Who Is Making More?

• A 2001 graduate of Hiram College got a job that pays $30,000 per year.

• Thirty years ago, her father started his career with a $7,500 job.

• Is she making four times as much as her father did?

Who Is Making More?

• In order to compare the incomes of two different periods we have to eliminate the effect of inflation.

• What happened to prices between 1969 and 2001?

• Let’s find out the Consumer Price Index (CPI).

Who Is Making More?

• According to Bureau of Labor Statistics (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), CPI in 1969 was 36.7.

• CPI in 2001 was 177.5. Base year was 1982-84.

• If the average price level in 1969 was lower than in 2001, our graduate must not have been three times better off.

Who Is Making More?

• In real terms:– She made (30,000/1.775) = $16,901.41 in 1983

dollars.– He made (7,500/.367) = $20,436 in 1983

dollars.

• How much was his pay in 2001 dollars?– His pay is (7,500)(1.775/.367) = $36273.84.

How To Calculate The CPI?

• Fix the basket a typical consumer will buy.

• Find the prices of the items for different years.

• Compute the basket’s cost for each year.

• Choose a base year.

• Calculate the cost of the basket for other years in terms of the base year.

• Calculate inflation rates.

CPI Calculation

Consumer Basket is 2 Pizzas and 10 SodasYear Pizza Price Soda Price Pizza Spending Soda Spending Total Spending CPI (base=1999) Inflation

1996 $10.00 $0.75 $20.00 $7.50 $27.50 82.091997 $10.50 $0.85 $21.00 $8.50 $29.50 88.06 7.27%1998 $10.75 $1.00 $21.50 $10.00 $31.50 94.03 6.78%1999 $11.50 $1.05 $23.00 $10.50 $33.50 100.00 6.35%

Problems With CPI•Substitution bias.

–Basket changes as a response to relative price changes do not get accounted.

•New products.

–Basket changes are ignored.

–Prices of new products fall before they are included in the new basket.

•Quality change.

–If the same gadget has higher quality now than in the past but viewed as the same item, an increase in price is not inflationary.

Median Household IncomeMedian Household IncomeAccording to the US Census Bureau,

nominal income for a family of four was $24,332 in 1980. In 1997, it was $53,350.

CPI in 1980 was 82.4; in 1997, 160.5.What happened to median real income?How would you change your answer if

Boskin Commission is right?

Real Median Household IncomeReal Median Household Income

Years Nominal Income CPI Real Income Growth Rate1980 $24,332.00 82.4 $29,529.131985 $32,777.00 107.6 $30,461.90 3.16%1990 $41,451.00 130.7 $31,714.61 4.11%1997 $53,350.00 160.5 $33,239.88 4.81%

http://www.census.gov/acs/www/Products/Profiles/Chg/2003/ACS/Tabular/010/01000US3.htm

GDP Deflator vs. CPI• Space shuttle costs more to operate.

– Deflator is up, CPI unchanged.

• Antiques cost more.– CPI is up, deflator unchanged.

• Porsche increases the price.– CPI is up, deflator unchanged.

• New homes cost more.– Both CPI and deflator up.

Indexation

• If payments are automatically corrected for inflation, they are said to be indexed.– COLA– Social Security– TIPS– Variable mortgage rates

Costs of InflationCosts of InflationShoe-leather costs

– Economizing on cash– More frequent trips to the bank– More bank employees– Efforts to avoid the erosion of purchasing

power

Costs of InflationCosts of Inflation

Noise in the price system– Is it an increase in the demand for a product or

is it a general increase in prices?– Should the supplier increase output or not?

Costs of InflationCosts of Inflation

Distortions of the tax system– Depreciation allowance and the replacement

cost– Bracket creep

Costs of InflationCosts of Inflation

Unexpected distribution of wealth– Real wage down => workers lose, employers

gain– Borrowers gain and creditors lose

Costs of InflationCosts of Inflation

Interference with long-run planning– Increase uncertainty– Impossible to predict the future

HyperinflationHyperinflationInflation of 500 or more per cent per year.Germany in early twenties.Argentina and currency board.

Real and Nominal Interest Rates

• If you lend someone $1000 for a year and ask for a 5% interest, you will get $1050 at the end of the year.

• If inflation during the year were 10%, the products you could buy with your $1000 at the beginning of the year now costs $1100.

• Are you better-off or worse-off?

Real and Nominal Interest Rates• Lenders will always ask a higher interest

rate than the expected inflation to earn income.

• Nominal interest rates are what the bank quotes, what the car dealer quotes.

• Real interest rates are nominal rates corrected for inflation.

• i = r + π

Real and Nominal Interest Rates