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 yeartoyear
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 19292003 Source: Economic Report of the President, 2004, http://www.gpoaccess.gov/eop/index.html, Table B64. 11 CAUSES OF INFLATION 1. Demandpull inflation
Caused by too much money
chasing too few goods
chasing
C + I + G + (XM) exceeds
available production, so price
system rations out scarce
production to those who can pay
for it. 12 CAUSES OF INFLATION
(CONTINUED)
2. CostPush 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 moneyholding
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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 Spring '08
 Kingston
 Macroeconomics, Inflation, Consumer price index, Hamburger

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