chapter 11 inflation and unemployment inflation is the general increase in the prices of goods and...
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Chapter 11Chapter 11
Inflation and Unemployment
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Inflation
Is the general increase in the prices of goods and services in an entire economy.
For ex: an annual inflation of 3% would mean that there is an overall increase in prices by 3%
Deflation is the general decrease in the level of prices
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The Consumer Price Index
CPI is used to measure price changes for a typical “basket” of consumer products.
CPI is one indicator of inflation or changes in the cost of living.
Statistics Canada calculates CPI to see what the typical Canadian mostly buys. For ex. in 1986 housing was the biggest expenditure
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The Consumer Price index…..Results of 1994 survey
Prices Quantity Consumed
Expenditure Weights
Hamburgers $2.00 10 $20 0.4
milkshakes $1.00 30 $30 0.6
$50
Prices in 1995
Prices 1995 Price x 1994 Quantity
hamburgers $2.20 $2.20 x 10 = $22.00
Milkshakes $1.05 $1.05 x 30 = $31.50
$53.50
CPI= ($53.50-$50) x 100 = 7 % = 1.07 $50.00
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Nominal Vs Real Income
Nominal income is income valued in current dollars Real income is when income is expressed in base-year
dollars. Real income = nominal income
CPI
A consumer’s income has to increase at the same rate of inflation.
Purchasing power is inversely related to CPI Therefore those whose incomes increase at a higher rate
than CPI enjoy a higher standard of living.
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Limitations of the CPI The CPI has 3 basic limitations, which under certain
circumstances can severely reduce the CPI’s usefulness. Consumer differences: some consumer’s preferences
might not match up with the average consumer this causes discrepancies in item weights.
Changes in spending patterns: consumer consumption is constantly changing and Statistics Canada needs to constantly update item weights and contents
Product quality: the index cannot reflect changes in quality that are not matched by changes in prices
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The GDP Deflator
Unlike CPI, the GDP deflator measures price changes for all goods and services and weights them in terms of the economy’s total output
the GDP deflator is updated yearly and is more accurate than the CPI but this causes the values of the GDP deflator to be less available than the CPI.
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GDP Deflator…..Year Output Price Output at
Current PriceOutput at 1994 Price
GDP Deflator
1994 1000 $0.20 $200 $200 1.0
1995 2000 $0.30 $600 $400 1.5
Much like the CPI, the base year has a value of 1, which is used as comparison for further years. To calculate the GDP deflator the Output at Current price is Divided by Output Price at 1994. In this example we see that inflation rate was 50% in 1995
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Nominal vs. Real GDP
A nominal GDP is expressed in current dollars.
Real GDP, much like Real income, gives an indication of the purchasing power of an entire economy.
Real GDP= nominal GDP/ GDP deflator
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Inflation Effects
In Figure 11.5 in the text book (p314) Canada’s inflation record since 1926 is illustrated.
Why are inflation rates considered a serious problem? They redistribute purchasing power in ways that can be economically harmful and unjust.
To see the effects of inflation lets look at the effects on household incomes and on borrowing and lending.
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Incomes
If a household income increases steadily but inflation increases at a higher rate then the households lose purchasing power.
Fully indexed incomes: nominal incomes that automatically increase at the rate of inflation.
Partially indexed incomes: nominal incomes that increase at rates less than that of inflation.
Fixed incomes: nominal incomes that remain fixed at the same dollar amount regardless of inflation.
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Borrowing and Lending
If the lender loans funds at an interest rate that is not adjusted for inflation, then the lender may lose out.
The nominal interest rate is the interest rate expressed in money terms.
Real interest rate = nominal interest rate -inflation rate
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Borrowing and Lending….
For ex: Company A borrows $2000 at 5% per annum. So 5% would be the nominal interest rate. If the inflation rate is 3% the year Company A borrows the loan. Then the real interest rate would be 2%.
The real interest rate reflects the fact that due to inflation the loan has less purchasing power at the end of one year as opposed to the time when the loan was made.
Once the nominal rate has been agreed on the lenders have to anticipate the rate of inflation during the loan period and this rate is added into the nominal interest rate and is called inflation premium.
Nominal interest rate = desired real interest rate + inflation premium.
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Borrowing and lending…
If the inflation rate is predicted to be 2% and the bank wanted a real interest rate of 3% the bank would receive real interest of $60 ($2000 x 0.03) and an inflation premium of $40 ($2000 x 0.02)
This is to compensate for the reduced purchasing power of the $2000.
If the inflation rate turns out to be higher than what was predicted then the lenders lose out.
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INFLATION
300 300
200 200
100 100 100
200
300
100
200
300
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What kind of income increases by less than the rate of inflation?
Back
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What are provisions for income
adjustments to accommodate
changes in price levels called?
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What is the formula for real interest rate?
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What kind of income is a nominal income that remains fixed at some dollar amount
regardless of the rate of inflation?
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Name 2 tools that are used to
measure overall changes in price
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What is the formula for
nominal interest rate?
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Name 3 limitations for the consumer price index
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What is the formula for real income?
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What is nominal GDP expressed in?
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What was the biggest
expenditure, according to
Statistics Canada’s 1986 survey?
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If a consumer spends $30 on
hotdogs and $20 on Coke, what are
the item weights of each good?
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A workers original monthly income is
$1000, and the inflation rate is 10%. If
his income rises to $1100 what kind of
income does he have?