Chapter 11 Inflation and Unemployment Inflation Is the general increase in the prices of goods and services in an entire economy. For ex: an annual.

Chapter 11Chapter 11

Inflation and Unemployment

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

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

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

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.

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

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.

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

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

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.

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.

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

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.

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.

INFLATION

300 300

200 200

100 100 100

200

300

100

200

300

What kind of income increases by less than the rate of inflation?

Back

What are provisions for income

adjustments to accommodate

changes in price levels called?

Back

What is the formula for real interest rate?

Back

What kind of income is a nominal income that remains fixed at some dollar amount

regardless of the rate of inflation?

Back

Back

Name 2 tools that are used to

measure overall changes in price

What is the formula for

nominal interest rate?

Back

Name 3 limitations for the consumer price index

Back

What is the formula for real income?

Back

What is nominal GDP expressed in?

Back

What was the biggest

expenditure, according to

Statistics Canada’s 1986 survey?

Back

Back

If a consumer spends $30 on

hotdogs and $20 on Coke, what are

the item weights of each good?

Back

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?