Introduction to Macroeconomics

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Introduction to Macroeconomics

• Chapter 5.
• Measuring Changes in Prices

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Chapter 5. Measuring Changes in Prices

• 1. Inflation and deflation
• 2. Costs of inflation
• 3. Measuring inflation with price indexes
• 4. Causes of inflation

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1. Inflation and Deflation Definitions

• Inflation
• Increase in average level of prices
• Deflation
• Decrease in average level of prices

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1. Inflation and Deflation Hyperinflation

• Hyperinflation
• a very high rate of inflation
• over 50 per month
• over 200 per year
• Generally caused by governments printing money to
  finance large fiscal deficits caused by wars,
  revolutions, the establishment of new states, or
  exorbitant social programs.

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2. Costs of Inflation

• Purchasing power
• Menu costs
• Expected versus unexpected inflation

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2. Costs of Inflation Purchasing Power

• Purchasing Power
• the quantity of goods and services that can be
  purchased with a given amount of money the value
  of money.

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2. Costs of Inflation Menu Costs

• Menu Costs
• opportunity costs of resources required (e.g.,
  cash costs) to change prices.

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2. Costs of Inflation Unanticipated
Inflation

• Arbitrary redistribution of income - between
  borrowers and lenders, between employers and
  labor
• Uncertainty - more difficult to enter into
  contracts
• Uncertainty - change in relative versus change in
  average prices

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3. Measuring Inflation with Price Indexes

• Price indexes
• GDP deflator
• Consumer price index (CPI)
• GDP deflator - CPI differences
• Problems with price indexes
• Chain-weighted index

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3. Measuring Inflation with Price Indexes
Price Indexes

• Price Index - a measure of the change in the
  average level of prices
• GDP Deflator
• Consumer Price Index

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3. Measuring Inflation with Price Indexes
GDP Deflator

• Nominal GDP
• Value of output measured at actual prices
  (current dollar output)
• Does not correct for inflation
• Real GDP
• Value of output based on prices of some base
  period (constant dollar output)
• eliminates effect of inflation
• GDP Deflator Nominal GDP x 100
• Real GDP

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3. Measuring Inflation with Price Indexes
GDP Deflator Sample Problem 1
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3. Measuring Inflation with Price Indexes
Nominal and Real GDP

• Nominal GDP
• Current year Quantities
• x Current year Prices
• Real GDP
• Current year Quantities
• x Base year Prices

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3. Measuring Inflation with Price Indexes
GDP Deflator Sample Problem 1
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3. Measuring Inflation with Price Indexes
GDP Deflator Sample Problem 1

• GDP Deflator Nominal GDP 100
• Real GDP
• 1992 GDP Deflator 127 100 100.0
• 127
• 1994 GDP Deflator 160 100 111.9
• 143

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3. Measuring Inflation with Price Indexes
GDP Deflator Sample Problem 1

• Change in GDP Deflator (Inflation) from 1992 to
  1994
• (1994 Deflator - 1992 Deflator) 100
• 1992 Deflator
• (111.9 - 100.0) 100 11.9
• 100.0

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3. Measuring Inflation with Price Indexes
GDP deflator - CPI differences
Year 0 (base year) 1 2
CPI S P0 Q0 S P0 Q0 S P1 Q0 S P0 Q0 S P2 Q0 S P0 Q0
GDP Deflator S P0 Q0 S P0 Q0 S P1 Q1 S P0 Q1 S P1 Q2 S P0 Q2
where, for products a and b S P0 Q0 (p0a
x q0a) (p0b x qob)
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3. Measuring Inflation with Price Indexes
GDP deflator - CPI differences

• GDP Deflator
• All final goods and services included
• Quantities variable
• Imports excluded
• Consumer Price Index
• Only goods and services purchased by households
  included
• Quantities fixed (the market basket)
• Imports (of consumer goods) included

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3. Measuring Inflation with Price Indexes
Problems With Price Indexes

• Substitution bias - changes in relative prices
• between goods (butter vs margarine)
• between stores (small mom and pop versus large
  discount stores)
• Quality changes and new products

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3. Measuring Inflation with Price Indexes
CPI versus GDP Deflator
Consumer Price Index
GDP Deflator
Source CPI - Bureau of Labor Statistics
(www.bls.gov) GDP Deflator
Bureau of Economic Analysis (www.bea.doc.gov)
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3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator Sample Problem 2

• Assumptions
• Income does not change
• Only 2 products food and toys
• Each household spends ½ of their income on food
  and ½ on toys
• Price of food has been constant
• Price of toys increasing by 10 per year
• Year 1 is base year for real GDP and CPI
• Implication
• The cost of living has been increasing 5 per year

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3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator Sample Problem 2
Year 1 2 3 4
Food Q 100 100 100 100
P 100 100 100 100
Total 10,000 10,000 10,000 10,000
Toys Q 100 90.91 82.64 75.13
P 100 110 121 133.1
Total 10,000 10,000 10,000 10,000
As the price of toys becomes more expensive
relative to the price of food, households buy
fewer toys.
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3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator Sample Problem 2

• where,
• Pn price in year n (i.e., 1, 2, 3, or 4)
• Qn quantity in year n
• Pb price in base year (year 1)
• Qb quantity in base year (year 1)
• S Pn Qn sum of prices x quantities
• SP2Q2 (100 x 100) (110 x 90.91) 20,000
• SPbQ2 (100 x 100) (100 x 90.91) 19,091

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3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator Sample Problem 2
Year 1 2 3 4
Nominal GDP SPn Qn 20,000 20,000 20,000 20,000
Real GDP SPb Qn 20,000 19,091 18,264 17,513
GDP Deflator Nominal Real 100.00 104.76 109.50 114.20
Inflation 4.8 4.5 4.3
CPI SPn Qb SPb Qb 100.00 105.00 110.50 116.55
Inflation 5.0 5.2 5.5
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3. Measuring Inflation with Price Indexes
Chain Weighted Index

• Problem the measures of real GDP, GDP deflator,
  Consumer Price Index, and inflation become less
  and less accurate as you move further away from
  the base year.
• Solution always use the previous year as the
  base year. Individual year deflators are
  chained (multiplied) together to produce the
  GDP deflator.

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3. Measuring Inflation with Price Indexes
Chain Weighted Index Sample Problem 2
Year 1 2 3 4
Nominal GDP SPn Qn 20,000 20,000 20,000 20,000
Deflated GDP SPn-1 Qn 19,091 19,091 19,091
Deflator Nominal Real 104.76 104.76 104.76
GDP Deflator Deflatorn-1 x Deflatorn 100 104.76 109.75 114.97
Inflation 4.8 4.8 4.8
Real GDP 20,000 19,091 18,224 17,396
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4. Causes of Inflation

• Money supply
• Demand-pull and cost-push inflation
• Expectations

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4. Causes of Inflation Money Supply
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4. Causes of Inflation Demand-Pull and
Cost-Push Inflation

• Demand-Pull Inflation - caused by an increase in
  aggregate demand for goods and services.
• Cost-Push Inflation - caused by an increase in
  the costs of production of goods and services.

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4. Causes of Inflation Expectations