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

1. Section 3B- Modules 14/15- Inflation and the Business Cycle

2. When you have completed your study of these modules, you will be able to 1 2 3 Module Checklist • Explain what the Consumer Price Index (CPI) is and how it is calculated. 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.

3. Inflation An upward movement in the average level of prices Deflation A downward movement in the average level of prices Inflation

4. 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

5. 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

6. 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.

7. 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

8. 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 19821984.

9. 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 19821984. • 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.

10. 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

11. Stage 1: The Market Basket Figure below shows the CPI basket. This shopping cart is filled with the items that an average household buys.

12. 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.

13. 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.

14. 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

15. Cost of CPI basket at current period prices x 100 Cost of CPI basket at base period prices $50 $70 x 100 x 100 = 140 = 100 For 2000, the CPI is: $50 $50 For 2003, the CPI is: Stage 3: Calculating the CPI CPI = The CPI for the base period is always 100. Always!!! Once we determine the CPI for these years we can now determine the inflation for these years!

16. CPI in current year  CPI in previous year x 100 Inflation rate = CPI in previous year 140  100 x 100 = 40% percent Inflation rate = 100 Formula for the Rate of Inflation • Measuring Inflation • Inflation rate • The percentage change in the price level from one year to the next. 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!

17. 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? CPI in current year  CPI in previous year x 100 Inflation rate = CPI in previous year 140  120 x 100 = 16.7 percent Inflation rate = 120 This means there has been a 16.7% increase in inflation between the previous year and current year.

18. 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 CPI today CPI in past = X

19. 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. 207 15.2 Amount in today’s dollars $80,000 X = Answer is $1,089,474

20. THE CONSUMER PRICE INDEX Figure shows the CPI in part (a) and the inflation rate in part (b).

21. 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.

22. THE CONSUMER PRICE INDEX In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.