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# Ch.7 - CHAPTER 7 CHAPTER INFLATION INFLATION FALL 2010 1...

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Unformatted text preview: CHAPTER 7 CHAPTER INFLATION INFLATION FALL, 2010 1 WHAT IS INFLATION? A rise in the average price level : rise average Some prices rise Other prices fall Some prices may remain Some unchanged Relative prices change Relative 2 HOW IS INFLATION HOW MEASURED? MEASURED? The GDP price index The Discussed in Chapter 5 Discussed Covers all goods and services Covers all The Consumer Price Index (CPI) Includes only consumer goods. Includes only Most commonly known measure of Most inflation. inflation. Prepared by BLS Prepared Select “market basket” of goods Select based on urban family expenditures. Set expenditure weights Measure % price changes Weight % price changes by Weight 3 expenditure weights MEASURING THE COST MEASURING OF LIVING: Slide 1 : Product A B C D 1998 Price \$10 \$06 \$06 \$20 \$20 \$10 \$10 1998 Quan. 10 10 02 00 1998 1998 Exp. % of Exp. Exp. of \$100 50% \$060 30% \$040 20% \$000 00% \$000 00% \$200 100% \$200 Cost of purchases at 1998 prices = \$200 Cost 1999 Prices 1998 Quantities: 1998 A = \$12 \$12 B = \$09 C = \$16 \$16 D = \$90 \$90 10 10 02 00 = \$120 \$120 = \$090 = \$032 = \$000 --------------------\$242 \$242 Cost of fixed basket of goods at 1999 Prices Cost = \$242 \$242 4 MEASURING THE COST MEASURING OF LIVING: Slide 2 Slide Cost of purchases at 1999 prices equals……….\$242 Cost of purchases at Cost 1998 prices equals ………\$200 1998 Ratio of \$242/\$200 = 1.21 So average prices have increased 21% . Using old & new prices and old quantities yields a 21% increase in average prices. 5 MEASURING THE COST OF MEASURING LIVING: LIVING: Using a price index Item Weight Weight 1998 1999 % Price Price Change A B C D \$10 \$06 \$20 \$10 50% 30% 20% 00% \$12 \$09 \$16 \$90 20% 50% -20% 800% First, calculate the percentage change in First, percentage the price of each product. (as shown above) above) Second, then multiply the percentage Second, change in price by the expenditure weight and add. (see next slide) weight 6 MEASURING THE COST OF MEASURING LIVING: Using a price index (continued) (continued) Item Weight A 50% B 30% 30% C 20% D 00% EQUALS EQUALS % Ch. +20% +20% +50% +50% -20% -20% +800% +800% Weighted Weighted %Change +10% +10% +15% - 04% 00% 00% +21% If price index base year is 1998, then: 1998 CPI = 100 1998 1999 CPI = 121 Note importance of 0% weight above 7 Measuring Changes in the Cost Measuring of Living of In the previous example, the In average (unweighted) percentage change in prices was (20%+ 50% - 20% + 800%) / 4 = 850/4 = 212.5%. This may have been the average percentage change in prices, but it does not tell us what happened to not the cost of living. A cost of living index takes into account the relative importance of each item in relative the typical household budget. the The cost of purchasing a fixed The basket of goods increase by 21% in this example, This is the weighted average of the weighted percentage change in prices. percentage 8 CALCULATING THE CALCULATING INFLATION RATE INFLATION Calculating the annual rate of inflation Calculating requires calculating year-to-year percentage change in CPI Example: 2000 CPI = 172.2 2000 1999 CPI = 166.6 Annual inflation rate = Annual { (172.2 – 166.6)/166.6} * 100 = 3.4% See text, page 170 See 9 CPI MEASUREMENT CPI PROBLEMS PROBLEMS 1. 1. Different expenditure patterns Different Retirees vs. college students Small vs. large families Rural vs. urban residents Rural 2. Quality Changes ( e.g., computers) 3. Fixed expenditure weights: Fixed Causes failure to adjust for substitution effect Result: CPI overstates inflation (perhaps by 1.1% per year. (perhaps 10 XHIBIT 4 The U.S. Inflation Rate 1929-2003 Source: Economic Report of the President, 2004, http://www.gpoaccess.gov/eop/index.html, Table B-64. 11 CAUSES OF INFLATION 1. Demand-pull inflation Caused by too much money chasing too few goods chasing C + I + G + (X-M) exceeds available production, so price system rations out scarce production to those who can pay for it. 12 CAUSES OF INFLATION (CONTINUED) 2. Cost-Push inflation: Caused by events that cause supply curves to shift upwards and to the left. (Need upwards Chapter 10 to more fully explore the concept of “aggregate supply”). Example: OPEC oil embargo. 13 CONSEQUENCES OF INFLATION: 1. Reduces real incomes. IInflation nflation 1. Reduces reduces real income if prices are rising reduces (Nominal Income) (Nominal Real Income = --------------* 100 CPI Example: Nominal Income 1996 = \$60,000 Nominal CPI for 1996 = 120 \$50,000 = (\$60,000/120) * 100 Note: If nominal income rises by 5% and the CPI rises by 2%, then real income has increased by only about 3%. 14 CONSEQUENCES OF CONSEQUENCES INFLATION: INFLATION: (continued) 2. Redistributes Incomes . 2. Redistributes Some live on fixed incomes (e.g., Some retired persons) others don’t. Lenders vs. borrowers vs. 3. Redistributes wealth 3. Redistributes Inflation acts as a tax on money-holding Inflation reduces value of wealth held in the form of money Some assets (e.g., real estate) rise in price more than others price 4. Reduces the amount and distorts the composition of real investment composition 15 QUESTIONS ON CHAPTER 7??? 16 TEXT EXAMPLE OF TEXT CALCULATING A PRICE INDEX, Exhibit 2, Page 175 INDEX, Product Product Exp. ------------------Hamburg Hamburg Gasoline Jeans 1982 1982 1996 1996 Qty Price Price ------- -------- ------- ------050 \$00.80 \$1.00 \$050 \$00.80 250 \$00.70 \$0.90 \$225 002 \$15.00 \$30.00 \$060 \$15.00 1982 Expenditure = \$245. 1996 Expenditure = \$335 1996 CPI = \$335/\$245 * 100 = 136.7 1996 Note: This is the same result as the one that would have been Note: same achieved had we constructed a price index for 1996 and then divided it into the 1996 nominal GDP to obtain the value for the 1 1996 real GDP. This is shown on the following page.7 PRICE INDEX PRICE CONSTRUCTION: CONSTRUCTION: Text, page 175 Total expenditures for 1982 Total \$40.00 for hamburger \$40.00 \$175.00 for gasoline \$30.00 for jeans \$30.00 Total expenditure = \$245.00 Total Percentage of total budget for 1982 Percentage allocated to: Hamburger = \$40/\$245 = 16.3% Hamburger Gasoline = \$175/\$245 = 71.4% Jeans = \$30/\$245 = 12.3% So, now multiply the % changes in So, 18 price * fixed weights price PRICE INDEX PRICE CONSTRUCTION: CONSTRUCTION: Text, page 175 Percentage changes in price: Hamburger = +25.0% Hamburger Gasoline = +28.6% Jeans = +100.0% Jeans Weighted average price changes: Weighted Hamburger = 25.0% * 16.3% = 04.1% Gasoline = 28.6% * 71.4% = 20.4% Jeans= 100.0% *12.3% = 12.3% Sum of weighted average price changes = Sum 4.1% + 20.4% + 12.3% = 36.8% If price index read 100 in 1982, then price index for 1996 has value of 136.8% index 19 ...
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