Section 3C- Modules 14/15- Inflation and the Business Cycle

Module Checklist

When you have completed your study of these modules, you will be able to

Explain what the Consumer Price Index (CPI) is and how it is calculated.

1

Explain the limitations of the CPI as a measure of the cost of living.

Adjust money values for inflation and calculate real wage rates and real interest rates.

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3

Inflation

Inflation

An upward movement in the average level of prices

Deflation

A downward movement in the average level of prices

Inflation

Purchasing Power

The value of money for buying goods and services

Varies with prices and income

Disposable Income

*During inflation purchasing power of a dollar falls

*During deflation purchasing power of a dollar rises

Inflation

Nominal Value

Price expressed in today’s dollars

Real Value

Varies with the rate of inflation

Value expressed in purchasing power which varies with inflation

Inflation

Inflation- Measured by computing a price index which is defined as the cost of a market basket today, expressed as a percentage of the cost of that market basket in some starting or base year. In the base year the price index is always equal to 100. Inflation is measured by the rise in a price index.

Base year chosen as a point of reference for comparison.

THE CONSUMER PRICE INDEX

Consumer Price Index (CPI)

•A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services.

•Allows you to compare the cost of a market basket from one year to another year in terms of inflation

Inflation

Market Basket

Representative bundle of goods and services

Reference Base Year (Period)

The point of reference for comparison of prices in other year.

A period for which the CPI is defined to equal 100. Currently, the reference base period is 19821984.

THE CONSUMER PRICE INDEX

In May 2005, the CPI was 194.4.

The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 94.4 percent higher in May 2005 than it was on the average during 19821984.

In April 2005, the CPI was 194.6.

The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services decreased by 0.2 of a percentage point in May 2005.

THE CONSUMER PRICE INDEX

Constructing the CPI

Three stages:• Stage 1: Selecting the CPI basket• Stage 2: Conducting the monthly price survey• Stage 3: Calculating the CPI

Stage 1: The Market Basket

Figure below shows the CPI basket.This shopping cart is filled with the items that an average household buys.

Stage 2: Monthly Price Survey

The Monthly Price Survey

Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas.

Because the CPI measures price changes, it is important that the prices recorded refer to exactly the same items.

Stage 3: Calculating the CPI

Calculating the CPI

The CPI calculation has three steps:• Find the cost of the CPI basket at base period

prices.• Find the cost of the CPI basket at current period

prices.• Calculate the CPI for the base period and the

current period.

Stage 3: Calculating the CPI

Note- Always use the same quantity to determine the CPI for each year.The only thing that is changing is the price.

Base year Quantity X Current Year Price = CPI Basket

Stage 3: Calculating the CPI

CPI = Cost of CPI basket at current period pricesCost of CPI basket at base period prices

x 100

For 2000, the CPI is: = 100$50

$50x 100

For 2003, the CPI is: = 140$70

$50x 100

The CPI for the base period is always 100. Always!!!

Once we determine the CPI for these yearswe can now determine the inflation for these years!

Formula for the Rate of Inflation

Measuring Inflation

Inflation rate

The percentage change in the price level from one year to the next.

Inflation rate = = 40% percent140 100

100x 100

CPI in current year CPI in previous year

CPI in previous year

x 100Inflation rate =

This means there has been a 40% increase in inflation between the previous year and current year. But that is easy because you are working from the base year. Try this!

Formula for the Rate of Inflation

Measuring Inflation

Inflation rate- CPI for 2002 is 120 and CPI for 2003 is 140

What is the rate of inflation between 2002 and 2003?

Inflation rate = = 16.7 percent140 120

120x 100

CPI in current year CPI in previous year

CPI in previous year

x 100Inflation rate =

This means there has been a 16.7% increase in inflationbetween the previous year and current year.

Dollar Figures from Different Times

In 1931, Babe Ruth made $80,000. What is his salary equal to in 2007 dollars.

Need to know the CPI in 1931 and in 2007. CPI in 1931 is 15.2 CPI in 2007 is 207

Formula to convert dollar amounts from different times.

Amount in today’s dollars

= Amount in old dollars

X CPI todayCPI in past

Dollar Figures from Different Times

In 1931, Babe Ruth made $80,000. What is his salary equal to in 2007 dollars.

Need to know the CPI in 1931 and in 2007. CPI in 1931 is 15.2 CPI in 2007 is 207

Formula to convert dollar amounts from different times.

Amount in today’s dollars

= $80,000 X20715.2

Answer is $1,089,474

THE CONSUMER PRICE INDEX

Figure shows the CPI in part (a) and the inflation rate in part (b).

THE CONSUMER PRICE INDEX

In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.

THE CONSUMER PRICE INDEX

In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.

THE CPI AND THE COST OF LIVING

Cost of living index

A measure of changes in the amount of money that people would need to spend to achieve a given standard of living.

The CPI does not measure the cost of living because• It does not measure all the components of the cost

of living• Some components are not measured exactly

So the CPI is possibly a biased measure.

THE CPI AND THE COST OF LIVING

Sources of Bias (Discrepancies) in the CPI

The potential sources of bias in the CPI are• Goods Evolve/New Good Bias• Quality Differences• Consumer substitutes• Outlet substitution bias

THE CPI AND THE COST OF LIVING

New Goods Bias

What if the market basket base year was from 1912?

• New goods do a better job than the old goods that they replace, but cost more.

• The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate.

Quality Change Bias• Better cars and televisions cost more than the

versions they replace.• A price rise that is a payment for improved quality

is not inflation but might get measured as inflation.

THE CPI AND THE COST OF LIVING

Commodity Substitution Bias• If the price of beef rises faster than the price of

chicken, people buy more chicken and less beef.• The CPI basket doesn’t change to allow for the

effects of substitution between goods.

Outlet Substitution Bias• If prices rise more rapidly, people use discount

stores more frequently.• The CPI basket doesn’t change to allow for the

effects of outlet substitution.

THE CPI AND THE COST OF LIVING

The Magnitude of the Bias

The Boskin Commission estimated the bias to be 1.1 percentage points per year.

If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year.

To reduce the bias, the BLS has decided to increase the frequency of its Consumer Expenditure Survey and revise the CPI basket every two years.

When the BLS revises the CPI basket, the reference base period does not change.

Inflation

Real World Price Indexes

Producer Price Index (PPI)

A statistical measure of a weighted average or prices of commodities that firms purchase from other firms. Generally for non-retail markets

Used as a leading indicator of the CPI

PPI’s for:• Food materials• Intermediate goods• Finished goods

Inflation

Real World Price Indexes

GDP Deflator

A price index measuring the changes in prices of all new goods and services produced in the economy

Broadest measure

Not based on a fixed market basket, but a survey of a wide variety of goods.

The GDP Deflator

The GDP Deflator: A Better Measure?

In principle, the GDP deflator is not subject to the biases of the CPI because it uses the price change and the public response to those price changes in the basket of goods and services produced in the current year and the preceding year.

In practice, the GDP deflator suffers from some of the CPI’s problems because the Commerce Department does not directly measure the physical quantities of all the goods and services that are produced.

THE CPI AND THE COST OF LIVING

Figure shows the two measures of inflation in part (a) and the corresponding two measures of the price level in part (b).

THE CPI AND THE COST OF LIVING

The two measures of the inflation rate fluctuate together, but the CPI measure rises more rapidly than the GDP deflator measure.

But the price levels get farther apart.

Both measures probably overstate the inflation rate.

Inflationary Periodsin U.S. History

NOMINAL AND REAL VALUES

Nominal and Real Values in Macroeconomics

Macroeconomics makes a big issue of the distinction between nominal values and real values:

• Nominal GDP and real GDP• Nominal wage rate and real wage rate• Nominal interest rate and real interest rate

NOMINAL AND REAL VALUES

Just because you get an increase in the nominal value, doesn’t mean you are better off than you were before.

We will need to deflate nominal values by the price index to calculate real values for anything- Wages, Income, GDP, etc…

Formula for Real Values

Real = Nominal__________________

Price Index

* The price index can be the CPI, PPI, or the GDP Deflator.

X 100

NOMINAL AND REAL VALUES

Nominal and Real Wage Rates

Nominal wage rate

The average hourly wage rate measured in current dollars.

Real wage rate

The average hourly wage rate measured in the dollars of a given reference base year. Reflects inflation!

NOMINAL AND REAL VALUES

Real wage rate in June 2002 = = $8.16 $14.68

179.9x 100

To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100. That is,

Nominal wage rate in 2002

CPI in 2002x 100Real wage rate in 2002 =

So the $14.28 in the nominal hourly wage in 2002 is worth $8.16 in 19821984 dollars.

What is the nominal hourly wage of $14.28 in 2002 worth in 1982-1984 dollars.

22.3 NOMINAL AND REAL VALUES

Figure 22.4 shows nominal and real wage rates: 1975–2005.

The nominal wage rate has increased every year since 1975.

The real wage rate increased briefly during the late 1970s, decreased through the mid-1990s, and then increased slightly.

Nominal and Real Income

Example: 2002- Nominal income is $40,000 2003- Nominal Income is $41,000 2002- CPI 181.6 2003- CPI 185

Q. 1- What is my real income for each year?

Q. 2- Did my purchasing power increase in

2003? Am I better off in 2003?

Nominal and Real Income

2002 Real Income= $40,000/181.6 x 100= $22,026 2003 Real Income= $41,000/185 x 100= $22,162 Real income has increased by $136. You are better

off in 2003 than in 2002.

Nominal and Real Income

What if your income only increased to

$40,500 in 2003.

Calculate: 1) Real income for each year.

2) Did your purchasing power

increase in 2003?

Nominal and Real Income

2002 Real Income= $40,000/181.6 x 100= $22,026 2003 Real Income= $40,500/185 x 100= $21,891 Real income has decreased by $135. So even though

your nominal income has increased by $500, your real income has decreased by $135.

Inflation

Anticipated Versus Unanticipated Inflation

The effects of inflation on individuals depends upon which type of inflation exists.

Anticipated Inflation

Anticipated Inflation

The rate of inflation that the majority of individuals believe will occur. If the rate of inflation is 10% and that is what the majority expected, then inflation was fully anticipated.

Unanticipated Inflation

Unanticipated Inflation

Inflation that comes as a surprise to individuals in the economy. If people expected an inflation rate of 5% and the actual rate of inflation was 10%, then 5% of the actual inflation rate was unanticipated inflation.

This is the inflation that wreaks havoc on the economy!

Unanticipated inflation hurts many people. When inflation is anticipated some of these people (lenders) are able to protect themselves.

All of this is important when dealing with interest rates!

22.3 NOMINAL AND REAL VALUES

Nominal and Real Interest Rates

Nominal interest rate

The percentage return on a loan expressed in todays dollars.

Real interest rate

The percentage return on a loan, calculated by purchasing power—the nominal interest rate adjusted for the effects of inflation.

Real interest rate = Nominal interest rate – Inflation rate

Inflation/Interest Rates

Real Interest Rate

1982 -- Home Mortgage• Nominal Interest Rate 15%• Increase in the price of housing of 25% (inflation)

Real Rate = 15% - 25% = -10%

Inflation/Interest Rates

Real Interest Rate

1998 -- Home Mortgage• Nominal Interest Rate 6.5%• Increase in the price of housing of 2%

Real Rate = 6.5% - 2% = 4.5% Question

Which scenario is the best for the lender? the borrower?

Does Inflation Necessarily Hurt Everyone?

All of this is extremely important with borrowers and creditors.

Banks must anticipate the inflation rate to cover all loans. Try to increase interest rates with the rate of inflation. This is not an exact science. Creditors/lenders must make sure that the nominal rate of interest is greater than anticipated inflation. It is the unanticipated inflation they can not predict.

Creditor gains if real interest rate is positive. Debtor gains if real rate of interest is negative Unanticipated inflation is the key!!

Higher unanticipated inflation helps borrowers/hurts creditors.

Does Inflation Necessarily Hurt Everyone?

Nom. Int. Rate - Infl. Rate = Real Int. Rate

10% 5% 5% creditor wins

10% 10% 0% draw

10% 15% -5% debtor wins

In the past inflation and nominal interest have risen and fallen together.

Effects of Inflation

Creditors (Lenders) Lose: Net creditors are individuals or businesses that have more savings than debt. A net creditor receives interest and, therefore, receives a reduced real interest return when there is unanticipated inflation.

Debtors (borrowers) Win: Net debtors are individuals or businesses that have more debt than savings. A net debtor pays interest, and therefore, pays a lower real interest rate when there is unanticipated inflation. A fixed rate of interest helps a debtor in the long term. Paying back a loan with less purchasing power during times of inflation.

NOMINAL AND REAL VALUES

Figure shows real and nominal interest rates: 1965–2005.

The nominal interest rate increased during the high-inflation 1980s.

During the 1970s, the real interest rate became negative.

Inflation

Protecting Against Inflation

Cost-of-living adjustments (COLAs)• Clauses in contracts that allow for increases in

specified nominal values to take account of changes in the cost of living

ARMS- Banks offer “Adjustable Rate Mortgages” that adjust the interest rate to keep up with changes in inflation

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Types of Inflation

Demand- Pull Inflation- More dollars chasing less goods. An increase in aggregate demand. Often results for too much money in the economy.

Cost-Push Inflation- Inflation due to an increase in production/ input costs. Results in a decrease of aggregate supply.

Types of Inflation

Double Digit Inflation Hyperinflation Stagflation- High inflation and unemployment.

Worst possible economic situation.

The Typical Course of Business Fluctuations

Four faces, measured by “Trough to Trough”. Phase 1 is Expansion. Avg. expansion 2 ½ years, contraction 1 ½ years.

Changing Inflation and Unemployment: Business Fluctuations

Expansion Peak Contraction Trough

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Changing Inflation and Unemployment: Business Fluctuations

Recession

A period of time during which the rate of growth of business activity is consistently less than its long-term trend or is negative

Depression

An extremely severe recession

National BusinessActivity, 1880 to Present

Causes of Changes in the Business Cycle

External FactorsInternational RelationsOPEC, war

New DiscoveriesResources, technology and innovation

Social/Political ChangesImmigration, shift in attitudes, political party

Weather

Internal FactorsCapital investment

Inventories

Aggregate demand

Government spending and the fluctuating money supply

Predicting Business Cycles

Leading Indicators Come before a change

in a phase of the cycle

• Building permits issued

• Orders for capital goods

• Orders for consumer goods

• Price of raw materials

• Stock prices

Coincident Indicators Change as you move

into a phase• Personal income• Sales volume• Industrial production levels

Predicting Business Cycles

Lagging Indicators- months after a cycle has changed

• Use of credit• Number and size of business income

Unemployment

unemployed the employed the Force Labor

force Labor

Unemployed rate ntUnemployme X 100

Labor force participation rate = Working-age population x 100

Labor force

Price Indexes/Inflation

CPI Market Basket Fixed Quantity X Prices of G/S= CPI Market Basket

Consumer Price Index

Cost of CPI basket at current period pricesCost of CPI basket at base period prices

x 100CPI =

Rate of Inflation

CPI in current year CPI in previous yearCPI in previous year

x 100Inflation rate =

Nominal and Real (Income or Wages)

Real Income:

Nominal Income current year X 100

CPI (Index)

Nominal Income:

Real Income X CPI (Index)

100

Inflation and Interest

Nom. Int. Rate - Infl. Rate = Real Int. Rate

OR

Real Int. Rate + Infl. Rate = Nominal Int. Rate

Real Values

Real GDP- Two ways to determine

100x

Deflator GDP

GDP nominal 1)

2) Price of good in base year X Quantity of good in current year

Price Indexes

GDP Deflator used as a price index for all goods and services in the economy.

Price of good in current year X 100Price of good in base year

Nominal GDP Real GDP

X 100