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Copyright©2004 South
-
Western

Inflation Calculator


In 1931 Babe Ruth earned $80,000 per year
while President Hoover earned $75,000.

“I had a better year.” Babe Ruth

How do those numbers compare to today’s salaries?

What do we need to take into consideration?





Inflation

How do we calculate inflation?


GDP Deflator

or


CPI


Consumer Price Index

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Inflation Calculator


Today the average baseball player earns


$ 3.2 Million per year


Alex Rodriguez earned $33 Million in 2010!

President Obama is paid $400,000


What is the largest grossing Hollywood Movie of all
time?

Gone with the Wind: $198 Million (1939) or

Avatar : $ 2.8 Billion (2009)

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How ‘bout some other prices

Ford Model “T” in 1908: $850

Today Ford Taurus:

$
28,000
Base 2011

Cost of a Model T in 1914:
$300!

Ford’s market share rose from
9.4% to 48% of the car market
by 1914 and net income rose
from $3 Mil. to $ 25 Mil.





How would
you describe
the price
elasticity of
demand for
cars in 1910?

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24

Measuring the Cost
of Living

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Figure 2 Two Measures of Inflation

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Let’s take another look at Nominal vs. Real GDP

NOMINAL

REAL

INFLATION

651

979

1348

1875

2246

2567


Nominal GDP = Real GDP +
Inflation

We could also say that…

Real GDP = Nominal
-

Inflation

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How are you effected by Inflation??


Rising Prices


Is that always a problem?

Are your wages effected by inflation?


What about your savings?


Is that effected by inflation?

How about loans that you take out?


Are loans effected by inflation?

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If you were to lend somebody money for 1 year, what is
the lowest rate of interest you would need to charge to
keep from losing money?


This year’s expected rate of
INFLATION


Banks must think the same way!

Interest Rates vs. Inflation

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Real and Nominal Interest Rates


The
nominal interest
rate is the interest rate
usually reported and not corrected for inflation.


It is the interest rate that a bank pays.


The
real interest rate
is the nominal interest
rate that is corrected for the effects of inflation.

Real interest rate = Nominal interest rate


Inflation

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RATE OF INFLATION VS. INTEREST RATES

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Figure 3 Real and Nominal Interest Rates

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How do Real and Nominal Interest Rates Effect
You?


Let’s say you put your money in the bank and
earn a nominal interest rate of 2% per year.


If Inflation was 4% over this time period, what
is your
REAL

rate of return on this investment?


Real interest rate = Nominal interest rate


Inflation

REAL = 2%
-
4% =
-
2%
Not a good investment

IF inflation = 1%,
then real interest







= 2%
-
1% = 1%

Savers need to beat inflation!!

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So how can you GAIN from inflation?


WHAT if you
borrowed $1,000 for one year.


Nominal interest rate was
5%.
(the rate you pay)


During the year inflation was 10%.

Real interest rate = Nominal interest rate


Inflation

=

5
%
-

10% =

-
5%

Is the real interest rate what you pay?

No, but if you earned at least the inflation rate
then your net cost was
-
5%.

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Western

Another scenario

You buy a house right now for 200k


If you pay a
fixed

rate of interest (say 4% per year for
30 years). The amount you pay is fixed, it doesn’t
change over time!


If your salary increases along with inflation and that is
greater than 4%, over time the cost of paying off your
loan will get lower and lower.


BUT your income must increase by more than 4%
(Cost of living increases, raises, etc.)


If wages don’t keep up with inflation you lose over time.

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Who is helped and who is hurt by high inflation?

1.
Banks extend many fixed rate loans. H
-
G
-
U

1.
Hurt
, since they are only receiving money back at a fixed interest

2.
A farmer buys machinery with a fixed rate loan to be repaid
over 10 years

1.
2. Gain,
since he earns more money and pays a fixed rate

3.
Your family buys a new home with an
adjustable

rate
mortgage, the rate you pay adjusts with interest rates.

1.
Hurt,
since you will pay higher interest if inflation causes rates to rise

4.
Your savings are in a savings account paying a fixed rate of
interest

1.
Hurt, since your receive only a fixed rate and interest rates and prices
of everything are rising.

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1.
A widow lives entirely on a fixed income from a pension the
woman receives from her former employer.

1.
Hurt, since prices are going up and the interest she receives is fixed.

2.
A retired couple lives entirely on income from a pension the
woman receives from her former employer.

1.
Unclear, since we don’t know if the pension is INDEXED to inflation.

3.
A retired man lives entirely on income from Social Security.


Unclear, since although SS is indexed to inflation we don’t know if it will
keep up with the man’s personal expenses.

4. The federal
gov
. has a $ 5 Billion debt.

1.
Unclear, since we don’t know if it’s borrowed at fixed rates or adjustable.


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Figure 1 The Typical Basket of Goods and
Services

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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.

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How the Consumer Price Index Is
Calculated


Find the Prices:

Find the prices of each of the
goods and services in the basket for each point
in time.

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How the Consumer Price Index Is
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.

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How the Consumer Price Index Is
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.

CPI (yr X) = Price of the Basket (yr X)





Price of the Basket (base year) X 100


HISTORICAL CPI
!


So, what is the value of
the CPI in the Base Year?




100

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Dollar Figures from Different Times


Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2001:


CPI DEFLATOR

CPI Deflator 2001

CPI Deflator 1931

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How the Consumer Price Index Is
Calculated

Compute the inflation rate:

The inflation rate is
the percentage change in the CPI from the
preceding period.


The
Inflation Rate


The
inflation rate
is calculated as follows:


Table 1 Calculating the Consumer Price Index and
the Inflation Rate: An Example

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The
quantity

stays the
same
each
year!

1.Find the
prices

2. Calculate
the cost of the
original basket
in each year.

3. Divide each
basket into the
base year
basket to find
the CPI
.

4. Calculate
change in
CPI to find
inflation
rate

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“Inflate or Deflate” Prices

You can put the price of any good from any year into
another year’s dollar value by calculating how much the
CPI grew or shrunk over that time period.

For instance:

What is the cost of a 1914 Ford Model “T” in 2011
prices?

Model “T” in 1914 = $300

CPI in 1914 = 10

CPI in 2011 = 225


$ 300 “inflated” to 2010 prices =

300 x 225/10 = $6750




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Figure 2 Two Measures of Inflation

1965

Percent

per Year

15

CPI

GDP deflator

10

5

0

1970

1975

1980

1985

1990

2000

1995

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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.

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Problems in Measuring the Cost of Living


Substitution bias


Introduction of new goods


Unmeasured quality changes

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Problems in Measuring the Cost of Living


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.

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Problems in Measuring the Cost of 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.

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Problems in Measuring the Cost of 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.

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The GDP Deflator versus the Consumer
Price Index


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
.