Macroeconomics Ch 6&7

Inflation affecting CPI

"Noise" in the Price System Inflation obscures the information transmitted by prices and reduces the efficiency of the market system Distortions of the Tax System Inflation, Indexation, and --- Bracket creep Capital depreciation allowance Interference with Long-Run Planning Retirement planning Investment and business strategies

Aggregate Measures of Money

1) M1 or narrow money (<=> 'Money Supply') = cash+checkable deposits+travelers checks 2) M2 adds 'near money' assets to M1 M2=M1+savings accounts+mutual funds accounts.

HOW THE CPI IS USED

1) POLICY TARGET 2) TO INDEX PAYMENTS. A payment is indexed when it is set by a formula so that it rises and falls proportionately with a price index. Example, Social Security recipients. 3) TO TRANSLATE FROM NOMINAL TO REAL VALUES

Inflation Cost

1) Part of inflation is usually unexpected which causes redistribution of income. 2) If inflation is higher than expected: debtors win and creditors lose wage earners often lose and business owners win

How is the Consumer Price Index Measured?

1. Bureau of Labor Statistics surveys families (30,000) to see what they buy 2. BLS employees price about 80,000 items each month across the country (87 urban areas) 3. BLS computes cost of the same bundle of goods each month where the bundle reflects average spending patterns 4. Current base period is July/1983. But we also use 1982-84 - the average level of prices over this 3 year period. 5. The CPI for July/2010 is 218. This means that prices are 118 % higher than over 1982-84.

Why the unemployment rate may understate unemployment:

1. Discouraged workers - people who would like to work but have given up looking for a job and so are not counted in the labor force. 2. Part-time workers may really want full-time work (Involuntary part-time).

index number

An index number is calculated as: (Value of Measure in Current Period/Value of Measure in Base Period) x 100 Base Year =A period to be used as a benchmark (=100)

Nominal and Real Interest Rates

Borrowers and lenders agree on a nominal interest rate based on their expectations of inflation: 1. nominal rate = expected + expected real rate inflation 2. expected = nominal - expected real rate rate inflation 3. actual = nominal - actual real rate rate inflation

Net Exports (NX):

Exports minus imports.

Types of unemployment

Frictional- due to people entering labor force or leaving jobs to look for a better job or a different location. 2. Structural - due to people losing jobs because of technological changes or perhaps international trade 3. Seasonal - due to weather or season of the year, (example: post-Christmas retail lay-offs) Note: These types of unemployment are generally considered to have microeconomic causes. 4. Cyclical unemployment - people losing jobs or being laid off due to slowdowns in the overall economy.

What is counted in GDP?

GDP includes all items produced in the economy and sold legally in markets. GDP excludes most items that are produced and consumed at home and that never enter the marketplace. GDP excludes items produced and sold illicitly, such as illegal drugs.

Inflation Cost

If actual inflation > expected inflation then actual real rate < expected real rate DEBTORS WIN If actual inflation < expected inflation then actual real rate > expected real rate CREDITORS WIN

Measuring Inflation

Inflation is the rate of change in prices over some period of time such as a year. EX: Inflation for 2009 using the CPI = [CPI for 2009 - CPI for 2008] x 100 CPI for 2008 = [217.5-211.5] x 100 = 2.8% 211.5

Value-Added Approach

Looking at what firms produce For any firm, the market value of its product or service minus the cost of inputs purchased from other firms Revenues - Cost of purchased inputs = Value added

Expenditure Approach

Looking at who gets the goods and services produced GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Y = C + I + G + NX

factor payments approach

Looking at who gets the income generated when goods and services are produced GDP=Sum of payments made by all firms = Wages and salaries+interest+rent+profit Or GDP= labor income (2/3) + capital income (profit + rent +interest=1/3)

Measurement of GDP

Output is valued at market prices. It records only the value of final goods, not intermediate goods (the value is counted only once). It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). It includes goods and services currently produced, not transactions involving goods produced in the past. It measures the value of production within the geographic confines of a country.

Problems calculating GDP

Quality Changes Underground economy Non-market production Long-Run x Short-Run Fluctuations

Real GDP

Real GDP adjusts nominal GDP for changes in the value of the dollar, that is changes in prices, so we say it is measured in constant prices.

Fisher Effect

Real interest rate = nominal interest rate - inflation rate Or, nominal interest rate = real interest rate + inflation rate Fisher effect=one-for-one adjustment of the nominal interest rate to the inflation rate. The nominal interest rate adjusts to expected inflation.

Is the CPI measure of inflation too high?

Recent commission argued CPI inflation rate is on average too high by .5 to 1.5 % per year. Why? 1. Inadequate adjustment for quality changes and introduction of new products 2. Substitution Bias: does not adjust for substitution by people from higher priced to lower priced goods (example, oil-related products in the 1970s) 3. Growth in discounting. (ex. Wal-Mart, outlets)

natural rate of unemployment

The "natural rate of unemployment" = frictional + structural + seasonal unemployed labor force If the economy is at the "natural rate" or at "full employment", cyclical unemployment = 0.

CPI x GDP Price Index (or GDP deflator)

The GDP deflator measures the prices of all goods and services included in U.S. GDP It includes some prices that the CPI ignores. But ignores some prices included in the CPI.

The PRICE LEVEL

The PRICE LEVEL refers to the general or average level of prices in the economy

CONSUMER PRICE INDEX or CPI

The most popular index is the CONSUMER PRICE INDEX or CPI

nominal interest rate

The nominal interest rate is the rate quoted in the newspaper or at the bank ( for example a car loan might have a nominal interest rate of 7%).

Participation Rate

The percentage of the working-age population in the labor force (that is, the percentage that is either employed or looking for work) (labor force/pop 16+) x 100

real interest rate

The real interest rate is the nominal rate minus inflation. For example, if the inflation rate was 5% and the nominal interest rate was 7%, the real interest rate = 7 - 5 = 2%.

Consumption (C):

The spending by households on goods and services, with the exception of purchases of new housing.

Investment (I):

The spending on capital equipment, inventories, and structures, including new housing.

Government Purchases (G):

The spending on goods and services by local, state, and federal governments. Does not include transfer payments because they are not made in exchange for currently produced goods or services.

GDP

Total value of all final goods and services produced for the marketplace during a given year within nation's borders

The PRICE LEVEL

We use a weighted-average of prices called a PRICE INDEX to measure the price level.

You are in the labor force if:

a. you are 16 or older b. you have a job (employed) c. expect to start or return to a job (unemployed) d. you are looking for work (unemployed)

Nominal GDP

is the sum of the final goods and services produced during the year using current prices.

labor force

labor force = employed + unemployed

unemployment rate

unemployment rate = (unemployed /labor force) x 100