Chapter 8 the Price Level and Inflation

Three reasons (CPI can overstate true inflation)

1. Substitution 2. Changes in quality (measuring prices differences due to inflation) 3. New products and locations (don't shop at Blockbuster, KB toys anymore; don't diversify where people are shopping, mom and pop shops not included)

Costs of inflation

1. shoeleather costs 2. Money illusion 3. Menu costs 4. Uncertainty about future price levels 5. Wealth redistribution 6. Price confusion 7. Tax distortions

inflation in the US

4% on average (only that high bc of 70s) closer to 3% w/o the 70s (Austin Powers reference)

consumer price index

CPI, measure of the price level based on the consumption pattern of a typical consumer Goal: include everything purchased by a typical consumer to get a measure of the cost of living

difference between GDP deflator and CPI

GDP deflator based on entire economy, CPI more specific

tax distortions

capital tax gains are taxes on the gains realized by selling an asset for more than its purchased price problem: often the price rises due to inflation rather than an increase in the value of the good (like with a house)

money illusion

consumers misinterpret nominal changes as real changes if prices and wages all go up by 2%, there is no real change in your purchasing power ppl w/ money illusion think they are richer in this case

inflation

continuing rise in general price level measured as a growth rate in the average level of prices

prices included in the CPI

education, housing, transportation, food and beverages, medical care, recreation, communication, apparel, other goods and services

new goods, services, and locations

electronics like flash drives and iPads Previously BLS updated CPI after long delays, caused upward bias for 2 reasons (1. new product prices often drop, 2. new retail outlets like online stores)

Bureau of Labor statistics

gov't agency that reports inflation and unemployment data determines how much "weight" to put on certain consumer prices

Historical observations (about inflation)

historical avg about 4% in past 50 years inflation was over 14.5% between April 1979 and March 1980 Since 1983, inflation has averaged less than 3% only time US inflation rates were negative was during recession of 2008-2009

money illusion example

if nominal wages go up by 3% but prices go up by 5%, money illusion may cause you think you are wealthier, but your real wages have actually decreased (your life will be 2% worse next year)

price confusion

inflation makes it difficult to read price signals, and this confusion can lead to misallocation of resources difficulty analyzing price changes as a result of demand shifts or inflation implications are very different (whether increase in prices are because of demand or inflation??)

menu costs

inflation means firms must incur extra costs to change their output prices

uncertainty about future price levels

long-term agreements may not be signed if lenders, firms, and workers are unsure about future price levels\ "wage and other input contacts often have long-term commitment. Firms may have to borrow today and pay back $$ later...uncertainty about price may make borrowing riskier"

Substitution

microeconomics: when price of A rises, we buy more B since 1999, BLS has used a formula that accounts for price change and shift in goods consumption

concerns about CPI accuracy

most common concern is that CPI overstates true inflation

prices don't all move together

most prices rise over time Travel, education, health care Some prices fall consumer electronics (usually due to great technological advancement) Flat panel TV 1997: $7,000 Flat panel TV 2012: $500

causes of inflation

no debate on cause of inflation - Inflation is an accepted cost of economic growth so some inflation is also acceptable

real wage

nominal wage adjusted for inflation changes in GDP

difficulty w inflation

not all prices are caused by inflation when the relative price of just one good rises, people sometimes call it inflation inflation is a continued rise in the general price level

deflation

opposite of inflation...price level falls

BLS surveys

price info on over 8,000 goods and services each month 211 categories 38 geographic locations also must estimate how each good impacts a typical consumer budget

Using CPI to compare dollar values across time

prices from different time periods can be confusing 1924 you could buy a fully constructed house for $1,969 formula: PRICE TODAY= PRICE EARLIER X PRICE LEVEL TODAY/PRICE LEVEL EARLIER

quality changes

prices may rise because quality is better (Ex: flat screen HD TVs, compared to when they existed in early 1990s)

Shoeleather costs

the time resources wasted when inflation encourages people to reduce their money holdings time, effort, and fuel costs that people bear when they try to use more $$

biggest problem of inflation

uncertainty about price changes create problems for firms and workers long-term wages difficult to agree upon consumers may change buying patterns due to uncertainty

nominal wage

wage in current dollars

wealth redistribution

wealth can be redistributed between borrowers and lenders ex: you borrow $50,000 and expect to pay back $60,000 in five years If unexpected inflation occurs, you are better off, bank is worse off if the inflation was expected, the bank would have required more in return for the loan (you'd have to repay $75,000 in five years)