Introduction to Macroeconomics

Lecture 09

February 5, 2013

Inflation

The CPI is Used to Measure the Rate of Inflation

Becomes a problem when it is high & “out of control”

The annual inflation rate is the percentage change in the consumer price index (CPI) from one year to the next.

CPI2010 = 218.056

CPI2011 = 224.939

The inflation rate for 2011 =

((224.939 – 218.056) / 218.056) x 100% = 3.16% Your dollar lost 3.16%

The higher the rate of inflation, the more quickly the U.S. $ loses its value in terms of real goods and services. ((CPI 2002-CPI2001) / CPI 2001) X 100

Year

Annual Inflation Rate

2002

1.6%

2003

2.3%

2004

2.7%

2005

3.4%

2006

3.2%

2007

2.8%

2008

3.8%

2009

-0.4%

2010

1.6%

2011

3.2%

2012

2.1%

Some Bad Inflation Years in the U.S.

1974: 11.0%

1979: 11.3% Based on CPI

1980: 13.5%

1981: 10.3%

Measuring Inflation Using the GDP Deflator (Similar to CPI- also a measure of national price/ eval)

• GDP Deflator for 2011 = (NOMINAL GDP in 2011 / REAL GDP in 2011) x 100

($15.0757 t / $13.2991 t) x 100 = 113.34

• Because real GDP was measured using 2005 prices, the base year for this calculation is 2005.

Because the GDP Deflator must = 100 in 2005 and the GDP Deflator = 113.4 in 2011, we know that PRICES have increased 13.4% between 2005 and 2011.

The GDP Deflator can also be used to measure inflation as the annual percentage change in the deflator

In 2012, the GDP Deflator = 115.4

Inflation rate in 2012 =

((115.4-113.4)/113.4) x 100% = 1.76%

The GDP Deflator INCLUDES goods and services not bought by consumers but EXCLUDES imports

CPI or Deflator measures National Price level

Inflation rate measures annual percent change in CPI or deflator

The Inflation Rate and Interest Rates

An interest rate is the rate at which funds are paid by a borrower for the use of the money that they borrow from a lender. It’s essentially the “price” of borrowing.

If interest rates are low, borrowing is cheap.

If interest rates are high, borrowing is expensive.

i= interested rate on borrowed funds

Households make loans

Indirectly through banks

Directly by buying bonds Corporate bonds Government bonds Because banks can lend out “excess deposits”

The riskier the loan, the higher the interest rate

The longer the loan, the higher the interest rate

The prime rate is the interest rate that commercial banks charge their most credit-worthy customers (usually large corporations) = 3.25% last week

• An interest rate is made up of 2 components:

A real interest that depends on how much households want to save and how much businesses want to invest (we’ll talk about the real interest rate later in the course)

+

The rate of inflation

Notation in text: i = r +

Equation is known as the Fisher Equation

Example:

Suppose you are offered a school loan at 7% interest per year. If inflation is occurring at 3% per year, then r = 4%.

R = i + pi

The lender wants to be paid back in dollars that are worth the same amount as the dollars lent.

Graph of an Interest Rate and Inflation Rate over Time:

SEE NOTES

The Inflation Rate and Exchange Rates

• An exchange rate is the rate at which the currency of one country can be exchanged for the currency of another country. It can be expressed as dollars per unit of foreign currency OR as units of foreign currency per dollar:

On January 31, 2013: 1 U.S. $ = 0.74 Euro 1 U.S.