Class Notes (839,626)
MGEA06H3 (167)
Lecture

# ecma06

21 Pages
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Department
Economics for Management Studies
Course Code
MGEA06H3
Professor
Ata Mazaheri

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Description
ECMA06 – Inflation and Unemployment 1 Inflation and Unemployment Outline  Consumer price index (CPI):  How to construct the CPI?  CPI vs. GDP deflator  Use of the CPI.  Unemployment:  Unemployment rate.  Labour force participation rate. ECMA06 – Inflation and Unemployment 2 Inflation  Inflation refers to the percentage change in (general) price level (%  in price) each year.  To get the %  in price level, we:  Collect information on the prices and quantities of goods and services bought.  Compute the cost of bundle: P  Q  Calculate the %  in the cost of bundle (i.e., the %  in price) ECMA06 – Inflation and Unemployment 3 Example: How to Measure Changes in Prices Suppose an average household consumes two goods only. Period 1 Period 2 (Base year) (Current year) Price Quantity Price Quantity Food \$1 400 \$1 800 Clothing \$6 100 \$12 60 Using the Period-1 Bundle to Calculate the %  in Price  Cost of period-1 bundle in period 1 (1 1 ):  Cost of period-1 bundle in period 2 (2 1 ):  How much have prices rise? ECMA06 – Inflation and Unemployment 4 Using the Period-2 Bundle to Calculate the %  in Price  Cost of period-2 bundle in period 1 (P Q 1: 2  Cost of period-2 bundle in period 2 (P Q 2: 2  How much have prices rise?  You probably notice that using Period-1 bundle gives a bigger increase in prices. This is typical, because  It is because consumers respond to price changes (the substitution effect!)  Period-1 bundle (or the initial bundle) tends to give more weight to items that go up in price a lot; while Period-2 bundle (or the current bundle) tend to give less weight to items that go up in price a lot. ECMA06 – Inflation and Unemployment 5  Question: Which one measures the rise in prices correctly? a) Using Period-1 bundle b) Using Period-2 bundle c) Neither one is correct.  Answer: Two Price Indices  We will consider two price indices: 1) GDP deflator – it measures how fast the prices of goods and services produced within Canada change over time. It uses the current-year bundle. 2) Consumer Price Index (CPI) – it measures how fast the prices of goods and services bought by a typical Canadian household change over time. It uses the base- year bundle. ECMA06 – Inflation and Unemployment 6 CPI – The Most Commonly Used Price Index  It is the most commonly used price index to compute inflation rate.  Statistics Canada is responsible for the computation of the CPI. To construct the CPI, it will:  Choose a base year and determine a bundle purchased by a typical household in that year.  Get the cost of that bundle in different time periods, i.e., P t Q Base-year  Multiply the cost of that bundle in different time periods by 100 to get the price index. PBase-year Base-year  Use the series to compute inflation rate. Inflation calculator: http://www.bankofcanada.ca/en/inflation_calc.htm ECMA06 – Inflation and Unemployment 7 Example: CPI vs. GDP Deflator Period 1 Period 2 (Base year) (Current year) Price Quantity Price Quantity Food \$3 4 \$5 6 Housing \$10 2 \$30 1.5 Using CPI to Calculate the %  in Price  Cost of base-year bundle in Period 1 (P1Q Base-year 1Q )1  Cost of base-year bundle in Period 2 (P Q ): 2 1  CPI:  %  in prices: ECMA06 – Inflation and Unemployment 8 Using GDP Deflator to Calculate the %  in Price  Cost of current-year bundle in Period 1 (P Q ): 1 2  Cost of current-year bundle in Period 2 (P Q ): 2 2  GDP deflator:  %  in prices ECMA06 – Inflation and Unemployment 9  Question: Are you better off in the Period 1 or Period 2?  Answer: We are not sure!  P Q1= \$12 & P2Q 2 \$75  The value of the bundle has risen by 134.75% (\$75/\$32 – 1 = 1.34375)  Depending on the index we used to find the inflation rate, prices have risen by between 127.3% and 150%. ECMA06 – Inflation and Unemployment 10 Differences between GDP deflator and CPI 1)CPI uses the bundle purchased by a typical household; while GDP deflator uses the bundle produced within the country.  Changes in the prices of imported consumption goods.  Changes in the prices of goods that are only bought by firms or government. 2)GDP deflator uses the bundle that is currently produced and CPI uses a fixed bundle (the base-year bundle)  GDP deflator tends to understate the increase in price a bit, while CPI tends to overstate the increase in price a bit. ECMA06 – Inflation and Unemployment 11 More on the CPI Series & the Use of the CPI Example 1: Compute Inflation Rate over a Period of Time Suppose CPI in 1990 = 78.4 CPI in 2010 = 116.5 (Actual CPI, 2002 = 100) What happened to prices over that 20-year period from 1990 to 2010 (i.e., the inflation rate over the period of 1990–2010)? ECMA06 – Inflation and Unempl
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