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Frank & Bernanke 4th edition, 2009

Frank & Bernanke 4th edition, 2009. Ch. 5: Inflation and the Price Level. Who Is Making More?. A 2008 graduate of Hiram College got a job that pays $40,000 per year. Thirty-four years ago (1974), her father started his career with a $8,000 job.

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Frank & Bernanke 4th edition, 2009

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  1. Frank & Bernanke4th edition, 2009 Ch. 5: Inflation and the Price Level

  2. Who Is Making More? • A 2008 graduate of Hiram College got a job that pays $40,000 per year. • Thirty-four years ago (1974), her father started his career with a $8,000 job. • Is she making five times as much as her father did?

  3. Who Is Making More? • In order to compare the incomes of two different periods we have to eliminate the effect of inflation. • What happened to prices between 1974 and 2008? • Let’s find out the Consumer Price Index (CPI).

  4. Who Is Making More? • According to Bureau of Labor Statistics (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), CPI in 1974 was 49.3. • CPI in 2008 was 215.3. Base year was 1982-84. • If the average price level in 1974 was lower than in 2008, our graduate must not have been five times better off.

  5. Who Is Making More? • In real terms: • She made (40,000/2.153) = $18,578.73 in 1983 dollars. • He made (8,000/.493) = $16,227.18 in 1983 dollars. • How much was his pay in 2008 dollars? • His pay is (8,000)(2.153/.493) = $34,937.12

  6. How To Calculate The CPI? • Fix the basket a typical consumer will buy. • Find the prices of the items for different years. • Compute the basket’s cost for each year. • Choose a base year. • Calculate the cost of the basket for other years in terms of the base year. • Calculate inflation rates.

  7. The Consumer Price Index: Measuring the Price Level • Constructing the CPI • Bureau of Labor Statistics (BLS) • Pick a base year • Conduct the consumer expenditure survey to determine the base-year basket of goods and services • Measure the current prices of the base-year basket

  8. CPI Calculation CPI = 85/65 = 1.325

  9. Problems With CPI • Substitution bias. • Basket changes as a response to relative price changes do not get accounted. • New products. • Basket changes are ignored. • Prices of new products fall before they are included in the new basket. • Quality change. • If the same gadget has higher quality now than in the past but viewed as the same item, an increase in price is not inflationary.

  10. Calculating InflationRates: 1972 - 1976 Year CPI 1972 0.418 1973 0.444 1974 0.493 1975 0.538 1976 0.569

  11. Calculating InflationRates: 1929 - 1933 Year CPI 1929 0.171 1930 0.167 1931 0.152 1932 0.137 1933 0.130

  12. Does the CPI Measure“True” Inflation? • 1996 report by the Boskin Commission estimated that the CPI overstates inflation by as much as 1 to 2 percentage points a year. • Overstating Inflation • Would unnecessarily increase government spending • Underestimate the improvements in the standard of living

  13. Adjusting for Inflation • Real Wage • The wage paid to workers measured in terms of real purchasing power • The real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period

  14. Nominal and Real Wages for Production Workers’ 1960 - 2001

  15. GDP Deflator vs. CPI • Space shuttle costs more to operate. • Deflator is up, CPI unchanged. • Antiques cost more. • CPI is up, deflator unchanged. • Porsche increases the price. • CPI is up, deflator unchanged. • New homes cost more. • Both CPI and deflator up.

  16. Indexation • If payments are automatically corrected for inflation, they are said to be indexed. • COLA • Social Security • TIPS • Variable mortgage rates

  17. Adjusting for Inflation • Indexing to Maintain Buying Power • An example: Social Security Payment Inflation 2000 $1,000/month 2000 - 2005 = 20% 2005 $1,200/month indexed to inflation

  18. The Costs of Inflation:Not What You Think • Observations • Changes in relative price do not necessarily imply a significant amount of inflation. • Inflation can be high without affecting relative prices.

  19. The Costs of Inflation:Not What You Think • Observations • To counteract relative price changes, government policy would have to affect the market for specific goods. • To counteract inflation, the government must use monetary and fiscal policy.

  20. Costs of Inflation • Shoe-leather costs • Economizing on cash • More frequent trips to the bank • More bank employees • Efforts to avoid the erosion of purchasing power

  21. Costs of Inflation • Noise in the price system • Is it an increase in the demand for a product or is it a general increase in prices? • Should the supplier increase output or not?

  22. Costs of Inflation • Distortions of the tax system • Depreciation allowance and the replacement cost • Bracket creep

  23. Costs of Inflation • Unexpected distribution of wealth • Real wage down => workers lose, employers gain • Borrowers gain and creditors lose

  24. Costs of Inflation • Interference with long-run planning • Increase uncertainty • Impossible to predict the future

  25. Hyperinflation • Inflation of 500 or more per cent per year. • Germany in early twenties. • Latin America. • Zimbabwe: 150,000% in 2007!

  26. Hyperinflation • Economic Naturalist • Fischer, Sahay, and Vegh examined 133 market economies 1960 - 96 • 45 episodes of high inflation (100% +) in 25 countries • Real GDP/person fell by an average of 1.6%/yr • Real consumption/ person fell by an average of 1.3%/yr • Real investment/person fell by an average of 3.3%/yr "Modern Hyper- and High Inflations", Journal of Economic Literature. September 2002, Volume XL, Number 3, 837-880.

  27. Hyperinflation in Zimbabwe http://www.dallasfed.org/assets/documents/institute/annual/2011/annual11b.pdf

  28. Real and Nominal Interest Rates • If you lend someone $1000 for a year and ask for a 5% interest, you will get $1050 at the end of the year. • If inflation during the year were 10%, the products you could buy with your $1000 at the beginning of the year now costs $1100. • Are you better-off or worse-off?

  29. Real and Nominal Interest Rates • Lenders will always ask a higher interest rate than the expected inflation to earn income. • Nominal interest rates are what the bank quotes, what the car dealer quotes. • Real interest rates are nominal rates corrected for inflation. • i = r + π

  30. The Real Interest Rate in the United States, 1960 - 2001

  31. Inflation and Interest Rates in the United States, 1960 - 2001

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