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Inflation
an overall increase in prices, it results in a decrease of purchasing power in a nominal sum of money
-inflation icreases all prices including wages
Deflation
an overall decrease in prices, results in an increase in purchasing power of nominal sum of money
who benefits from unexpected inflation, or inflation rates that are higher than rates expected?
1. Borrowers at a fixed rate or amount will benefit. If someone lends you money and charges you an interest rate based on what they think inflation will be in the following years. If inflation is higher than expected, the purchasing power of a given amount of money to be given back in the future is lower than expected.
2. People paying others at a FIXED amount
-if you agree to pay someone a certain amount, but then there is unexpected inflation, you give up less purchasing power than you expected you needed to
3.a business where the price of the product increases faster than the price of the resources
purchasing power
value of goods and services that can be purchased with one unit of a country's currency
generally: how much you can buy for a certain amount of money
Who doesn't benefit from unanticipated inflation?
1.Lenders AT A FIXED INTEREST RATE
-if you lend someone money AT A FIXED INTEREST RATE, then you give up some purchasing power, and you expect to get that purchasing power plus some more back. If you give someone a certain amount of purchasing power, and there is more inflation then expected, you will get back less purchasing power than you expected to get back
2.People with a FIXED INCOME
-if there is inflation, and you have the same income for a certain amount of time. Then, you will get less real income or purchasing power then what you got the previous year
ex---> social security recipients, workers on multi-year wage contracts
3.Savers are hurt by inflation because the money that they saved now has less value than it did when they initially saved it
Real Value Formula
Real value= nominal value/(price index x 100)
-applies for GDP and CPI
Which of the following will happen if expected inflation rate is less than actual inflation rate?and why?
A)Borrowers of variable interest rate loans will be better off
B)borrowers of fixed interest rate loans will be worse off
C)lenders of variable interest rate loans will be worse off
D)lenders of fixed interest rate loans will be better off
E)Borrowers of fixed interest rate loan will be better off
Answer---> E
-variable rates accommodate changes in inflation rate (anyone with variable rates is fine)
-the borrower with the fixed rate benefits because they pay back less value in terms of purchasing power than they expected to
Real wage formula
Real Wage = Nominal Wage / Price Index (untouched, no multiplied by 100)
GDP deflator
broad measure of price levels in the economy (the index number shows how prices change since a base year)
GDP deflator formula
GDP deflator= Nominal GDP/Real GDP x 100
If the GDP deflator increases unexpectedly, would a borrower of fixed interest rates be better or worse off?
They would be better off.
The forrower with a fixed interest rate iab would be better off because the value of the loan repayments (in terms of purchasing power) is lower than what the borrower expected (to have to pay back)
Price stability
when expected inflation=actual inflation
Is inflation good or bad?
-stable inflation is okay
-hyperinflation is bad because banks won't spend due to the devaluing of the dollar and people don't save because they don't want to lose purchasing power
Is deflation good or bad?
Super Bad. If people know that money is becoming more and more valuable, then people won't spend money, they'll hold on to it because they want to gain more purchasing power over time
nominal wage
the dollar amount of any given wage paid
real wage
wage adjusted for inflation
-this wage measures purchasing power
Who is helped and hurt by inflation?
Man who lent out $500 to his girlfriend in 1960 and gets paid back in 2015
-the friend who lent got hurt
-100 dollars is not worth as much in 2016 as it was in 1960. the person who lent gave up more purchasing power than he got back
-the guy who borrowed benefits because he received and was able to use more purchasing power than he had to give back
Who is helped and hurt by inflation?
a tenant who is charged $850 a year for the apartment
-the tenant benefits because, due to inflation, the value of 850 or the purchasing power of 850 will decrease over time
-the landlord doesn't benefit because eventually, as we saw in Mumbai, the landlord will make so little money and will get less purchasing power than what they originally got
3 causes of inflation
1. The Government Prints TOO MUCH
Money (The Quantity Theory)
2. DEMAND-PULL INFLATION
3. COST-PUSH INFLATION
the quantity theory
the government prints too much money will lead to hyperinflation
result:
-banks refuse to lend so investment falls and people don't save up to buy products
-ex- Zimbabwe, Venezuela, Germany after WW1
Velocity of money
money supply x velocity = Price x Y(real GDP)
why does printing money lead to inflation?
due to velocity of money
assume that velocity is relatively constant because people's spending habits are not quick to change
-also assume the output (Y) is not affected by amount of money because it is based on production, not the value of the stuff produced
2nd inflation cause) Demand pull inflation
DEMAND PULLS UP PRICES
-"too many dollars chasing too few goods"
-an overheated economy with excessive spending but has the same amount of goods
3rd inflation cause) Cost Push inflation
-higher production costs increase prices of goods and services
A negative supply shock increases the cost of production and forces producers to increase prices
is inflation rate easily predictable?
no, it really isn't
price
a signal wrapped up in an incentive
ex- an increase in the price of oil signals to users of oil that oil has become more scarce. This incentivizes oil users to economize in ways like making flour production in warmer climates
price confusion
inflation makes price signals more difficult to interpret. People are usure of whether a price increase is due to too much demand for a good/scarcity or inflation
money illusion
when people mistake changes in nominal prices for changes in real prices
ex- imagine between year 1 and year 2 there is an inflation rate of 50%. Everything, including wages increases. When the movie ticket doubles in price due to inflation, even though every other price including wages is doubled, people believe that going to the movies has become more expensive. People here mistook the doubling in nominal movie ticket price for the doubling in real movie ticket price
what type of inflation is worrisome and costly?
high and volatile
real interest rate formula
real interest rate(R) = nominal interest rate(I) - inflation rate(pi symbol)
Fisher effect
people will adjust their interest rates based on predictions for inflation, the fisher effect shows that when people expect the inflation rate to increase, they will increase nominal interest rates
What happens if actual inflation>expected inflation
-borrowers are happy
-lenders are sad
what happens if expected inflation> actual inflation
-lenders are happy
-borrowers are sad
inflations unpredictability causes what fears?
-fear to borrow, for disinflation and having to pay back more purchasing power than expected
-fear to lend, for unexpected inflation and having to give more purchasing power than you get back
when calculating the nominal interest rate in the real interest rate formula and when you incorporate taxes..
calculate the nominal rate of return AFTER TAXES. THEN subtract it by the inflation rate. Otherwise, you have wrong and messy calculations
Purchasing power and market basket
the purchasing power is simply, also defined as, what market basket parts or how much of the market basket you could buy with a certain amount of money.
GDP deflator for base year always =
100. at the base year, real gdp=nominal gdp
If nominal GDP is $100B and real GDP is $80B, what is the gdp deflator
(review notebook for calculations)
ANS- 125 is gdp deflator
there was a 25% increase since the base year
If the real gdp is $200B and the deflator is 120B, what is the nominal GDP
240 Billion
If nominal GDP is 300B and the deflator is 150, what is the real GDP
200 B dollars
anemic growth
when there is very small GDP growth and government focuses too much on preventing inflation and slows down economy
recession
a 6 month or 2 quarter long period of decline in real GDP. If it is really bad, that is a depression
Nominal GDP
value of aggregate output in current dollars
CY abbreviation and BY abbreviation
current year and base year
Nominal GDP formula
Real GDP x aggregate price level/100
if gdp had a nominal increase, what happened to the price level and real gdp?
the price level and/or the real gdp increased
inflation rate
GDP deflator CY-GDP deflator BY/GDP deflator BY x 100
inflation rate general formula
new-old/old x 100
List the key differences between CPI and GDP deflator
(check notebook)
-CPI:
-used to determine how purchasing power changes over time
-based on changing prices of a fixed market basket (the price changes, the quantity stays consistent)
-holds quantity constant and evaluates a change in price
-reflects prices of goods and services bought by consumers (meaning C and it includes imports)
GDP deflator:
-used to determine the output changes over time
-based on goods/services produced in a given period in time
-holds the price constant and evaluates change in output
-reflects change in price of all goods, not the market basket
-Meaning C,I,G,X
Real gdp in terms of gdp deflator
Real GDP= Nominal GDP/(GDP deflator/100)
Nominal GDP in terms of gdp deflator
Real GDP x GDP deflator/100
what does the business cycle model depict?
relationship between output and time
output
the amount of goods and services that can be depicted as real gdp, real gdp per capita, nominal gdp, growth of any of the above
business cycle model- and its shape
- a linear line means that output is increasing at a constant rate over time
-the curve, however, is more realistic, and the linear line is potential output
what is the time in business cycles
time is measured in quarters
what are the phases of the business cycle
peak, recession, trough, expansion
Expansion AKA contraction (Business Cycle)
-when the curve is going upwards
-output is increasing and employment is rising
Recession (Business Cycle)
-when the curve is moving down
-output is decreasing, employment is falling
-less output=fewer working workers
Peak (business cycle)
The highest point between the end of an economic expansion and the start of a contraction in a business cycle.
-found when output goes from increasing to decreasing
Trough (business cycle)
-found when output goes from decreasing to increasing (the bottom point/flatness of the curve)
potential output AKA full employment output
level of GDP where unemployment (Ur)=NRU (Natural rate of unemployment)
the _______ represents potential output
the linear line
-and it is on the curve for PPC
what happens when actual output< potential output
-In the PPC, this would be under the curve
-this is called a recessionary gap
-unemployment> NRU(natural rate of unemployment)
inflationary gap
when actual output is greater than potential output
-this would be OUTSIDE the curve in PPC
how is output gap measured?
difference between actual and potential GDP
what is the business cycle in currect sequence
peak,recession,trough, expansion/contraction
Positive output gap
-economy is expanding quickly, lots of spending, this is not expansion
-it is the space between the potential gdp curve and the business cycle curve, that is above the line
negative output gap
-lots of inflation, economy overheating
-it is the space between the potential gdp curve and the business cycle curve, that is below the line
when current output is greater than potential output, the economy must have...
an inflationary gap
The Sahm Rule
if unemployment rate rises 0.5 percent relative to the low in previous 4 months, there will be a recession
