy additional goods.
• One of the most immediate consequences of inflation is
• Uncertainties created by changing price levels affect
  consumption and production decisions.
                     Inflation discussion

Uncertainty on the part of the
  consumer in trying to outguess
  the price of goods and services.
                                      • What Causes Inflation?
                                      • Nearly all economists
If consumers or producers               believe that rapid
    postpone or cancel their            expansion in the supply
    expenditure plans, the demand       of money is the cause
    for g & s will fall. Eventually     of inflation.
    production falls, and
    unemployment occurs…
 What happens if incomes go up to
    keep pace with inflation?
• Bracket creep is the movement of
  taxpayers into higher tax brackets (rates) as
  nominal incomes grow.
Deflation Dangers
• Deflation — a falling price level — might
  not make people happy either.
• Deflation reverses the redistributions
  caused by inflation. (Example: people today
  – upside down on their houses.)
Speculations from consumption and production

 • If you expect prices to rise, it makes sense
   to buy things now for resale later.
 • People may be encouraged to withhold
   resources from the production process,
   hoping to sell them later at higher price
 • As such behavior becomes widespread,
   production declines and unemployment
              Measuring Inflation

Measuring inflation serves two purposes:
  – Gauges the average rate of inflation.
  – Identifies its principal victims.
• Consumer Price Index (CPI)
• The CPI is the most common measure of
• The consumer price index (CPI) is a measure
  (index) of changes in the average price of
  consumer goods and services.
   Macroeconomic Measures - Prices
 Price Level - A weighted average of the prices of all goods
  and services.
 Price Index - A measure of the price level.
 Consumer Price Index (CPI) - A widely cited index
  number for the price level; the weighted average of
  prices of a specific set of goods and services purchased
  by a typical household.
  How to measure rate of inflation
Measuring the Rate of Inflation
• Market Basket
  – Representative bundle of goods and services

• Base Year
  – The point of reference for comparison of prices in
    other years
  Macroeconomic Measures - Prices

Base Year - The year chosen as a point of
 reference or basis of comparison for prices in
 other years; a benchmark year.
Computing the Consumer Price Index
          Consumer Price Index (CPI)

• By observing the extent of price increases, we
  can calculate the inflation rate.

The inflation rate is the annual
 percentage rate of increase in the
 average price level.
                        Changes in Prices
Percentage change in prices = Current year - later year   x100
                                  later year

          In 2005 the CPI was 195.3; in 2006 the index was
          201.6. What was the percentage change in prices
          from 2005-2006?
                       Click below for answer.

                                        3.22 %
       Here’s a little hint if you forget…C-L/L
                   CPI determined
 Calculates the inflation rate
 Market basket of goods and services
  (same each year.)                     • CPI expressed in base
                                           year ’82-84
 Bureau of Labor Statistics
  determines cost in 85 cities by       Constructing the CPI
  shopping 184 items.                   • The base period is the
 19,000 stores visited and 60,000         time period used for
  landlords,renters and homeowners         comparative analysis —
  surveyed each month                      the basis of indexing, for
 Statistics released each month.          example, of price
 Yearly average compiled.                 changes.
                   Shopping for CPI
 CPI is constructed by identifying a typical bundle of goods
  that the average consumer buys. This bundle stays the
  same each year.
 The base year is changed periodically. The base year used
  is ’82-’84 and prior to that it was ’63.The price level in the
  base period is designated as 100.
 The market basket (bundle) can be changed if BLS
  research shows that the “average” consumer no longer is
  purchasing that good or service.
 Each item in the bundle is weighted percent-wise in the
  market basket figures.
             The Market Basket

                           32.6%                Food

Insurance and pensions 9.3%                        Clothing 4.7%
                                            Miscellaneous 10.5%
                    Entertainment 5.1%
                                Health care 5.3%
        What is the difference?

So………if it cost you $225 in 2002 to buy the
  same bundle of goods that you bought in
  1983, you would be paying 225% more for the
  same “stuff.”
Look at the inflationary costs of: cars, health
  care, housing, (house 4 bedrooms, 2 baths, in
  Highland Park in 1960 cost approximately
  $30,000.) (Today?????)

Rate of Inflation = %       of PI(price index) from one year to
    the next.
When prices are rising, on average, the price index will rise.
  i = This year’s PI – Last year’s PI
          Last year’s PI x100
If price index this year was 220 compared to 200 last year,
    the inflation rate would equal 10%
 220 – 200
      200 x 100 = 10
 Formula hint: c-l/l x 100 (current-last/last x 100)
    Let’s try another calculation
In 2008 – CPI measured 215.3
In 2004 – CPI measured 188.9
What was the rate of inflation from 04 – 08?

         Ans. 13.9
  Is there a safety shield against inflation?

Answer: not much!!!
But Congress has passed the Cost-of-living
   adjustment (COLA) provision for those
   receiving Social Security Checks.
Checks are indexed each January…in the
   amount equal to inflation the previous year.
If inflation was 3% then the checks are
   adjusted accordingly.
Unions also negotiate for this COLA in their
   pay proposals…
Bankers in business to make a profit.
Some bankers build in that same philosophy- Adjustable-rate
  mortgage (ARM) stipulates an interest rate that changes
  during the term of the loan.
Actually, banks build the inflation factor into all their
  loans…the number of points depends on many variables
  we will discuss later.
• The real interest rate is the nominal interest rate minus
  the anticipated inflation rate.
   Inflation and Deflation (cont'd)
• Real-world price indexes
  – Consumer Price Index (CPI)
  – Producer Price Index (PPI)
  – GDP deflator
  – Personal Consumption Expenditure (PCE)
          What is stagflation?
High inflation and high unemployment….
A period during which an economy is
  experiencing both substantial inflation and
  either declining or slow growth in output.
Economists used to say this would and could
  never happen… it did in the 80’s
Paul Volker entered the scene as Fed
  chairman and held court on monetary
  policy.. More of this story later…
           CAUSES of inflation

• 1. Demand pull (too much aggregate
  demand and not enough aggregate supply.
• Cost Push (production costs rise) supply

Demand pull:
• Economy producing at capacity
• Consumers willing and able to buy more goods
• Can buy goods because of accumulated savings or easy
  access to credit (refinancing the house, second mortgages
  in Texas, low interest loans, credit card interest rates low,
  prime rate very low.)
• Pull to have more goods and only limited amount of goods
  available… causes prices to rise!
• Hence, a demand-driven rise in average prices or demand-
              Explanations Continued

Cost Push:
• When producers have to pay more for inputs (resources
  for production), the price of the good produced increases.

OPEC- prices of crude escalates any product dependent on
 crude (including heating costs, increases).-News Flash!
 Winter of 2007-2008 heating home costs rose 22%
 Winter of 2012-2013 is predicted to be 11% higher.
      Explanation of Dollars in Cost-push

Labor has generally been the most expensive of inputs for
    production up till now in our economy.
If wage rates are pushed upward…. The good or service
    would have an increase in price (longshoreman’s union,
    pilots,) Note that most of these are union connected.
    Tech industry workers took about a 50% cut to get jobs in
    2002 as opposed to their salaries in 1999.
If the Fed releases too much money in the economy
    (continually pushing down interest rates, the value of
    that money is not as solid as if there were less
    circulating… more later on that) 
Check the current inflation rate………..

           Bureau of Labor Statistics
   Another way to measure U.S. economic
Producer Price Index:
 The PPIs keep track of average prices received by
 October 20, 2005….PPI up highest in 15 years.
 3 indices…crude materials, intermediate goods, finished
 Identified in monthly surveys just like CPI is.
 In SR, PPI increases before CPI (takes a little while for the
   prices to be reflected in products we buy.
    Is the Growth of GDP real or inflated?

This is the real test!!!!!!!
Was there actual increase in production and
  services or did the prices just skew the GDP
  statistics when C+I+G was added?
Have to correct GDP for price changes so we
  can measure actual production.
CPI tells the consumer if they have to spend
  more dollars to get that loaf of bread… but
  other measures have to be evaluated.
Still another way to test the health of the U.S.
The GDP Deflator…. The broadest price index and covers all
  output including consumer goods, investment goods and
  government services. (C+I+G)
The GDP deflator isn’t a pure measure of price change. Its
  value reflects both price changes AND market responses
  to those price changes as reflected in new expenditure
The GDP deflator typically registers a lower inflation rate
  than CPI and the government watchdogs use this
  barometer more readily than current CPI
Year  Price of good Quantity                          GDP        Real GDP

1            $10                    100               $1,000     $1,000

2            $12                    120               12x120   10 x 120
                                                      = $1,440 = $1,200

3            $14                    140               14 x 140 10 x 140
                                                      = $1,960 = $1,400

    Can you calculate the percentage change from year 2 and 3?
                       Bottom Line
CPI is designed to measure the impact of price changes on
  the cost of a typical bundle of goods purchased by
  households(remember, market basket and only for urban
GDP deflator is a broader price index and is designed to
  measure the change in the average price of the market
  basket of goods included in GDP (in addition to consumer
  goods it includes capital goods, & g & s by government.)
CPI measures money income of consumers in relation to
  rising prices (only consumer goods.)
GDP deflator measures economy wide inflation- more g & s
  included in measurement.
  Personal Consumption Expenditure
 More accurate than CPI
 Quantifies changing expenditure patterns for
 Is a weighted measure
 Doesn’t always have same items calculated
 BEA uses continually updated surveys of
  consumer purchases to determine index
 Federal Reserve uses this measure for their
  predictions and assessments.
               Historical Record Graph

0                                                             B
12                                                    Deflation
     1920   1930   1940   1950   1960   1970   1980    1990   2000
Inflation 2011 to 7/2012
What really is the goal of fiscal and monetary
The CPI’s market basket of goods and services was
   overhauled in 1998.
Price Stability…..
 Major changes in the general level of prices indicate
   upsets in the economic system.
 Prices act as allocators of economic goods, they are the
   mechanism that determines the answer to the three basic
   questions, What, How and For Whom.
 Prices act as the basic force in a capitalistic economy 
What does a pair of Nike shoes cost
  compared to a pair of Keds?

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