Inflation - Penguinomics

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AP Macroeconomics
Price Level – Average price of all goods and
 services in an economy at a specific time. Often
 measured with a CPI

Inflation - the rate that the Price Level (average
 prices) rises
Anticipated vs Unanticipated
Most people expect a 2% - 4% inflation rate

We are mostly concerned with unexpected
 What does money decreasing in purchasing power
  mean for you?
 Creates winners and losers
Anticipated vs Unanticipated
 Holders of assets that rise in value faster than other
  assets rise in value
   Like Gold
   Treasury Bonds
Real rate of return = Nominal – Inflation rate
Nominal = What you see
Real = What you get
Anticipated vs Unanticipated
   Repay creditors with dollars worth less than the ones
    they received or used
 Governments that owe money
Anticipated vs Unanticipated
 Government – Taxes
   Unanticipated inflation causes nominal wages to
   Causes people to go into higher tax brackets – owe
    more money in taxes
Anticipated vs Unanticipated
 Savers at a fixed rate
Anticipated vs Unanticipated
 Individuals living on a fixed income
   Social Security before 1975
   Now receive Cost of Living Adjustment (COLA)

   Banks – Make loan at 6% (nominal – what you see) and
    inflation is at 4% = 2% real rate of return
   But…if inflation goes up to 6% = 0% real rate of return
Anticipated vs Unanticipated
   Banks – Make loan at 6% (nominal – what you see) and
    inflation is at 4% = 2% real rate of return
   But…if inflation goes up to 6% = 0% real rate of return

 Individuals with variable-interest rate loans
   Credit Cards
   Home equity loans
   Variable rate home loans
Anticipated vs Unanticipated
 Holders of long-term bonds
Anticipated vs Unanticipated
General Rule of thumb
 When there is rapid inflation people want to get out
  of money savings and invest in something real –
   1972 inflation – 3.3%
   1973 inflation – 6.3%
   1974 inflation – 11%
Demand Pull vs Cost Push
Consumer Price Index
CPI: measure of the average change over time in
 the prices paid by urban consumers for a market
 basket of consumer goods and services

 Reveals price level
 Helps determine inflation rate

 Not included: People living in rural areas, Armed
  Forces, people in asylums and prisons

 Compile information from selected families who are
  interviewed and keep diaries listing purchases

 CPI-U vs CPI-W
Consumer Price Index
 200 categories of goods - sorted in 8 major groups

 FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken,
  wine, full service meals, snacks)
 HOUSING (rent of primary residence, owners' equivalent rent,
  fuel oil, bedroom furniture)
 APPAREL (men's shirts and sweaters, women's dresses, jewelry)
 TRANSPORTATION (new vehicles, airline fares, gasoline, motor
  vehicle insurance)
 MEDICAL CARE (prescription drugs and medical supplies,
  physicians' services, eyeglasses and eye care, hospital services)
 RECREATION (televisions, toys, pets and pet products, sports
  equipment, admissions);
 EDUCATION AND COMMUNICATION (college tuition, postage,
  telephone services, computer software and accessories);
 OTHER GOODS AND SERVICES (tobacco and smoking products,
  haircuts and other personal services, funeral expenses).
Consumer Price Index
Sets average index level (avg price level) for 36
 month period covering years 1982, 1983, 1984 –
 equal to 100
  Example: Price index of 1985 is 110 = 10% price level
Best Measure of Inflation?
CPI: Measures inflation as experienced by
 consumers in their day-to-day life
PPI: Measures inflation at earlier stages of the
 production process
GDP Deflator: Measures inflation experienced by
 consumers, government and entities supplying
 goods to consumers.

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