Inflation, Unemployment, Business Cycle and CPI, Phillips Curve, Circular Flow Model but Maybe Not in That Order Measuring the Cost of Living

AP Macroeconomics Unit III Fall 2011

Inflation, Unemployment, Business Cycle and CPI, Phillips Curve, Circular Flow Model But maybe not in that order Measuring the Cost of Living

• Inflation (tt) – occurs when the economy’s overall price level is rising. • Inflation Rate (tt%) – the percentage change in the price level from one time period to another. THE CONSUMER PRICE INDEX • The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. • The Bureau of Labor Statistics reports the CPI each month. • It is used to monitor changes in the cost of living over time. THE CONSUMER PRICE INDEX • When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. How the Consumer Price Index Is Calculated • Fix the Basket: Determine what prices are most important to the typical consumer. – The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. – The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services. How the Consumer Price Index Is Calculated • Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. How the Consumer Price Index Is Calculated • Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. How the Consumer Price Index Is Calculated • Choose a Base Year and Compute the Index: – Designate one year as the base year, making it the benchmark against which other years are compared. – Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. How the Consumer Price Index Is Calculated

• Compute the inflation rate: (tt%) The inflation rate is the percentage change in the price index from the preceding period. How the Consumer Price Index Is Calculated

• The Inflation Rate (tt%) – The inflation rate is calculated as follows:

CPI in Year 2 -CPI in Year 1 Inflation Rate in Year 2 = 100 CPI in Year 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

• Calculating the Consumer Price Index and the Inflation Rate: Another Example – Base Year is 2002. – Basket of goods in 2002 costs $1,200. – The same basket in 2004 costs $1,236. – CPI = ($1,236/$1,200) 100 = 103. – Prices increased 3 percent between 2002 and 2004. FYI: What’s in the CPI’s Basket?

16% Food and beverages

17% 41% Transportation Housing

Education and 6% communication 6% 6% 4% 4%

Medical care Other goods Recreation Apparel and services

Copyright©2004 South-Western Problems in Measuring the Cost of Living • The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. Problems in Measuring the Cost of Living • Substitution bias • Introduction of new goods • Unmeasured quality changes Problems in Measuring the Cost of Living • Substitution Bias – The basket does not change to reflect consumer reaction to changes in relative prices. • Consumers substitute toward goods that have become relatively less expensive. • The index overstates the increase in cost of living by not considering consumer substitution. Problems in Measuring the Cost of Living • Introduction of New Goods – The basket does not reflect the change in purchasing power brought on by the introduction of new products. • New products result in greater variety, which in turn makes each dollar more valuable. • Consumers need fewer dollars to maintain any given standard of living. Problems in Measuring the Cost of Living

• Unmeasured Quality Changes – If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. – If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. – The BLS tries to adjust the price for constant quality, but such differences are hard to measure. Problems in Measuring the Cost of Living

• The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. – The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. – The CPI overstates inflation by about 1 percentage point per year. The GDP Deflator versus the Consumer Price Index • The GDP deflator is calculated as follows: Nominal GDP GDP deflator = 100 Real GDP The GDP Deflator versus the Consumer Price Index • The BLS calculates other prices indexes: – The index for different regions within the country. – The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. The GDP Deflator versus the Consumer Price Index • Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. • There are two important differences between the indexes that can cause them to diverge. The GDP Deflator versus the Consumer Price Index • The GDP deflator reflects the prices of all goods and services produced domestically, whereas... • …the consumer price index reflects the prices of all goods and services bought by consumers. The GDP Deflator versus the Consumer Price Index

• The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)... • …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. Inflation

• Inflation – a rise in the level of prices • Measured by CPI comparisons (year to year; month to month) • Normal economic growth = 2-3% change • Inflation is above 6% – “double digit” is very serious for U.S. • Hyperinflation can be devastating to output and employment Inflation’s Positive Effects

• Flexible-Income receivers are unaffected (COLA like SS, businesses with prices rising faster than costs, commission sales positions, any business that anticipates inflation, etc.) • Debtors (borrowers pay back loans with “cheap” dollars – lower interest than inflation %) Inflation’s Negative Effects

• Fixed income receivers (elderly retirees, government workers, minimum wage earners, landlords, etc.) • Savers (paper assets lose value over time when interest rate is lower than inflation rate) • Creditors (lenders are paid back in “cheaper” dollars & have a loss of “real” income) Happy or Sad Face? Banks lend out billions of dollars in fixed- rate home mortgages to consumers. Unexpected inflation will cause?

Bank Borrower Happy or Sad Face? You borrow $15,000 for a new car and agree to a variable interest rate loan. Unexpected inflation will cause?

Bank Borrower Types of Inflation

• Demand – Pull Inflation – Caused by changes in spending beyond the production capacity – i.e. failure to produce more drives up price – “too much money chasing too few goods” – In long run, wages will go up as workers are in demand & cost of living increases Types of Inflation

• Cost – Push Inflation – Caused by increase in factors of production costs – Per unit production costs rise – Business must raise prices to make profits – “wage price spirals” as wages are the largest single production cost – Also caused by “supply shocks” (raw materials or energy costs rise abruptly) Two Measures of Inflation

Percent per Year 15

CPI

5 GDP deflator

0 1965 1970 1975 1980 1985 1990 1995 2000

Copyright©2004 South-Western Dollar Figures from Different Times • Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001: Price level in 2001 Salary Salary 2001 1931 Price level in 1931

177 $80,000 15.2

$931,579 The Most Popular Movies of All Times, Inflation Adjusted

Copyright©2004 South-Western Real (r%) and Nominal Interest (i%) Rates • Interest represents a payment in the future for a transfer of money in the past. Real (r%) and Nominal Interest (i%) Rates • The nominal interest (i%) rate is the interest rate usually reported and not corrected for inflation (tt%). – It is the interest rate that a bank pays. • The real interest rate (r%) is the nominal interest rate that is corrected for the effects of inflation (tt%). Real (r%) and Nominal Interest (i%) Rates • You borrowed $1,000 for one year. • Nominal interest rate was 15%. • During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation r% = i% - tt% r% = 15% - 10% r% = 5% Real and Nominal Interest Rates

Interest Rates (percent per year) 15

10 Nominal interest rate

Real interest rate –5 1965 1970 1975 1980 1985 1990 1995 2000

• The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. • The index is used to measure the overall level of prices in the economy. • The percentage change in the CPI measures the inflation rate. Summary

• The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality. • Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point. Summary

• The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. • In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes. Summary

• Dollar figures from different points in time do not represent a valid comparison of purchasing power. • Various laws and private contracts use price indexes to correct for the effects of inflation. • The real interest rate equals the nominal interest rate minus the rate of inflation r% = i% - tt% The Business Cycle • The United States’ GDP is not constant from year to year. • Instead, the GDP grows most years and then shrinks in some years. • The ups and downs in GDP over time is referred to as the business cycle. The Business Cycle Illustrated: Business Cycles • Economic Growth is a major goal • Measured by – increase in real GDP or increase in real GDP per capita • Sources of growth: 1) increase resources and 2 ) increase the productivity of the resource inputs • Productivity = real output per unit of input Health, training, education & • Results from motivation of workers The Business Cycle

• Peak Illustrated: – temporary maximum in Real GDP. At this point the unemployment rate (u%) is probably below the natural rate of unemployment, and the inflation rate (π%) is probably increasing. • Recession – The contractionary phase of the business cycle. A period of decline in Real GDP accompanied by an increase in u%. To be classified as a recession, the economic decline must be at least 6 months long. • Trough – The bottom of the business cycle. The u% is probably high and π% is probably low. • Recovery – The phase of the business cycle where the economy is returning to full employment. The Business Cycle Illustrated: • Causes – Irregularity of Investment – Changes in productivity – Changes in total spending (aggregate demand) • Durable goods manufacturing is most susceptible to the effects of the business cycle • Business cycle has become less severe because of technological advancements in supply-chain management and structural changes in U.S. economy. Unemployment • Population – Number of people in a country • Labor force – Number of people in a country that are classified as either employed or unemployed – Labor Force Participation Rate • % of working age population in the labor force (U.S. is approx 66%) • Employed – People 16 years and older that have a job. – It doesn’t matter if it’s part-time or full-time, as long as they work at least 1 hour every 2 weeks • Unemployed – People 16 years and older that don’t have a job, but have actively searched for a job in the last 2 weeks – Unemployment rate = # of unemployed / # of people in labor force • Not in Labor Force – Kids, military personnel, retired people, stay at home Moms and Dads, full-time students, your 40 year old uncle who sleeps on the couch all day, most of the homeless. Types of Unemployment • Frictional – “between jobs”, voluntary, good for individuals and society • Structural – Associated with lack of skills or declining industry (ex. High school dropouts, type-writer repairmen). Think “Creative Destruction” • Cyclical – Associated with downturns in business cycle. Bad for society and individuals. • Seasonal – Mall Santas, Schlitterbahn Life-guards, Ride operators at Fiesta Texas, Golf-pros in Alaska during January. Full Employment • Occurs when there is no cyclical unemployment present in the economy • Associate with the Natural Rate of Unemployment (NRU). – The level of unemployment experienced when the economy is producing at its full potential. – The United States’ NRU is approx. 4%-5% • Associate Full Employment (FE) with the PPC, the long-run aggregate supply (LRAS) and the long-run Phillips curve (LRPC) Why Unemployment is bad • Okun’s Law- Every 1% increase in the u% causes a 2% decline in Real GDP. • The burden of unemployment is not equally shared in society. • It causes social unrest and is hard on individuals and families. Phillips Curve . In the short run, inflation & unemployment are inversely related . In the long run, unemployment is unaffected by inflation

LRPC – at Inflation % natural rate of SRPC unemployment

Unemployment THE CURVEPHILLIPS CONCEPT Annual rate of inflation (percent) 3 4 5 6 7 0 1 2 1 2 3 4 5 6 7 Unemployment Unemployment rate (percent) As inflation As inflation declines... unemployment increases And versa! vice SRPC THE CURVEPHILLIPS CONCEPT Annual rate of inflation (percent) 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Unemployment Unemployment rate (percent) Rate Unemployment of LRPC = right Shift to the SRPC With Stagflation, Isthe natural SRPC existing along shift, move With AD SRPC1 SRPC2 Phillips Curve • Short run trade-off between inflation and unemployment. • In the Long Run there is no trade off. The long run Phillips curve is Vertical! • Stagflation (an increase in Unemployment and inflation) or an Aggregate Supply Shock will shift the SRPC to the right. • Decreases in Inflation and Unemployment will shift the SRPC to the left. (and increase in AS would cause this) TWO WAYS TO SHOW ECONOMIC GROWTH

C ASLR1 ASLR2

Price Level Price Capital Goods Capital

B D Q Q Consumer Goods 1 2 Real GDP “Redelsheimer’s Graphs to Know” Causes of Economic Growth 1. Increased investments in Capital Stock. 2. Increased investments in Human Capital (education, training) and increases in quantity of human resources 3. New Technology leading to increased productivity 4. Increase in quantity and quality of natural resources

“ Circular Flow Model

$ COSTS $ INCOMES

RESOURCE MARKET

RESOURCES INPUTS

BUSINESSES GOVERNMENT HOUSEHOLDS

GOODS & GOODS & SERVICES SERVICES

PRODUCT MARKET

$ REVENUE $ CONSUMPTION