ECON202 CHAPTER 9: INFLATION (the percentage increase (change) in the price level from one year to the next

calculating the inflation rate

inflation rate2016= (CPI2016 - CPI2015) ----------------------------- X100 CPI 2016

GPD Deflator

measure of the price level calculated by dividing nominal GDP by real GDP & multiplying by 100. includes all final goods & services in GDP (how board it is)

briefly explain whether you agree or disagree with the following statement: "I dont believe the government price statistics. the CPI for 2010 was 218, but I know that the inflation rate couldnt have been as high percent in 2010"

**** inflation rate we need CPI of 2009, so we dont know what it is

Consumer Price Index CPI

-a measure of the average change over time in the prices a typical urban family of 4 pays for the goods and services they purchased -cost of living index -an index comparing the cost of buying the market basket of goods & services in the current year to the cost of buying the same market basket in the base period

CPI: market basket & CPI formula

-market basket: >>>>>representative group of goods & services (211 different types) purchased by the typical urban family of four CPI2016 =expenditures on market basket in current year2016 _________________________________________________________________X100 expenditures on market basket in base year

nominal interest rate =

-real interest rate + (expected) inflation rate

Problem with unanticipated inflation (bigger problem)

-redistributes income between borrowers & lenders when actual inflation rate differ from expected inflation rate

CPI OVERSTATES: the cost of living & inflation rate

-substitution bias >>using fixed market basket, the CPI assumes that consumers do not buy less of good whose relative price rises & more of a good whose relative price falls -increasing in quality bias >>quality improvements of goods & services are not filtered out completely & show up as an increase in the cost of living (inflation) EXAMPLE>>>UoL student transfer to UK cost more but not inflation BETTER QUALITY -omit new product bias & outlet bias

actual inflation < expected inflation LENDER GAINS, BORROWERS LOSE

-suppose actual inflation = 0%, instead of 5% -actual real interest rate= nominal interest rate - actual inflation rate 7% = 7% - 0% ***lender receives & borrowers pays a nominal interest rate (7%0 with an expected inflations rate (5%) larger than the actual inflation rate (0%) that occurs; thereby, lender receives & borrowers pay an actual real interest rate (7%) larger than the expected real interest rate (2%)

actual inflation > expected inflation LENDER LOSE, BORROWERS GAINS

-suppose actual inflation = 10%, instead of 5% -actual real interest rate= nominal interest rate - actual inflation rate -3% = 7% - 10% ***borrowers gain by paying a nominal interest rate with an expeceted inflation rate (5%) smaller than the actual inflation rate (10%) that occurs; thereby, paying an actual real interest rate (-3%) smaller than the expected real interest rate (2%)

interpreting the value of the CPI LOOK AT SLIDES FOR MORE HELP

-the CPI is the cost of the market basket in a specific year as a percentage of the cost of the SAME market basket -a CPI of 110 indicates that the cost of the market basket is 110 percent of the cost of the market basket in the base period. in other words, THE COST INCREASED FROM THE BASE PERIOD BY 10%

interest rates: Nominal vs Real

-the interest rate is the cost of borrowing funds, expressed as a percentage of the amount borrowed -nominal interest rates>>>>>>>stated interest rate on a loan -real interest rates>>>>>>>equals nominal interest rate minus the inflation rate >>>>>>>is a better measure than the nominal interest rate of the true cost of borrowing & the true return from lending

using price indexes to adjust for the effects of inflation

-variables that are calculated in current-year prices are referred to as NOMINAL VARIABLE (grams first job's nominal pay) -to correct for the effects of inflation, divide the nominal variable by a PRICE INDEX and multiply by 100 real wage= nominal wage (what is reported) --------------------------------------- X 100 CPI real wages====>>> what you actually get -the real variable will be measured in dollars of the base year (referred to as constant dollars)

why inflation is a problem: wrong reason

-wrong reason: **inflation increases the cost of living but not nominal incomes -from circular flow of expenditures & income: **total output(total expenditures)=total income -suppose inflation raises the cost of a big mac from $4.50 to 9.00, what happens to income? >>>>needs to go up -inflation raises, in general, both the cost of living and nominal income

calculate the nominal & real interest rate ********************************************* you borrow $1000 for one year & at the end of the year you repay the $1000 plus $100 of interest & the inflation rate is 8%

100 ---- X100 =10%>>>>>>>>nominal 1000 10%-8%=2%>>>>>real

Real nominal interest = . interest . - inflation rate . rate rate

2% = 7% - 5%

suppose you borrow $1000 at an interest rate of 5% (nominal). if the expected real interest rate is 2%, then the rate of inflation over the upcoming year that would be most beneficial to you would be a rate of inflation

5% - 2% = 3% GREATER THAN 3%

nominal real . expected interest = . interest . + inflation rate . rate rate

7%=2%+5%

Producer Price Index (PPI)

an average of the prices received by producers of goods & services at all stages of production process

problem with deflation

consumers reduce consumption spending, waiting for even lower prices. -increase the burden on borrowers, if the deflation is unexpected, because it increases the real interest rate ***real interest rate = nominal interest rate - inflation rate

consumer Price Index CPI

cost of living index

personal consumption expenditure price index PCE

measure of the price level that is similar to the GDP deflater except it includes only the prices of goods and services in GDP consumption ***for its inflation target the federal reserve uses the % change in the PCE (boardest measure of inflation to consumers )

is it possible for the nominal interest rate to be less than the real interest rate?

need the expected inflation rate to be negative.... Which is called DEFLATION....so yes