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Section 14 Notes.doc

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ECON 0110

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SECTION 14: INFLATION A sustained increase in the average level of prices Not an increase in price of a single specific item TWO MAIN PRICE INDEXES CONSUMER PRICE INDEX (CPI) Based on prices of things consumers buy Includes used goods Includes imports Does not include raw materials (steel, aluminum, oil, wheat, etc.) Good indicator of changes in cost of living for consumers GDP DEFLATOR Includes prices of all new goods and services produced in the U.S. Includes prices of raw materials Does not include prices of used goods or imports HOW TO CREATE A PRICE INDEX Create a “typical” MARKET BASKET Find cost of basket in a BASE YEAR Find cost of same basket in CURRENT YEAR The INDEX compares the current cost to the cost in the base year CPI EXAMPLE: Base year = 1983 CPI for 2001 = 177.1 Interpretation: What cost $100 in 1983 would cost $177.10 in 2001 CALCULATION OF THE INDEX CPI = (Cost of market basket in current year / cost same market basket in base year) x 100 EXAMPLE: Basket cost = $400 in 1983 Basket cost = $708.40 in 2001 CPI in 1983 = ($400/$400) x 100 = 100 CPI in 2001 = ($708.40/$400) x 100 = 177.1 CALCULATION OF THE INFLATION RATE Inflation rate = Rate of growth of price index = [(New value - old value) / old value] x 100% CPI in 1999 = 168 CPI in 2000 = 174 Inflation rate for 2000 = [(174 - 168)/168] x 100% = [6/168] x 100% = .034 x 100% = 3.4% A PRICE INCREASE DOES NOT CAUSE AN OVERALL LOSS Increased payment by buyer = Increased income for seller Redistribution of income from the buyer to the seller INFLATION AND STANDARD OF LIVING If wage increase = Inflation rate Then, standard of living = Constant If wage increase > Inflation rate Then, standard of living improves If wage increase < Inflation rate Then, standard of living decreases HARMFUL EFFECTS OF VARIABLE INFLATION Uncertainty inhibits long term planning and long term investment More uncertainty implies greater risk ANTICIPATED VS. UNANTICIPATED INFLATION When we make decisions, we take into account our expectations about the future inflation rate. CONTRACTS ARE BASED ON EXPECTED INFLATION If actual inflation = Expected inflation Then, borrower and lender are content If actual inflation > Expected inflation Then, borrower gains and lender loses If actual inflation < Expected inflation Then, borrower loses and lender gains UNANTICIPATED INFLATION HURTS LENDERS UNANTICIPATED INFLATION HELPS BORROWERS When inflation is higher than expected, the lender is repaid with dollars that can buy less than was expected With hyperinflation, the lender is repaid with dollars that are practically worthless DEFLATION A decrease in the average level of prices HURTS DEBTORS Must repay debts with more valuable dollars Tends to occur when the economy is in a steep economic decline 1933: CPI declined by 5.1% GDP deflator declined by 2.1% DEFLATION HURTS DEBTORS Farmers People with home mortgages Business owners who have debts DISINFLATION A decrease in the inflation rate Disinflation does not mean deflation 1990: Inflation rate = 5.4% 1991: Inflation rate = 4.2% 1992: Inflation rate = 3.0% Prices increased, but the rate of increase decreased STAGFLATION = simultaneous existence of high inflation and high unemployment (or recession) Economic stagnation and inflation occurring together 1975: Inflation Rate = 9.1% Unemployment rate = 7.8% HYPERINFLATION Very high inflation Sometimes defined as Inflation > 50% per month Caused by a very rapid increase in the money supply Germany (1921-1923) Total inflation = 1 trillion percent!! Contributed to Hitler’s rise Brazil (1989): Total inflation = 3,398% Argentina (1989): Total inflation = 4,
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