Inflation

1. Inflation By Matthew Cali November 29th, 2010

2. What is Inflation? • A persistent, substantial rise in the general level of prices related to an increase in the volume of money • Results in the loss of value of currency • “Too many dollars chasing too few goods” • Purchasing power of the currency decreases so need more per good • Average increase in price in all goods and services, not just one specific item

3. Where does Inflation Come From? • Two Main Theories on the origin of Inflation • Prices rise as “Cost-Push inflation,” or inflation that begins when rising costs result in increased prices, or “Demand-Pull inflation,” or when people’s ability to spend rises more rapidly than the availability of goods and services • Demand-Pull Model • When Government prints an excess of money to deal with a crisis • Prices will rise quickly to keep up with currency surplus • People will spend their money quickly before value decreases • Prices are forced upwards because of a high demand • Rise in Production Costs (Cost-Push Model) • Increase in final price of product • Ex: Raw materials are more expensive so producers raise prices of products to cover these expenses

4. Where does Inflation Come From? • Rising Labor Costs (Cost-Push Model) • As workers demand higher wages, companies pass on costs to consumers • Federal Taxes put on Consumer Goods • As taxes rise, suppliers pass the costs onto customers • Catch: Once price increases, it rarely goes back down • Wars • Governments must repay money borrowed during war or war reparations

5. Four Main Factors of Inflation • Overall, the price of goods will be affected by four things: • The supply of money goes up. • More Money = Less Purchasing Power • The supply of other goods goes down. • Lesser amount of goods leaves more money chasing the fewer goods model (High Demand and Low Supply) • Demand for money goes down. • If there is less of a demand for money, money loses its value and you will need more money quantitatively to equal the original cost. • Demand for other goods goes up. • High Demand for goods makes prices go up because more buyers and thus relatively less goods.

6. Benefits of Inflation • Business Growth • Savings are frequently invested to avoid net loss in banks. When there is controlled inflation, people spend their money since they are afraid prices will go up. Therefore, they choose to save their money they worked for by buying now instead of paying more later • Decreased Debt Values • Higher inflation (controlled) decreases the real value of currency. Therefore, any money that one owes is actually less in value than it was before the inflation.

7. Benefits of Inflation (cont.) • Stock Values Increase • Stocks owned prior to inflation could experience a price increase and be sold at a higher value • Controlled Inflation is a sign that the economy is growing

8. Harms of Inflation • Make it difficult to budget or plan long term spending or savings • Discourages investment saving due to uncertainty about the future purchasing power • Can Impose hidden tax increases as inflated earnings push taxpayers into higher income tax rates (unless the tax brackets are indexed to inflation) • Hurts those with fixed nominal incomes (pensions that are fixed) • Increased Prices caused places with set “menus” to have to reprint more frequently

9. How to measure Inflation • Measuring inflation is a difficult problem for government statisticians. They must take a number of goods that are representative of the economy and put it together in a “market basket.” The cost of this basket is then compared over time. This results in a price index. The price index is the cost of the basket today as a percentage of the cost of the same basket in the starting year.

10. Consumer Price Index (CPI) • A consumer price index (CPI) measures changes through time in the price level of consumer goods and services purchased by households. • The CPI is defined by the United States Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a marker basket of consumer goods and services.” • The annual percentage change in a CPI is used as a measure of inflation. It can be used to index (adjust for inflation) the real value of wages, salaries, pensions, regulating prices and to show changes in real values.

11. Calculating CPI • The "updated cost" is the price of an item at a given year, divided by the initial year, and multiplied by one hundred. • Thus, any year denoted as the base period will be given a value of 100

12. How to Calculate Inflation • Each month the Bureau of Labor Statistics (BLS) surveys prices and generates the CPI. Using the CPI Formula, one item that is indexed at 100 because it costs $1.00 in 2000, is priced at $1.75 today. The Index would be 175.0 • We can see the index increased but by how much. We need to take 175 and subtract 100. This results in 75. Thus, the cost of the item “inflated” by 75 points. • Now we must compare the increase in the CPI to the original price. We divide 75/100 to get 0.75. We convert this to a percent by multiplying by 100% and our result is a 75% increase since 2000.

13. A less “Inflated” Example • ((B - A)/A)*100 is the formula for inflation where B is the current CPI Index and A is the starting year’s CPI Index • So if one year ago the Consumer Price Index was 178 and today the CPI is 185, then the calculations would look like this: • ((185-178)/178)*100%  0.0393*100% = 3.93% Inflation over the Sample Year

14. Review for All Inflation • Fortunately, The method of calculating Inflation is the same, no matter what time period we desire. We just substitute a different value for the B. So if we want to know how much prices have increased over the last 12 months (the commonly published inflation rate number) we would subtract last year's index from the current index and divide by last year's number and multiply the result by 100 and add a % sign. 

15. Inflation of Gasoline Prices • Difference between Nominal Price and Price Adjusted for Inflation • Nominal is price at that time • Adjusted for Inflation is comparing the price at that time to an equivalent price of today • 1980-1981 Gas is over $1.00/gal for the first time ($1.35/gal) • 1969 Gas was $0.35 a gallon • This is a 286% Increase in 12 years (in case you were wondering) • The 1981 price is equivalent to $3.24 in 2010. • Compare this to the 10 year period of 1998-2008 where at its peak, gas prices hit $4.02 in July of 2008 and the average price of gas in 1998 was $1.02. That is a 294% increase in price in 10 years • However, the Average price of 2008 was $3.23, almost identical to the 1981 price when it was adjusted for inflation • The Overall average price in 2010 dollars between 1918 and 2010 is $2.39 a gallon. Thus whenever it was above this gas prices can be considered high while when they are below this level, gas prices could be considered cheap.

17. Inflation with Milk

19. Inflation Fun Facts • The annual inflation rate in the United States has fluctuated greatly over its history, ranging from nearly zero inflation to 23% inflation. The federal government tries to keep inflation around 2-3%. • The Civil War’s direct cost was about $6.7 billion in 1860 money, which would be $139 billion today. However, some economic historians believe the indirect cost (such as disruption of the economy) would measure approximately $46 trillion in current money. • In 2008, the top three countries with the most inflation were Zimbabwe (12,563.0%), Burma (35%), and Guinea (23.4%).

20. More Fun Facts • Nations who were on the Gold Standard during the 19th century until 1914 experienced little or no inflationary trends. • The dollar has lost 21% of its purchasing power in the last decade. • Adjusted for inflation, the top five highest grossing movies of all time are (Pre-Avatar) Gone With the Wind ($1,606,254,800), Star Wars ($1,416,050,800),  Sound of Music($1,132,202,200),  ET: Extra Terrestrial ($1,127,742,000),   The Ten Commandments ($1,041,450,000).