Inflation What is it? Who wins & loses? How is it calculated? Mr. Clifford Explains Inflation & CPI (16:00) Curious What Things Cost in the Past? See Inflation Calculator What is Inflation? Inflation is rising general level of prices and it reduces the “purchasing power” of money. Examples: •It takes $2 to buy what $1 bought in 1989. •It takes $6 to buy what $1 bought in 1972. •It takes $25 to buy what $1 bought in 1913. When inflation occurs, each dollar of income will buy fewer goods than before. What’s wrong with just adding up the total amount of money (Nominal Gross) that it earned at the box office to calculate the biggest movie hit of all time? Copyright 3 ACDC Leadership 2019 What would you have to do to get a more accurate idea of how much real money it earned? REAL Gross (adjusted for inflation) Copyright ACDC Leadership 2019 NOMINAL vs. REAL • Economic numbers must be adjusted for inflation – Real numbers – adjusted for inflation – Nominal numbers – NOT adjusted for inflation • A country sells 10 pairs of blue jeans in both 1999 & 2019. – Blue Jeans cost $20 in 1999 and $40 in 2019 (assume same exact jeans) – What is the change in nominal & real GDP for 2019? • Nominal GDP doubles from $200 to $400 • Real GDP is unchanged = 10 pairs of jeans sold in both years (only the price rose, not the production) Where do you think the goods/services below belong on the graph? 1. TVs 2. College Tuition 3. New Cars 4. Hospital Services 5. Toys 6 Where do you think the goods/services below belong on the graph? 1. TVs 2. College Tuition 3. New Cars 4. Hospital Services 5. Toys 7 2-Types of Inflation (This matters more when we study what polices governments use to combat inflation in Units 3 & 4) • Demand-Pull Inflation: – Too many dollars chasing too few goods (caused by excess money supply) – Spending increases faster than production – Demand Side Inflation • Cost-Push Inflation – Caused by large increase in cost of factors of production (input prices) – Examples: price of oil, labor, steel, etc. rise quickly – Supply Side Inflation (Occurred in late 1970’s in USA) Inflation: Expected vs. Unexpected • Unexpected or sudden inflation is what really creates winners & losers in our economy • In theory, when actual inflation is predictable, workers, employers, savers, lenders & borrowers have time to adjust & plan. – Therefore, expected inflation is less harmful Who is helped by inflation? • People in large amount of Debt – Those who owe fixed interest rates on Mortgages, Car Loans, Student Loans – Loan debt stays the same in Nominal Dollars – Loan debt falls in Real Dollars • People on a fixed income – Ex: $500 a month pension = Nominal dollars unchanged BUT real income falls • Minimum wage workers – Wage increases usually increases lag behind inflation • Savers – When the interest earned is less than the inflation rate Why Inflation is Bad? • Difficult for businesses to plan (Lowers Business Investment) • Lowers value of currency (Reduces Trade) • Lowers purchasing power (Hurts Consumers) • Raises long term interest rates (Lowers Financial Investment) 2008 Exam 2012 Exam Inflation Around the World in 2017 Measuring Inflation Inflation is measured using a Price Index A price index converts nominal numbers into real numbers A price index will have a base year (which always = 100) and uses the prices from the base year for all goods/services as a comparison to other years CPI Index • Consumer Price Index (CPI) measures consumer inflation • CPI uses a consumer market basket of goods & services – Government economists research prices of “market basket” each month – Compares cost of the new basket to old basket Example 2011: Market Basket cost $1,000 2012: Market Basket cost $1,100 So inflation = +10.0% What is in the CPI’s Market Basket? 17% Transportation 15% Food and 42% beverages Housing Education and 6% communication 6% 6% 4% 4% Medical care Other goods Recreation Apparel and services 2012 Exam Consumer Price Index (CPI) The most commonly used measurement of inflation for consumers is the Consumer Price Index (CPI). Here is how it works: • The base year is given an index of 100. • To compare, each year is given an index # as well. Price of market basket CPI = x 100 Price of market basket in base year 1997 Market Basket: 1 Movie is $6 & 1 Pizza is $14 Total = $20 (Index of Base Year = 100) 2009 Market Basket: 1 Movie is $8 & 1 Pizza is $17 Total = $25 (Index of 125) • This means inflation increased 25% between ’97 & ‘09 Copyright• Items that cost $100 in ’97 cost $125 in ‘09 ACDC Leadership 2019 Calculating the Market Basket Good Year 1 Year 2 Year 3 1 lb of Apples $2.00 $2.00 $2.50 1 lb of Bananas $.25 $.50 $.75 1 Gallon Milk $1.75 $2.50 $2.75 Cost of Market Basket (COMB) $4.00 $5.00 $6.00 To get the cost of the basket, add up the prices of all items in the basket in a given year. The quantity in the basket must be the same as the base year. Only items that consumers would normally purchase are included in the Consumer Price Index (CPI) 21 Calculating the Market Basket Good Year 1 Year 2 Year 3 1 lb of Apples $2.00 $2.00 $2.50 1 lb of Bananas $.25 $.50 $.75 1 Gallon Milk $1.75 $2.50 $2.75 Cost of Market Basket (COMB) $4.00 $5.00 $6.00 CPI = Price of market basket Price of market x 100 basket in base year Use Year 1 as the Base Year: What is the CPI for Year 1? (4/4)x100=100 What is the CPI for Year 2? (5/4)x100=125 What is the CPI for Year 3? (6/4)x100=150 22 CPI Units of Price Inflation Year Output Per Unit (Year 1 as Base Year) Rate 1 10 $8 2 10 $10 3 15 $12 4 20 $4 5 25 $16 6 10 $8 Hint- You’re looking for the change in price, not output! 23 CPI Units of Price Inflation Year Output Per Unit (Year 1 as Base Year) Rate 1 10 $8 (80/80)*100=100 2 10 $10 (100/80)*100= 125 3 15 $12 (120/80)*100=150 4 20 $4 (40/80)*100=50 5 25 $16 (160/80)*100=200 6 10 $8 (80/80)*100=100 Price of market basket in the particular year CPI x 100 = Price of the same market basket in base year 24 CPI Units of Price Inflation Year Output Per Unit (Year 1 as Base Year) Rate 1 10 $8 100 - 2 10 $10 125 25% 3 15 $12 150 20% 4 20 $4 50 -66% 5 25 $16 200 300% 6 10 $8 100 -50% New # – Old # Inflation x 100 Rate = Old # 25 Khan Academy Video On Calculating Inflation & CPI (7:30) CPI Index Calculation Current $ Value Basket X 100 = CPI Index $ Value Basket in Base Year Price ($) Value of Basket Use 2005 as base year 2005 $10 CPI Index = $10/$10 X 100 = 100 2007 $12 CPI Index for 2007 ($12/$10) X 100 = 120 Inflation Rate: From 2005 to 2007: Inflation rate was +20% (120 – 100)/100 X 100 = +20% Inflation Rate Formula: [(Ending Index – Beginning Index) / Beginning Index] * 100 Practice Problems Mr. Clifford Does Some Inflation Problems (7:30) Year CPI Index 1994 146 2016 236 1) What was the inflation rate from 1994 to 2016? 1) +61.6% 2) You made $500,000 year in 1994, what is the equivalent pay in 2016? 2) $808,219 3) You made $70,000 in 2016, what is the equivalent pay in 3) $43,120 1994? CPI in 2016 CPI in 1994 * 1994 USD value = 2016 USD value [(Ending Index – Beginning Index) / Beginning Index] * 100 CPI Index vs GDP Deflator • Both measure inflation but two important differences often cause them to diverge • CPI Index uses prices of a market basket of some goods/services bought by consumers (the C in C+I+G+(X-M) – Narrow, consumer index but includes imports • GDP Deflator uses prices of all goods/services – Broader index than CPI (Includes the I, G & X) but excludes imports GDP Deflator • Purpose: Converts Nominal GDP into Real GDP – Nominal - absolute dollars from that year – Real - inflation adjusted dollars from base year • Real dollars also called “Constant Dollars” • Only real GDP reflects true quantity of goods/services produced If Real GDP a country is making more goods/services Mr. Clifford Calculates Nominal & Real GDP Using the GDP Deflator Old AP Exam Question Explained GDP Deflator math is similar to CPI Index Nominal GDP X 100 GDP Deflator = Real GDP Real GDP = Nominal GDP X 100 Price Index Sample Problem Video Do Practice Problems Sets #1 #2 #3 & #4 Answers will be posted on website & Discussed in class.