Goal #2LIMIT INFLATION

What is Inflation?Inflation: a rise in the average level

of prices

Inflation reduces the purchasing power of money

Examples: •It takes $2 to buy what $1 bought in 1982

•It takes $6 to buy what $1 bought in 1961

Consumer Price Index (CPI)and GDP Deflator

Measuring Inflation

CPI Calculation

1. Government adds up prices of a “market basket” made up of ~300 commonly purchased goods

2. Compares basket price from year to year

3. Inflation Rate = % change in prices between two years

=Price of market

basket in base year

x 100CPI Price of market basket

Consumer Price Index (CPI)The U.S. Government’s Inflation Statistic

How it works:• Base year given index of 100• Year being compared also given an index #

1997 Market Basket: Movie is $8 & Pizza is $12

Total = $20 (Index of Base Year = 100)

2015 Market Basket: Movie is $10 & Pizza is $15Total = $25 (Index of )

125• This means inflation increased 25% b/w ’97 & ’15• Items that cost $100 in ’97 cost $125 in ‘15

Problems with CPI1. Substitution Bias – As prices increase for goods in

“market basket,” consumers may switch to cheaper substitutes outside of basket. (Result: CPI overestimates what consumers are really paying)

2. New Products – CPI basket may not include newest consumer products. (Result: CPI measures prices but not increase in choices)

3. Product Quality – CPI ignores changes in product quality. (Result: CPI assumes that the quality of items in the m

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GDP Deflator

Real GDP Growth

Rate

Nominal GDP Growth Rate≈ –

GDP Deflator Growth Rate

• The GDP deflator, like CPI, is a measure of the average price level

• Key difference: GDP deflator includes producer prices as well as consumer prices

• GDP deflator is used to calculate real GDP growth

World Inflation Rates

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Inflation: Friend or Foe?

• Borrowers– e.g. fixed-rate

mortgage holders,– e.g. the Federal

Government

• Lenders

• People with fixed incomes

• Savers

Hurt by Inflation Helped by Inflation

Who is helped/hurt by inflation?

1. A man who lent his friend $500 in 1960 and is still waiting to be repaid

2. A tenant who pays a fixed $850/mo. rent

3. An elderly couple living off fixed retirement payments of $2,000 a month

4. A woman who borrowed $1,000 from a friend in 1995 and paid it back, without interest, last week

5. A man who saves money by putting it under his mattress

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Expected and Unexpected Inflation

• All countries experience some degree of inflation over time

• Because inflation is so widespread, people expect that it will occur, and adjust their actions accordingly

• The expectation of inflation plays an important role in the interest rate – the price of borrowing money

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Expected and Unexpected Inflation

• Imagine a world without inflation, where $100 today can buy you the exact same basket of goods and services 1 year from now

• Suppose the interest rate in this world is 3%

• Now imagine that – for some reason – both lenders and borrowers suddenly expect that prices will increase by 3% over the next year

• Will lenders still be willing to accept 3% interest on loans?

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Nominal vs. Real Interest Rates• The nominal interest rate is simply the raw,

unadjusted interest rate• e.g. 4% interest on $100 is $4

• The real interest rate is the nominal interest rate adjusted for inflation• e.g. If prices rose by 4% over the term of

the loan above, the purchasing power gained by the lender is 0

Real Interest

Rate

Nominal Interest Rate≈ –

Inflation Rate

Causes of Inflation

1. Central Bank Expansion of the Money Supply

Causes of Inflation

• Governments – via the central bank – are constantly expanding the money supply

• Gov’ts that abuse this and expand the money supply too fast end up with hyperinflation

Examples:• Zimbabwe, Argentina,• Germany after WWI

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Warm Up• In base year 2013, the GDP deflator

was 100 and nominal GDP was $100 billion. In 2014, nominal GDP was $104 billion and the GDP deflator was 102. The real GDP growth rate between 2013 and 2014 was roughly _____%.

• A banks lends money to a borrower at 3% annual interest. Over the period of the loan, the price level increases by 5%. What is the real interest rate?

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Quantity Theory of Money

Suppose the amount of money in circulation is $100 Billion, but GDP is $400 Billion. How is this possible?

Answer: each dollar gets spent four times

Velocity of money = # of times the average dollar changes hands each

year (as part of a GDP-included transaction)

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Quantity Theory of Money Equation:

M x V = P x Y

M = money supply P = price level

V = velocity Y = real GDP

M x V = P x Y

•In the short run, velocity (V) and output (Y) are relatively stable

•If the central bank doubles the money supply (M), what will happen to the price level (P)?

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Why does printing money lead to inflation?

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• Assume a simple economy in which there is only one product produced and sold: Reese’s Peanut Butter Cups

• Each cup is sold for $1• The supply of money in Reesestan is $5

billion• There are 10 billion cups sold this year• What is the velocity of money?• If velocity and output stay the same, what

will happen if money supply quadruples to $20 Billion?

Reesestan

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National Debt Clock

What would happen if the government printed money to pay off the national debt all at

once?

2. COST-PUSH INFLATION

Rising input costs decrease output, raise prices

Example:

• In 1970s, OPEC imposed oil embargo on U.S. => increased costs for virtually all producers => raised prices

Causes of Inflation

M x V = P x Y ↑ ↓

Goal #3Limit Unemployment

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% of people in the labor force who want a job but don’t have one.

Who is in the labor force?• >16 years old•Able and willing to work•Not in jail or psychiatric hospital•Not in military, in school full time, or

retired

Unemploymentrate

# unemployed

# in labor forcex 100=

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The Unemployment Rate

#1. Frictional Unemployment

You’reFired!

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3 Types of Unemployment

•Unemployment due to people transitioning between jobs

Examples: •Recent graduates looking for jobs•People fired for poor performance•People who quit their jobs

Seasonal Unemployment•Those unemployed solely due to time of year

Examples: •Professional Santa Claus Impersonators•Tax preparers•Lifeguards

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3 Types of Unemployment

#2. Structural Unemployment•Changes in the economy make certain jobs obsolete

Examples: •Switchboard operators•Bowling pinsetters

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3 Types of Unemployment

Technological Unemployment•Type of structural unemployment where automation and machinery replace workers

Examples: •Robots replace auto workers•Self-Checkout replaces cashiers

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3 Types of Unemployment

#3 Cyclical Unemployment

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•Unemployment that results from economic downturns (recession and depression)

•As demand for goods and services falls, demand for labor falls and workers are laid off.

Example:

•Unemployment reached 25% during Great Depression

•Unemployment reached 10% during 2007-2009 recession

• Frictional and Structural unemployment are unavoidable

• Together they make up the natural rate of unemployment (NRU).• Usually around 4-6%

• If cyclical unemployment is 0, economy is at full employment

The Natural Rate of Unemployment

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US Unemployment Rate (2005 to 2015)

US Unemployment Rate (1948 to 2014)

In some European countries, it’s 8-10%• Why? Generous unemployment

benefits discourage people from “settling” for just any job

The Natural Rate of Unemployment

• “Discouraged” job seekers• If not actively looking, not

counted in labor force

• Part-Time (Underemployed) Workers• Counted as employed, even if

they want to be working more

• Illegal Workers• Not counted at all!

Problems with the Unemployment Rate

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