THE CHANGE IN PRICES OVER TIME

Inflation and Deflation

The Big Mac Index:

A market basket with only a Big Mac in it.

Mmm…?

It’s based on the average price of a Big Mac in America: $4.20

When I lived in Egypt I could get a Big Mac for about $2.

…but of course there were much more delicious things to eat.

Source: The Economist (2012)

Purchasing Power Parity (PPP)

How far does your dollar go?

When we talk about inflation, PPP refers to changes in how far your dollar goes over time.

Remember our lost $20 bill?

Why is this a terrible investment plan?

Prices change over time, and that’s okay.

You will probably make more than your grandparents did, but does your dollar go farther?

Prices change over time, and that’s okay.

You will probably make more than your grandparents did, but does your dollar go farther?

Real Wage = Wage Rate ÷ Price Level (Remember that price level is the average price of all

goods and services in an economy)

Prices change over time, and that’s okay.

You will probably make more than your grandparents did, but does your dollar go farther?

Real Wage = Wage Rate ÷ Price Level (Remember that price level is the average price of all

goods and services in an economy)

Real Income = Income ÷ Price Level

Inflation Rate Calculation, Again

Price index in year 2 – price index in year 1

*100Price index in year 1

The Costs of Inflation

Shoe Leather Costs

Menu Costs

Unit-of-Account Costs

Inflation and Interest Rates

Nominal Interest Rate: The interest rate in today’s dollars. (In Year ‘X’

dollars)

Real Interest Rate: Nominal Interest – Inflation Rate

Find the real interest rate.

Nominal interest rate: 10%

Inflation rate: 6%

Real interest rate: ___?___

THINK ABOUT NOMINAL VS. REAL RATES.

Does inflation hurt everyone?

Imagine. The year is 2007.

You just took out a $10,000 five year loan at 10% interest.

How much will you have to pay in 2012?

Fast forward to 2012.

Good news! Over the past five years, the price level has risen at a rate of 7%!

How much do you “really” have to pay on your $10,000 loan?

So, inflation is good for debtors.

How does the bank feel at the end of the 5 years?

Winners and Losers from Inflation

This happens because most loans (debts) are expressed in nominal interest rates.

Inflation causes the “real” rate of interest to change.

Winners = _____?______Losers = _____?_____

So, who wins from deflation?

Winners = _____?______

Losers = _____?_____

Inflation Target

Policy makers try to keep inflation at about 3%

It takes a recession to cure severe inflation. That’s a massive opportunity cost. U.S. in 1981-1982

P. 81

Planet Money on the Brazilian Hyperinflation: http://www.npr.org/blogs/money/2010/10/04/130329523/how-fake-money-saved-brazil