Get paid $1000 today... or get paid $1000 in ten years? Pay for your 50th birthday party today... or in 32 years?

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1 Would you rather... Get paid $1000 today... or get paid $1000 in ten years? Pay for your 50th birthday party today... or in 32 years?

2 Module 14 and 15: Effects of Inflation and finding inflation Costs of inflation Winners and Losers of inflation real and nominal income, wages, and interest rates deflation Measuring inflation: price index, CPI, PPI, GDP Inflator

3 Over history, the Federal Reserve Bank has shown a greater concern regarding the inflation rate than unemployment and output. Hyperinflation, rapidly increasing rates of inflation, have occurred in many nations since the early 1900, but never in the U.S. The greatest rate of inflation for the U.S. in peacetime has been 15% for a year. After WWI, Germany's government was in serious debt. Hyperfinflation occurred because the government paid off its debts by printing new money. A more economical approach would have been to raise taxes or decrease government spending. The average rate of inflation in Germany, 1923, was 3,250,000% per month. Roughly, the prices doubled every two days. The citizens of Germany, when receiving german currency, would literally run to the bank to deposit the currency and exchange it for some foreign currency. They would also run to the store to purchase items that would be twice the price the next day.

4 Inflation, a rise in price levels of a good, only hurts the economy if wages/income stay constant during the price increase, or increase by a smaller amount. You make $100 a month. Nominal Income. Then, Prices rise by 10%. Real Income = 100/1.1

5 Since JFK was President, price levels have gotten 7x larger. But generally speaking, wages/income have also gotten 7x larger. Real Wages = Nominal Wage Rate Price level Real Income = Nominal Income Price level

6 Level of prices vs. inflation rate Inflation Rate is the rate of change of the overall level of prices per year Price level year 2 Price level year 1 Inflation Rate = Price level year 1 *If negative, than rate of deflation

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8 The costs of inflation ~ Hyperinflation 1. Shoe Leather Costs: Holding money becomes stupid. Wear and tear on a society that is constantly running to the bank to exchange the currency. Or, running to the store as soon as you get paid to buy goods because they are going to increase in price quickly. Time and energy spent is a cost. 2. Menu Costs: costs to business of having to constantly change their prices to adjust for inflation. 3. Unit of account Costs: The role of the dollar as a basis for contracts and calculations is called the unit of account role of money. This role in our economy can be degraded by inflation. Economists believe the degradation of this role of money reduces the quality of economic decisions, and thus costs society due to inefficiency loss. With inflation, money is a less reliable unit of measure, causing society to be inefficient. example year 1: A man buys stock in a company worth $100,000 Inflation rate for that year is 10%. year 2: The man sells the stock the following year for $110,00. In terms of real income, the man breaks even. However, the government requires the man to pay a capital gains tax on his "profit" of $10,000. When you make an investment, you hope the rate of return is higher than the rate of inflation. High inflation rates cause less of these types of transactions from taking place: inefficiency.

9 Winners and Losers of Inflation Real Interest rate = Nominal Rate Inflation Rate Interest rates are applied whenever someone wants to take out a loan. It is the cost of borrowing money from someone. Borrower wants Real Interest rate to be low (low cost) Lender/Loaner wants Real Interest rates to be high (higher return) The Interest rates are typically fixed at the beginning of the transaction between the loaner and borrower. Sometimes, interest rates fluctuate over the length of the contract, called adjustable rate loans. At the beginning of the agreement between loaner and borrower, the Nominal Interest rate usually reflects and accounts for expected inflation. The loaners are smart, the don't want inflation to degrade the value of a future payment made to them.

10 Winners and Losers of Inflation Real Interest rate = Nominal Rate Inflation Rate Fixed Interest Rate Inflation is higher than expected Borrower Wins! Lender loses! Saver: Losers Savings worth less if inflation occurs because the purchasing power declines. Inflation is lower than expected Borrower Loses! Lender Wins!

11 In today's economy, the most important market where inflation creates winners and losers is the housing market! 2008 Housing Market experiences extreme deflation: bubble burst. Lower than expected inflation yr.1 Loan for a house 5% nominal interest yr. 2 House depreciates in value by 30%. House now worth 280,000. Real Interest Rate = Nominal Inflation rate 35% = 5% ( 30%) If you had to sell your house in 2009, you were not going to be happy.

12 Hurt or Helped by unanticipated inflation? Real Interest rate = Nominal Rate Inflation Rate 1) Banks extend many fixed rate loans 2) A farmer buys a new machine on a fixed rate loan 3) A family buys a new home with an adjustable rate mortgage 4) Your savings from working this summer are in a savings account with a fixed interest rate. 5) Russell Wilson signs a contract for the next ten years at a fixed salary. 6) The federal government has a $19 trillion debt.

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16 Disinflation: The process of bringing inflation rate down. Normal rate of inflation is about 2%. It is very costly and difficult to lower the inflation rate if it creeps too high. Some economists believe that the only way to reduce the inflation rate is to have an extended period of time of high unemployment rates. Not good. A recession is sometimes necessary to bring inflation down. Economists work very hard to make sure the inflation rate stays around 2%. Preventive medicine.

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18 Module 15 ~ Calculating Inflation Calculating: 1) Inflation Rate 2) Price Indexes: CPI, PPI, GDP deflator

19 How do we calculate Inflation? 1) Identify a bundle of goods and services that the average consumer wants 2) Track how much that bundle costs over time 3) Calculate the % of change in these costs (rate of inflation) How is this useful: tells us how the cost of living is changing involved in wage negotiations determines increase in social welfare payments

20 Definitions and Formulas: Consumption Bundle: a typical basket of goods and services Aggregate Price level: a single number to represent the overall level of prices. leads to a Price Index

21 Price Index = Cost of basket in a given year Cost of basket in base year x 100 Price Index in base year = 1.0 or 100 Inflation Rate = Price Index given yr 2 Price Index yr 1 Price Index yr 1 x 100

22 Finding the price index, rate of inflation. 3 goods in the consumption basket: Oranges, Grapefruits, Lemons Price Index = Cost of basket in a given year Cost of basket in base year = 1.84 Rate of Inflation (easy if going from base year to the next year)

23 Price of Bundle 2005 = $200 Price of Bundle 2006 = $248 Price of Bundle 2007 = $304 base year Find the Price Index of 2005, 2006 and Find the rate of Inflation from 2005 to Find the rate of inflation from 2006 to 2007.

24 Three well known Bundles ~ 1) Consumer Price Index (CPI) bundle is average consumption bundle in the average place for the average family in the U.S. base year index = 1.0 or 100 CPI is currently using a base year of chained (3 years!!) Bureau of Labor Statistics finds CPI Some argue as overstating inflation However, the CPI is the primary source used to measure inflation.

25 Three well known Bundles ~ 2) Producer Price Index (PPI) Typical bundle of goods and services purchased by the producer includes raw commodities, such as steel, electricity, coal, timber, etc. commodity producers are quick to raise prices when they expect increase demand. Quick to identify inflationary or deflationary pressures early warning signal

26 Three well known Bundles ~ 3) GDP Deflator All goods and services contained in GDP (not really a bundle) Still measures Inflation GDP Deflator = Nominal GDP for that year Real GDP for that year 2005 (base year) GDP deflator = 1 Current Nominal GDP = 19 Trillion Current Real GDP = 16 Trillion GDP Inflator = 1.19 Since 2005, 19% increase in price levels (Inflation)

27 Measuring Inflation, all three Indexes over history

28 Using the Indexes to get "REAL" values Real Wages Real Income Real GDP = Nominal Index with base year as 1.0

29 Year 1 CPI = 0.8 Year 2 CPI = 1.0 Year 3 CPI = 1.25 Year 4 CPI = 1.4 1) What is the base year? 2) Calculate the rate of inflation from year 3 to year 4. 3) Calculate real income for each year if your income was a constant $50,000 over all years.

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