Mr. Mayer AP Macroeconomics - Denton ISD

AP Macroeconomics

Unit III Fall 2011

Inflation, Unemployment,

Business Cycle and CPI, Phillips

Curve, Circular Flow Model

But maybe not in that order

Measuring the Cost of Living

• Inflation (tt)– occurs when the economy’s overall

price level is rising.

• Inflation Rate (tt%)

– the percentage change in the price

level from one time period to another.

THE CONSUMER PRICE

INDEX• The consumer price index (CPI) is a

measure of the overall cost of the goods and services bought by a typical consumer.

• The Bureau of Labor Statistics reports the CPI each month.

• It is used to monitor changes in the cost of living over time.

THE CONSUMER PRICE

INDEX

• When the CPI rises, the typical family

has to spend more dollars to

maintain the same standard of

living.

How the Consumer Price Index Is

Calculated

• Fix the Basket: Determine what prices are most important to the typical consumer.– The Bureau of Labor Statistics (BLS)

identifies a market basket of goods and services the typical consumer buys.

– The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

• Find the Prices: Find the prices of

each of the goods and services in

the basket for each point in time.


Calculated

• Compute the Basket’s Cost: Use the

data on prices to calculate the cost

of the basket of goods and services

at different times.


Calculated

• Choose a Base Year and Compute the Index:– Designate one year as the base year,

making it the benchmark against which other years are compared.

– Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.


Calculated

• Compute the inflation rate: (tt%)

The inflation rate is the percentage

change in the price index from the

preceding period.


Calculated

• The Inflation Rate (tt%)

– The inflation rate is calculated as

follows:

Inflation Rate in Year 2 =CPI in Year 2 -CPI in Year 1

CPI in Year 1100


Calculated

Calculating the Consumer Price Index and the Inflation Rate: An Example

Copyright©2004 South-Western


Calculating the Consumer Price Index and

the Inflation Rate: An Example


Calculated

• Calculating the Consumer Price Index

and the Inflation Rate: Another Example

– Base Year is 2002.

– Basket of goods in 2002 costs $1,200.

– The same basket in 2004 costs $1,236.

– CPI = ($1,236/$1,200) 100 = 103.

– Prices increased 3 percent between 2002 and

2004.

FYI: What’s in the CPI’s Basket?

16%

Food and

beverages

17%

Transportation

Medical care

6%

Recreation

6%

Apparel

4%

Other goods

and services

4%

41%

Housing

6%Education and

communication


Problems in Measuring the Cost of

Living

• The CPI is an accurate measure of

the selected goods that make up

the typical bundle, but it is not a

perfect measure of the cost of living.


Living

• Substitution bias

• Introduction of new goods

• Unmeasured quality changes

• Substitution Bias

– The basket does not change to reflect

consumer reaction to changes in

relative prices.

• Consumers substitute toward goods that

have become relatively less expensive.

• The index overstates the increase in cost of

living by not considering consumer

substitution.


Living

• Introduction of New Goods

– The basket does not reflect the change

in purchasing power brought on by the

introduction of new products.

• New products result in greater variety,

which in turn makes each dollar more

valuable.

• Consumers need fewer dollars to maintain

any given standard of living.


Living

• Unmeasured Quality Changes

– If the quality of a good rises from one year to

the next, the value of a dollar rises, even if the

price of the good stays the same.

– If the quality of a good falls from one year to

the next, the value of a dollar falls, even if the

price of the good stays the same.

– The BLS tries to adjust the price for constant

quality, but such differences are hard to

measure.


Living

• The substitution bias, introduction of new

goods, and unmeasured quality changes

cause the CPI to overstate the true cost

of living.

– The issue is important because many

government programs use the CPI to adjust

for changes in the overall level of prices.

– The CPI overstates inflation by about 1

percentage point per year.


Living

The GDP Deflator versus the

Consumer Price Index

• The GDP deflator is calculated as

follows:

GDP deflator =Nominal GDP

Real GDP100



• The BLS calculates other prices

indexes:

– The index for different regions within the

country.

– The producer price index, which

measures the cost of a basket of goods

and services bought by firms rather

than consumers.

The GDP Deflator versus the Consumer Price Index

• Economists and policymakers

monitor both the GDP deflator and

the consumer price index to gauge

how quickly prices are rising.

• There are two important differences

between the indexes that can

cause them to diverge.

• The GDP deflator reflects the prices

of all goods and services produced

domestically, whereas...

• …the consumer price index reflects

the prices of all goods and services

bought by consumers.



• The consumer price index compares the

price of a fixed basket of goods and

services to the price of the basket in the

base year (only occasionally does the BLS

change the basket)...

• …whereas the GDP deflator compares

the price of currently produced goods

and services to the price of the same

goods and services in the base year.



Inflation

• Inflation – a rise in the level of prices

• Measured by CPI comparisons (year

to year; month to month)

• Normal economic growth = 2-3%

change

• Inflation is above 6% – “double digit”

is very serious for U.S.

• Hyperinflation can be devastating

to output and employment

Inflation’s Positive Effects

• Flexible-Income receivers are

unaffected (COLA like SS, businesses

with prices rising faster than costs,

commission sales positions, any business

that anticipates inflation, etc.)

• Debtors (borrowers pay back loans with

“cheap” dollars – lower interest than

inflation %)

Inflation’s Negative Effects

• Fixed income receivers (elderly

retirees, government workers, minimum

wage earners, landlords, etc.)

• Savers (paper assets lose value over

time when interest rate is lower than

inflation rate)

• Creditors (lenders are paid back in

“cheaper” dollars & have a loss of “real”

income)

Happy or Sad Face?

Banks lend out billions of dollars in fixed-

rate home mortgages to consumers.

Unexpected inflation will cause?

Bank

Borrower

Happy or Sad Face?

You borrow $15,000 for a new car and

agree to a variable interest rate loan.

Unexpected inflation will cause?

Bank

Borrower

Types of Inflation

• Demand – Pull Inflation

– Caused by changes in spending

beyond the production capacity

– i.e. failure to produce more drives up

price

– “too much money chasing too few

goods”

– In long run, wages will go up as workers

are in demand & cost of living

increases

Types of Inflation

• Cost – Push Inflation

– Caused by increase in factors of

production costs

– Per unit production costs rise

– Business must raise prices to make

profits

– “wage price spirals” as wages are the

largest single production cost

– Also caused by “supply shocks” (raw

materials or energy costs rise abruptly)

Two Measures of Inflation

1965

Percent

per Year

15

CPI

GDP deflator

10

5

01970 1975 1980 1985 1990 20001995


Dollar Figures from Different Times

• Do the following to convert (inflate)

Babe Ruth’s wages in 1931 to dollars

in 2001:

Salary SalaryPrice level in 2001

Price level in 19312001 1931

$80,.

$931,

000177

152

579

The Most Popular Movies of All Times, Inflation Adjusted


Real (r%) and Nominal Interest

(i%) Rates

• Interest represents a payment in the

future for a transfer of money in the

past.

• The nominal interest (i%) rate is the interest rate usually reported and

not corrected for inflation (tt%).

– It is the interest rate that a bank pays.

• The real interest rate (r%) is the nominal interest rate that is corrected for the effects of inflation

(tt%).


(i%) Rates

• You borrowed $1,000 for one year.

• Nominal interest rate was 15%.

• During the year inflation was 10%.

Real interest rate = Nominal interest rate –Inflation

r% = i% - tt%r% = 15% - 10%

r% = 5%


(i%) Rates

Real and Nominal Interest Rates

1965

Interest Rates

(percent

per year)

15

Real interest rate

10

5

0

–51970 1975 1980 1985 1990 1995 2000

Nominal interest rate


Summary

• The consumer price index shows the cost

of a basket of goods and services relative

to the cost of the same basket in the

base year.

• The index is used to measure the overall

level of prices in the economy.

• The percentage change in the CPI

measures the inflation rate.

Summary

• The consumer price index is an imperfect

measure of the cost of living for the

following three reasons: substitution bias,

the introduction of new goods, and

unmeasured changes in quality.

• Because of measurement problems, the

CPI overstates annual inflation by about 1

percentage point.

Summary

• The GDP deflator differs from the CPI

because it includes goods and services

produced rather than goods and services

consumed.

• In addition, the CPI uses a fixed basket of

goods, while the GDP deflator

automatically changes the group of

goods and services over time as the

composition of GDP changes.

Summary

• Dollar figures from different points in time do not represent a valid comparison of purchasing power.

• Various laws and private contracts use price indexes to correct for the effects of inflation.

• The real interest rate equals the nominal interest rate minus the rate of inflation

r% = i% - tt%

The Business Cycle• The United States’ GDP is not constant

from year to year.

• Instead, the GDP grows most years

and then shrinks in some years.

• The ups and downs in GDP over time is

referred to as the business cycle.

The Business Cycle

Illustrated:

Business Cycles

• Economic Growth is a major goal

• Measured by – increase in real GDP or

increase in real GDP per capita

• Sources of growth: 1) increase resources

and 2 ) increase the productivity of the

resource inputs

• Productivity = real output per unit of

input

• Results from Health, training, education &

motivation of workers

The Business Cycle

Illustrated:• Peak

– temporary maximum in Real GDP. At this point the unemployment rate (u%) is probably below the natural rate of unemployment, and the inflation rate (π%) is probably increasing.

• Recession– The contractionary phase of the business cycle. A period of

decline in Real GDP accompanied by an increase in u%. To be classified as a recession, the economic decline must be at least 6 months long.

• Trough– The bottom of the business cycle. The u% is probably high and π%

is probably low.

• Recovery– The phase of the business cycle where the economy is returning to

full employment.

The Business Cycle Illustrated:

• Causes

– Irregularity of Investment

– Changes in productivity

– Changes in total spending (aggregate demand)

• Durable goods manufacturing is most susceptible

to the effects of the business cycle

• Business cycle has become less severe because

of technological advancements in supply-chain

management and structural changes in U.S.

economy.

Unemployment• Population

– Number of people in a country

• Labor force– Number of people in a country that are classified as either

employed or unemployed

– Labor Force Participation Rate• % of working age population in the labor force (U.S. is approx 66%)

• Employed – People 16 years and older that have a job.

– It doesn’t matter if it’s part-time or full-time, as long as they work at least 1 hour every 2 weeks

• Unemployed– People 16 years and older that don’t have a job, but have

actively searched for a job in the last 2 weeks

– Unemployment rate = # of unemployed / # of people in labor force

• Not in Labor Force– Kids, military personnel, retired people, stay at home Moms and

Dads, full-time students, your 40 year old uncle who sleeps on the couch all day, most of the homeless.

Types of Unemployment• Frictional

– “between jobs”, voluntary, good for individuals and society

• Structural– Associated with lack of skills or declining industry (ex.

High school dropouts, type-writer repairmen). Think “Creative Destruction”

• Cyclical– Associated with downturns in business cycle. Bad for

society and individuals.

• Seasonal– Mall Santas, Schlitterbahn Life-guards, Ride operators at

Fiesta Texas, Golf-pros in Alaska during January.

Full Employment• Occurs when there is no cyclical

unemployment present in the economy

• Associate with the Natural Rate of

Unemployment (NRU).

– The level of unemployment experienced when

the economy is producing at its full potential.

– The United States’ NRU is approx. 4%-5%

• Associate Full Employment (FE) with the

PPC, the long-run aggregate supply (LRAS)

and the long-run Phillips curve (LRPC)

Why Unemployment is bad• Okun’s Law- Every 1% increase in the u%

causes a 2% decline in Real GDP.

• The burden of unemployment is not equally

shared in society.

• It causes social unrest and is hard on

individuals and families.

Phillips Curve

In the short run, inflation &

unemployment are inversely related

In the long run, unemployment is

unaffected by inflation

Inflation %

Unemployment

SRPC

LRPC – at

natural rate of

unemployment

An

nu

al

rate

of

infl

ati

on

(per

cen

t)

Unemployment rate (percent)

7

6

5

4

3

2

1

0

1 2 3 4 5 6 7

As inflation declines...

THE PHILLIPS CURVE CONCEPT

unemployment

increases

And vice versa!

SRPC

An

nu

al

rate

of

infl

ati

on

(per

cen

t)

Unemployment rate (percent)

7

6

5

4

3

2

1

0

1 2 3 4 5 6 7

THE PHILLIPS CURVE CONCEPT

SRPC 1

LRPC = Is the natural

Rate of Unemployment

SRPC 2

With Stagflation,

Shift SRPC to the

right With AD

shift, move

along

existing

SRPC

Phillips Curve• Short run trade-off between inflation and

unemployment.

• In the Long Run there is no trade off. The

long run Phillips curve is Vertical!

• Stagflation (an increase in Unemployment

and inflation) or an Aggregate Supply Shock

will shift the SRPC to the right.

• Decreases in Inflation and Unemployment will

shift the SRPC to the left. (and increase in AS

would cause this)

“Redelsheimer’sGraphs to Know”

TWO WAYS TO SHOW ECONOMIC GROWTH

A

B

C

D

Cap

ital

Good

s

Consumer Goods

Pric

e L

evel

Real GDP

ASLR1 ASLR2

Q1 Q2

“

Causes of Economic Growth

1. Increased investments in Capital Stock.

2. Increased investments in Human

Capital (education, training) and

increases in quantity of human

resources

3. New Technology leading to increased

productivity

4. Increase in quantity and quality of

natural resources

BUSINESSES HOUSEHOLDS

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCT

MARKET

GOODS &

SERVICES

GOODS &

SERVICES

$ CONSUMPTION$ REVENUE

GOVERNMENT

RESOURCE

MARKET

Circular Flow Model

Mr. Mayer AP Macroeconomics - Denton ISD

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