Macroeconomic Measures: Inflation and Price Indexes

1. Macroeconomic Measures: Inflation and Price Indexes Macroeconomics

2. Inflation Inflation is a general and ongoing rise in the level of prices in an entire economy

3. Inflation is NOT: • A relative rise in prices where the prices of some goods rise while other fall or remain stable • one-time price increases in the supply-and-demand model, representing a shift from a previous equilibrium to a new one • High prices – it refers to the rate of change in price not the price level

4. Inflation and Deflation Inflation is an increase in the average level of prices, and deflation is a decrease in the average level of prices. In an economy experiencing inflation, most prices are likely to be rising, whereas in an economy experiencing deflation, most prices are likely to be falling.

5. Calculating Inflation and Deflation Prices of a variety of goods and services are combined into a single price level; the inflation rate is simply the percentage change in the price level The rate of inflation or deflation is the percentage rate of change in a price index between two periods. Given price-index values for two periods, we can calculate the rate of inflation or deflation as the change in the index divided by the initial value of the index, stated as a percentage: Rate of inflation or deflation = Percentage change in index / Initial value of index =Percentage change

6. Price Level To calculate the price level, economists begin with the concept of a basket of goods and services, consisting of the different items individuals, businesses, or organizations typically buy. The next step is to look at how the prices of those items change over time

7. The Eight Major Categories in the Consumer Price Index • Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks) • Housing (renter’s cost of housing, homeowner’s cost of housing, 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, cable television, 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)

8. The Weighting of CPI Components

9. Is Unexpected Inflation Good or Bad? • If you are a borrower, it reduces the value of money that you must repay • If you are a lender, it is a bad thing because it reduces the value of future payments you will receive • Inflation is hard on people with fixed incomes • It can create uncertainty about the future U.S. Minimum Wage and Inflation: After adjusting for inflation, the federal minimum wage dropped more than 30 percent from 1967 to 2010, even though the nominal figure climbed from $1.40 to $7.25 per hour.

10. What about Deflation? • Unanticipated deflation hurts borrowers and helps lenders • People will be reluctant to spend or borrow money which slows the economy • Deflation also creates uncertainty

11. So what is best? • Some economists think a steady price level is best • Others think that very low inflation (2%) is good for economic growth

12. Nominal vs. Real Values • The nominal value of any economic statistic means the statistic is measured in terms of actual prices that exist at the time • The real value refers to the same statistic after it has been adjusted for inflation

13. Computing Real Values Using Price Indexes The real value of a nominal amount X at time t, Xt, is found using the price index for time t: Real value of Xt = Xt / Price index at time t

14. The Implicit Price Deflator The implicit price deflator, a price index for all final goods and services produced, is the ratio of nominal GDP to real GDP. The implicit price deflator is thus given by: Implicit price deflator = nominal GDP / real GDP

15. Real and Nominal Gross Domestic Product • Real GDP is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices • Nominal GDP is the total value of final goods and services for a particular period valued in terms of prices for that period

16. Practice Question If you had a crystal ball that told you that inflation would increase to 12% in the coming year, what would you be more likely to do? Lend money Borrow money Save money Spend money

17. Quick Review • What is the concept of a price index and how are price indices derived? • What is the rate of inflation and how is it calculated? • What are the consequences of price instability (i.e. inflation)? • How do you use a price index to translate between real and nominal data? • What is the GDP price index (also known as the GDP deflator or the Implicit Price Deflator)? • What is the difference between nominal GDP and real GDP?