Macroeconomic Problems

Inflation
Economics

What is Inflation?
The general upward movement in the average level of prices of the goods and services in an economy

What is Deflation?
The general decrease in the average level of prices of the goods and services in an economy

How is Inflation measured? Consumer Price Index (CPI)? A measure of the cost of a fixed market basket of consumer goods and services

Consumer Price Index (CPI)

The CPI is a market basket of 364 items at 21,000 establishments in 91 cities that the typical householder buys. It does not include exports because we do not buy exports but does include imports. About 55% of the CPI is services.

[CPI measures cost of living relative to a base year[100]

CPI in Indonesia
Since June 2008, the CPI calculation uses base year of 2007 (2007 = 100) and covers 66 cities. The data cover 284 - 441 goods and services which are classified into seven expenditure groups namely: 1. food; prepared food, beverage, 2. cigarette & tobacco; 3. housing, water, electricity, gas & fuel; 4. clothing; 5. health; 6. education, recreation & sports; and 7.transport, communication & financial services.

How is the CPI calculated?

Value of the market basket

CPI =

in the current period x 100 = PRICE INDEX

Value of the market basket in

the base period

Figuring CPI
Consumers in this economy buy only two goodshot dogs & hamburgers. Step 1. Fix the basket. What percent of income is spent on each. Consumers in this economy buy a basket of:

4 hot dogs and 2 hamburgers

Step 2. Find the prices of each good in each year. Year Price of Hot Dogs Price of Hamburgers 2001 $1 $2 2002 $2 $3 Step 3. Compute the basket cost for each year. 2001 ($1 per hot dog x 4 = $4) + ($2 per hamburger x 2 = $4), so $8 2002 ($2 per hot dog x 4 = $8) + ($3 per hamburger x 2 = $6), so $14
Step 4. Choose one year as a base year (2001) and compute the CPI 2001 ($8/$8) x 100 = 100 2002 (14/$8) x 100 = 175 Step 5. Use the CPI to compute the inflation rate from previous year 2002 (175/100 x 100 = 175%) or to get actual % (175-100)/100 x 100 =75%

Figuring CPI for an Individual

Q. Suppose that a typical consumer buys the following quantities of these three commodities in 2000 and 2001. Commodity Food Clothing Shelter Quantity 5 units 2 units 3 units 2000 per Unit Price $6.00 $7.00 $12.00 2001 per Unit Price $5.00 $9.00 $19.00

Which of the following can be concluded about the CPI for this individual from 2000 to 2001? a. It remained unchanged. c. it decreased by 20% b. It decreased by 25%. d. It increased by 20% e. It increased by 25%.
(Answer)

Year 1 [2000]: [5 food x $6 = $30; 2 clothing x $7 = $14; 3 shelters x $12 = $36, for dollar value of $80. CPI = 100 ($80/$80 x 100 = 100 for 2000)] Year 2 [2001]: [5 food x $5 = $25; 2 clothing x $9 = $18; 3 shelters x $19 = $57, for value of $100. CPI =125 ($100/$80 x 100 = 125% for 2001)] So, the CPI increased by 25%.

If the value of the CPI equals 120, what does this mean?

The fixed market basket of goods costs 20% more than in the base period of time

1962 Prices v. 2006 Prices in the United States

Tuition at MIT - $1,500 Starting salary - $6,000 [college graduate] New house for $10-15,000 [2.5 times the income of a new college graduate] Coke - 10 cents Movies - .50 1962 Chevy - $1,500 Tuition at MIT - $32,300 Starting salary - $44,000 [college [college graduate] New median house price is $218,000 [5 times the income of todays college grads] Coke - 60 cents Movies - $7 2006 Chevy - $23,000

2006 Corvette $58,000 62 Corvette $2,995

Dollar Figures From Different Times

Babe Ruth made $80,000 in 1931. That would be equivalent to $1 million today.

President Herbert Hoovers salary in 1931 was $75,000. That would be equivalent to $900,000 today. George Bush is being paid $400,000 a year. President Kennedy was paid $100,000 in 62 [$650,000 today] $80,000=$1 M

John D. Rockefellers [1839-1937] wealth would be worth $200 billion in todays money, or 4 times that of Bill Gates. Although Rockefeller was worth $200 billion, he could not watch TV, play video games, surf the internet, or send email to his grandkids. For most of his life, he could not use AC, travel by car or plane, use a telephone to call friends, or take advantage of antibiotics to prolong & enhance life.

Who is the Richest American Ever?

Perhaps the average American today is richer than the richest American a century ago.

GDP Deflator more broad GDP Deflator includes prices for all goods that we produce:
1.What householders are buying 2.What businesses are buying 3.What the government is buying 4.What foreigners are buying [does not include imports because we dont produce imports]

GDP Deflator Compared to the CPI [CPI is normally higher.]

Who measures inflation?

The Bureau of Labor Statistics

in the U.S

Badan Pusat Statistik

in Indonesia

UK National Statistics
in United Kingdom

What are the effects of unexpected inflation?

Inflation redistributes income
some people win the ones getting the higher prices (i.e oil/gas companies) Some people lose the ones paying the higher prices (think YOU!)

Who wins and who loses from inflation?

Debtors win
Borrowers pay back loans with inflated dollars (dollars that are worth less)

Creditors lose
Lenders are paid back with inflated dollars (dollars that are worth less)

 Those on fixed incomes lose

More winners and losers of inflation

Income does not keep up with prices - standard of living goes down. Exception if fixed income is INDEXED to inflation (CPI)

Savers often lose

If prices rise faster than the rate of interest they are getting from their savings (investment) then they lose purchasing power

Government sometimes wins

Government wins Biggest debtor in the World (Debtors WIN!) Government loses surplus in savings, increase in salaries and other prices paid

Menu costs of inflation

Individuals and business must allocate resources to keep up with changing prices increases transaction costs

Inflation and uncertainty

Do I spend today, or save? Prices going up or not? What is happening to my purchasing power? ARRRGGHH!

The Inflation-GDP-Unemployment Connection

GDP is calculated by taking the price of a good or service and multiplying it by the quantity of the good or service produced.
Example (assume a one product economy)
Dry Erase Marker (sold this year) $1.00 (Price of one) X 1,000 produced this year

GDP = $1,000

The Inflation-GDP-Unemployment Connection

Lets assume next year the price of Dry Erase Markers is $2.00 each and the economy still produces 1,000 markers.
$2.00 X 1,000 GDP = $2,000
Has our GDP grown? What caused GDP to rise? Is this good? What should be our main concern?

The Inflation-GDP-Unemployment Connection

Our main concern should be the growth of the production of goods and services (G/S). The implication is that with the growth of production of G/S more workers will be needed to produce the G/S, thereby putting people to work and getting closer to the Economic Goal of Full-employment.

The Inflation-GDP-Unemployment Connection

Our example tells us that we only experienced a rise in price, not a rise in the quantity of the good produced.
We had inflation. To see how we are doing from year to year in the production of G/S we need to factor out Inflation

The Inflation-GDP-Unemployment Connection

Terms we need to know and understand:
Nominal GDP the GDP calculated in any given year using that particular years prices or price level. Real GDP the GDP calculated for a given year with the change in price level (Inflation) factored out. Measures the production of G/S in terms of a base year price level GDP Deflator- calculates the change in price level for a particular year compared to an established base year price level.

Year

Price of Goods and Services Produced

Quantity of Goods and Services Produced

Nominal GDP
(unadjusted for Price Change)

GDP Deflator

Real GDP
(adjusted for Price Change)

1999
2000 2001 2002 2003

.50
.75 .75 1.00 1.50

1,000
1,000 1,200 1,100 1,150

Nominal GDP = Price of G&S x Quantity of G &S GDP Deflator = Current Price/Base Year Price Real GDP = Nominal GDP/GDP Deflator X 100

What does all this mean???

Unemployment Inflation GDP Real Growth Rate 2.5% to 5%
1% to 2%

Good Worry Bad

6% or less 6.5% to 8% 8.5% or more

1% to 4% 5% to 8%

9% or more .5% or less

Unemployment Rate 9.7

% Inflation Rate -2.10% Real GDP -6.0%

IT IS A MUST TO REMEMBER THIS FORMULA:

Real = Nominal - Inflation

GDP
Interest rate

GDP Interest rate

Increased