inflation- the consumer price index and the cost of living principles of macroeconomics lecture 5
TRANSCRIPT
What do you think?
1976: Starting salary for an economics professor was $15,000
2001: Starting salary for an econ. prof. was $55,000.
Considering the REALITY PRINCIPLE, who had a better life?
Reality Principle
What matters to people is the real value of money – its PURCHASING POWER – not the nominal or face value of money.
CPI:
Consumer Price Index
A price index that measures the cost of a fixed basket of goods chosen to represent the consumption pattern of individuals. Tracks the cost of
living over time.
What is in the “market basket”? Food and
Beverages Housing Apparel Transportation Medical Care Recreation Education Other goods and
services
Housing
Rent for primary residences
Owners equivalent rent
Fuel Oil (home heating)
Bedroom furniture
Medical Care
Prescription drugs
Medical supplies Doctor services Eyeglasses Eyeglass services Hospital care
Education and Communication
College Tuition Postage Telephone
Services Computer
Software Computer
accessories
Other Goods and Services
Tobacco and smoking products
Haircuts Other personal
services Funeral Expenses
CPI versus GDP
CPI measures goods produced in prior years (older cars) as well as imported goods.
Chained GDP does not measure either of these. ONLY new goods and those produced in the country.
CPI vs GDP
Because consumers will cut back on goods that cost more – the CPI will tend to overstate true changes in cost of living. If chicken goes up
in price, we switch to hamburger.
CPI Problems
Does not “cut back” on higher priced goods like consumers do.
Would still count the same share of chicken as it did before the price index.
What Economists THINK
CPI may be overestimated by 0.5% to 1.5% each year.
BIG argument among the econ community.
Cost of Living Adjustments
Automatic increases in wages or other payments that are tied to a price index.
For Future Reference on contract negotiations: Called COLA.
COLA and CPI
As CPI goes up, our wages or Social Security makes adjustments to keep up with the cost of living.
Calculating Inflation Rates
Inflation Rate = percentage rate of change of a price index.
See page 124 for more on how to calculate!
Types of InflationTypes of Inflation
Demand-Pull Inflation Cost-Push Inflation Monetary Inflation Stagflation Hyperinflation
Demand-Pull InflationDemand-Pull Inflation
When the demand for goods and services exceeds the production capacity.– Prices rising because
of shortages.
Cost-Push InflationCost-Push Inflation
Inflation can arise from changes in the costs of production of goods and services.– Increase in the price of raw
materials– Increase in the price of
labor– Increase in the cost of
capital.
Cost-Push v. Demand Pull Cost-Push v. Demand Pull
They push and pull prices up.– Labour contracts
containing COLA clauses.
Cost-Of-Living
Adjustments.
Monetary InflationMonetary Inflation
Inflation caused by excessive growth in the money supply.– Value of money
decreases if it isn’t that “rare.”
Rule for Monetary Inflation: Rule for Monetary Inflation: VELOCITYVELOCITY
Quantity Equation– M x V = T x P– Money supply times
the velocity at which it changes hands equals the number of transactions times the average level of prices.
What happens when the What happens when the quantity equation is quantity equation is ““offoff””??
Hyperinflation Money supply
increases much, much faster than an economy’s output of goods and services.– THINK RUSSIA in
1990s.– Zimbabwe in 2000s– Germany post WWI
Phillips Curve: The Phillips Curve: The relationship between relationship between
unemployment and inflation.unemployment and inflation.INVERSE relationship.
Unemployment goes UP, then inflation goes DOWN.
Stagflation: When things Stagflation: When things REALLY go wrong on the REALLY go wrong on the
Phillips CurvePhillips Curve Inflation and
unemployment were at higher levels.– Combination of
stagnation and inflation.
– Both were increasing.
1970s: What caused 1970s: What caused Stagflation?Stagflation?
Spending on the Vietnam War PLUS spending on domestic social programs.
Inflationary expectations Rise in energy costs caused by OPEC Monopolistic pricing
What is wrong with Inflation?What is wrong with Inflation?
Inflation reduces REAL INCOME of those whose incomes do not rise as fast as the price level.
Hurts:– People holding assets
in MONEY– Lenders
Special Note: Phillips Curve Special Note: Phillips Curve InternationalInternational
– Europe 1970s had higher inflation and unemployment.
– Worse because: Labour union practices Tax structures Government economic
policies
Consequences of INFLATIONConsequences of INFLATION
Income Effects:– Reduced purchasing
power of the dollar– Reduced real income
for fixed income receivers
– Reduced real wealth of savings
Income Effects of Inflation Income Effects of Inflation (cont.)(cont.)
Benefits those whose incomes rise faster than the inflation rate.
Benefits owners of real assets (real estate, precious metals (kinda!))
Benefits debtors
How Inflation effects Real How Inflation effects Real OutputOutput
Inflation initially stimulates output
Near full employment, there arise bottlenecks in supplies
Costs begin rising faster than prices
Interest rates accelerate, discouraging new investment.