Measurement of Economic Performance: Inflation

1. Measurement of Economic Performance: Inflation AP Economics Mr. Bordelon

2. Inflation • Inflation. A general increase in prices and fall in the purchasing value of money. • Only relative prices matter. It’s not about the level of prices, but the rate of change of prices.

3. Inflation Billy has an income of $20 per week to spend on gas ($2/gallon) or coffee ($4/cup). Above is his purchasing possibilities. What happens if his income doubles, and so did the price of gas and coffee? Nothing. The price of gas and coffee, relative to income, is unchanged. The price of gas and coffee, relative to each other, is unchanged.

4. Inflation What happens if gas and coffee doubles, but Billy’s income stays the same? The price of coffee and gas, relative to each other, is unchanged. Relative to income, however, it costs Billy twice as much. Inflation decreases purchasing power because income doesn’t keep up.

5. Costs of Inflation • Shoe leather costs. Allusion to the wear and tear caused by the extra running around that takes place when people are trying to avoid holding money, or, in other words, the increased transaction costs caused by inflation. • From the above example, Billy could spend a lot of time looking for substitutes. Billy could decide she needs to basically get the $20 of out of his wallet and into something else that might hold value better (say, a Certificate of Deposit). • The time and effort spent on this costs Billy.

6. Costs of Inflation • Menu costs. Costs incurred by sellers to update prices. • Sellers of gas and coffee would have to change their menus/signs. • Not such a big deal for the gas station, just change the sign. • Bigger deal for restaurants and cafes, as they need to print new menus. • If inflation continues, with prices rising every few months, signs and menus would have to be changed constantly.

7. Costs of Inflation • Unit-of-Account Costs. Costs arising from the way inflation makes money a less reliable unit of measurement. • Alex owns a house worth $100,000. Florida has a property tax of 1%, meaning Alex owes $1,000 annually. • Within a year, Florida experiences Zimbabwe-like inflation, and now the house is worth $200,000, but it’s the same house, it didn’t get better. • Alex now owes $2,000 on that house. • Assuming Alex didn’t double his income too, he is worse off because the property tax system didn’t take into account that inflation caused the house to increase in value.

8. Winners and Losersfrom Inflation • This is about borrowers and lenders. We learned from GDP of the idea of a nominal value and a real value. We have this same concept in lending as well. • Nominal interest rate. The amount of interest charged on a loan. • Real interest rate = nominal interest rate – expected inflation • Awesome. Why do we care?

9. Winners and Losersfrom Inflation • Joey lends Tyler $100, and Tyler agrees to pay Joey back in one year. Joey should charge him interest. • Joey is providing a service for which he should be compensated. By giving over the $100 for one year, Joey does not have that $100 to spend for himself. • When Tyler pays Joey back, inflation will have reduced the purchasing power of the $100. Joey should be entitled to enough interest so that inflation doesn’t hurt his purchasing power. • Interest rate must have two parts: • 1. Compensation for service provided. • 2. Amount to offset inflation that is expected to occur. • Key word: EXPECTED

10. Winners and Losersfrom Inflation • Joey believes inflation will be 5%, and the service is 3%. As such, Joey charges 8% interest. After one year, three possibilities. • 5% inflation expected and happened. Purchasing power of $100 was unchanged, and compensated Joey exactly the amount of money lent adjusted for inflation. • 5% inflation expected, but only 1% inflation happened. Purchasing power increased because Tyler had to pay more than enough to compensate for inflation. • 5% inflation, but 8% inflation happened. Purchasing power decreased by Tyler had to pay back less than enough to compensate for inflation.

11. Winners and Losersfrom Inflation • Key points • When actual inflation is below expected inflation, lenders win and borrower loses. • When actual inflation is above expected inflation, lenders lose and borrowers win.

12. Disinflation • Inflation. Overall rise in prices. • Defllation. Overall decline in prices. • Disinflation. Process of reducing inflation to a smaller, less damaging, amount of inflation. • But this is problematic! As you will learn, a high rate of inflation is caused by too much money being circulated and spent in the economy. To reduce inflation, you must reduce the amount of money in the economy. This means demand for g/s will be reduced, which in turn means unemployment will increase. No g/s needed, then no workers needed.

13. Market Basketsand Price Indices • Market basket. Typical basket of g/s purchased within a given year. • Example. Economy revolves around four foods: salami, hash, ham, and cheese. Table on the next page shows prices and quantity consumed for 2010 and 2011.

14. Market Basketsand Price Indices To figure out the price index, we need to figure out whether the market basket became more or less expensive to purchase. For the market basket, you multiply price times quantity. 2010 cost: ($300 x $4) + (200 x $5) + (100 x $2) + (500 x $3) = $3,900 2011 cost: ($300 x $6) + (200 x $7) + (100 x $1.50) + (500 x $2.50) = $4,600

15. Market Basketsand Price Indices For the price index, the equation is as follows: PI = (given year/base year) x 100 In this case: ($4,600/$3,900) x 100 = 118 This ratio tells us that this market basket increased in overall price by about 18% from year to year, though some prices fell.

16. Market Basketsand Price Indices Okay, this gives us the price change but what about inflation? To calculate inflation, you do a percentage change equation between the PI of the base year, and the PI of the given year. We learned from GDP, that the base year will always be 100. So the PI for 2010 is 100. Using 118 for 2011, we calculate inflation as follows: [(118 – 100)/100] x 100% = 18%

17. Price Indices • Consumer Price Index. PI aimed at a market basket of g/s consumed by consumers. Most widely used measure of inflation. Market basket uses 80,000 g/s for a typical urban family of four. • Producer Price Index. Measures cost of market basket of g/s purchased by producers (commodities: steel, electricity, etc.) • You can use both just like the example above, but CPI is more immediate. Inflation affects consumers initially.

18. Price Indices • GDP deflator. Not a price index, but works the same way. GDP deflator equals 100 times the ratio of nominal GDP to real GDP (expressed in a base year). • GDP deflator = (nominal GDP/real GDP) x 100 • Real GDP is currently expressed in 2010 dollars, and as such the GDP deflator for 2010 is 100 (see discussion on GDP and real interest rate). • Nominal GDP increases by 5%. Real GDP does not change. GDP would indicate the aggregate price level increased by 5%.

19. Price Indices • GDP deflator. Not a price index, but works the same way. GDP deflator equals 100 times the ratio of nominal GDP to real GDP (expressed in a base year). • GDP deflator = (nominal GDP/real GDP) x 100 • Real GDP Base Year = $100,000 • Nominal GDP for Year 1 = $125,000 • GDP deflator = (125,000/100,000) x 100 • GDP deflator = 1.25 • This ratio would indicate that inflation increased by 25% over the time period measured.