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Eco 6351 Economics for Managers Chapter 10c. The Business Cycle

Eco 6351 Economics for Managers Chapter 10c. The Business Cycle. Prof. Vera Adamchik. Inflation. The biggest fear as an economy reaches full employment is inflation. Inflation is an increase in the average level of prices and services , not a change in any specific price.

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Eco 6351 Economics for Managers Chapter 10c. The Business Cycle

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  1. Eco 6351Economics for ManagersChapter 10c. The Business Cycle Prof. Vera Adamchik

  2. Inflation • The biggest fear as an economy reaches full employment is inflation. • Inflationis an increase in the average level of prices and services, not a change in any specific price. • Deflation is a decrease in the average level of prices of goods and services.

  3. The average price level • The average level of prices is measured by a price index • The two most commonly used price indexes are: • The Consumer Price Index (CPI) • The GDP Deflator

  4. The Consumer Price Index • The Consumer Price Index, or CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

  5. Information for the CPI In order to calculate the CPI we need: • to select a base period • to determine the “basket” of goods and services that a typical urban family buys • to collect data on the prices of the items in the “basket” in the base period and in the following periods

  6. Whose buying habitsdoes the CPI reflect? • All Urban Consumers (CPI-U), about 87 percent of the total U.S. population • Urban Wage Earners and Clerical Workers (CPI-W), about 32 percent of the total U.S. population (a subset of the CPI-U's population • Not included in the CPI are the spending patterns of persons living in rural non-metropolitan areas, farm families, persons in the Armed Forces, and those in institutions, such as prisons and mental hospitals

  7. How is the CPI market basket determined? • The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. • For the current CPI, this information was collected from the Consumer Expenditure Survey over the three years 1993, 1994, and 1995.

  8. The Consumer Expenditure Survey • In each of these three years, more than 5,000 families provided information on their spending habits in a series of quarterly interviews. • Another 5,000 families in each of the 3 years kept diaries listing everything they bought during a 2-week period. • Altogether, more than 30,000 individuals and families provided expenditure information for use in determining the importance, or weight, of the over 200 categories in the CPI index structure.

  9. What goods and services does the CPI cover? More than 200 expenditure categories are arranged into eightmajor groups: • Food and Beverages • Housing • Apparel • Transportation • Medical Care • Recreation • Education and Communication • Other Goods and Services

  10. How are CPI prices collected and reviewed? • Each month, BLS data collectors (called economic assistants) visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States to obtain price information on thousands of items used to track and measure price change in the CPI. • These economic assistants record the prices of about 80,000 items each month.

  11. How to interpret an index? • The CPI index has a 1982-84 reference base. That is, BLS sets the average index level (representing the average price level) - for the 36-month period covering the years 1982, 1983, and 1984 - equal to 100. • The Bureau measures changes in relation to that figure. • Historically, BLS has updated its reference periods every 10 years or so.

  12. The CPI: A simplified calculation Year 1982-1984 Item Basket Price Expenditure Oranges 5 $0.80 $4.00 Haircuts 6 $11.00 $66.00 Bus rides 200 $0.70 $140.00 Total expenditure $210.00 (value of basket in the 1982-84 prices)

  13. The CPI: A simplified calculation Year 2002 Item Basket Price Expenditure Oranges 5 $1.20 $6.00 Haircuts 6 $12.50 $75.00 Bus rides 200 $0.75 $150.00 Total expenditure $231.00 (value of basket in the current 2002 prices)

  14. The formula for the CPI CPI = Value of basket in the current prices Value of basket in the 1982-1984 prices  100 CPI in 2002 year = ($231/$210)*100 = 110

  15. How CPI is used • To calculate inflation rate • To translate from nominal to real values ( for example, in order to compare wages over time)

  16. The CPI and inflation • Inflation has been defined as aprocess of continuously rising prices, or equivalently, of a continuously falling value of money. • Various indexes have been devised to measure different aspects of inflation. • The CPI measures inflation as experienced by consumers in their day-to-day living expenses.

  17. The inflation rate • The inflation rate between Year 2 and Year 1 is the percent change in the CPI. • Inflation = [(CPI Year 2 – CPI Year 1)/ CPI Year 1] * 100%.

  18. The biased CPI • The CPI is likely to overstatethe inflation rate for three reasons • Substitution bias • New goods bias • Quality change bias • Growth in discounting • It is estimated that the CPI overstates the inflation rate by 1.1 percentage points per year

  19. Quality change bias • A 1955 television does not compare in quality to a 2000 television. • Today's automobiles cost more that Henry Fords model T, but part of that price is reflected in the higher quality.

  20. New goods bias • The market basket used to measure the CPI changes. • Products like computers did not exist in the 1972-73 CPI market basket. • DVD players did not exist in the 1987 CPI market basket.

  21. Nominal versus Real Values Real value = Nominal value / Price Index APPROXIMATELY: % change in real value = % change in nominal value – % change in price index (inflation)

  22. Nominal vs Real Income (Wage) • Nominal income (wage) is the amount of money income received in a given time period, measured in current dollars. • Real income (wage) is income in constant dollars — nominal income adjusted for inflation.

  23. 200 190 180 170 160 150 140 130 120 110 100 1982 1984 1986 1988 1990 1992 1994 1996 2000 Nominal Wages and Prices Nominal wages Prices(CPI) Real wage

  24. Nominal vs. Real Wealth • Inflation alters the real value of savings.

  25. Inflation’s Impact, 2001-2011

  26. The Price Stability Goal • Price stability is the absence of significant changes in the average price level. • The Full Employment and Balanced Growth Act of 1978 holds the rate of inflation to less than 3%. • Why 3 Percent? • Congress weighs the tradeoff between inflation and full employment.

  27. The GDP deflator Real GDP = Nominal GDP/GDP deflator The GDP deflator measures the average level of prices of all the goods and services that are included in GDP

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