ECON 2105, Week 7 Notes
ECON 2105, Week 7 Notes ECON 2105
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This 6 page Class Notes was uploaded by Randi on Sunday October 2, 2016. The Class Notes belongs to ECON 2105 at University of Georgia taught by McWhite in Summer 2016. Since its upload, it has received 4 views. For similar materials see Macroeconomics in Macro Economics at University of Georgia.
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Date Created: 10/02/16
Week 7 Notes ECON 2105 PROF. MCWHITE Review: • A home may have cost $7000 in 1945. However, it may cost $62,000 in 2016. Nominally speaking, it costs more now… in real terms, it may not. • Inflation o An increase in the overall price level o There is also hyperinflation o Related to the money supply in the economy relative to the quantity of goods and services o Governments can cause it on purpose • Deflation o Decrease in overall price level o Deflation is not necessarily a good thing • Consumer Price Index (CPI) o For a given period, a measure of costs of a standard basket of goods/services, relative to the cost of said basket in a base year o CPI is a basic tool for economists to measure the price level and inflation in the economy for consumers o Also known as a measure of the cost of living • What’s in a “basket” of goods/services? o Goods consumers would buy on a regular basis o Examples: food, housing, medical care • What is not in the “basket”? o CPI does not include stocks, bonds, real estate, life insurance o These goods are savings goods and consumption expenses • Bureau of Labor Statistics (BLS) is in charge of CPI o They determine what is important to consumers o The basket should reflect where consumers put their resources • BS records prices of goods (reported monthly and for the year) CPI = (Price of Basket in the current year) X Quantity of Base Year (Price of Basket in the base year) X Quantity of Base Year Week 7 Notes *the Q stays the same from the base year *the basket is not GDP Week 7 Notes • CPI vs. GDP Deflator o Real GDP holds Price constant § CPI holds goods/services constant o GDP and Deflator consider all goods/services in the US § CPI considers a basket of goods/services relevant to consumers o GDP is not affected by changes in the price of foreign goods § CPI can be if it is part of the basket • Issues with Inflation 1. Uncertainty about the future decisions 2. Price Confusion 3. The cost of holding money (“shoe leather costs”) 4. Money Illusion 5. Menu Costs 6. Wealth Redistribution and Tax Distribution • Uncertainty o Not knowing what to expect from the price levels in the future changes behavior of individuals and firms • Price Confusion o What is causing prices to change? o You may mistake inflation with changes in demand or changes in the markets for your inputs • Holding Money o If inflation is increasing, the value of money decreases o You spend more time switching money from savings accounts to spending cash o This is not as big an issue in countries with stable credit and updated banking systems o This was a bigger issue in the past Week 7 Notes • Money Illusion o As inflation increases, real values of money become more difficult to determine o Your nominal wages and nominal good prices change o The real value of your wages is changing o You may make decisions on incorrect information o You think goods are more expensive even if your wages change as well o You’re not likely to want your wages to fall even if prices do • Menu Costs o Costs change o Less informed customers think you’re just raising prices and shop elsewhere… until they realize it’s increasing every where else as well • Wealth/Taxes o Wealth distribution: § Borrowers are made better off by inflation § The real value of money paid back is less o Taxes: § Taxes don’t account for inflation § If you’re wages rise to maintain the real value of your pay, what happens? • The IRS actually changes tax rate margins yearly Week 7 Notes • Limitations with CPI o The estimate from CPI may over or underestimate the true change 1. Substitution Effect 2. Changes in Quality 3. New Products in the Economy o Substitution Effect o Consumers respond to price changes o When price rises, Quantity Demanded falls and consumers will buy other goods if it’s an option o CPI assumes no change in the amount bought which exaggerates the price effect o Quality Changes o CPI makes no distinction about quality of goods o If you’re paying a higher price for a better product, that is not an inflation effect o CPI will be biased upward § Upward bias: prices are estimated to have gone up more than what they really have o New Products o The CPI is updated, but not quickly o New goods tend to decrease in price at first, so that’s not captured in the delay o The surveys are done in stores, which misses online sales o The solution is a chained CPI § Chained CPI keeps track of things online and in store § It keeps track of upward bias o Substitution Effect o As price increases, quantity demanded decreases o Consumers will buy other goods if its an option Week 7 Notes • Social Security is adjusted based on the CPI o Cost of Living Adjustment (COLA) o COLA keeps real Purchasing Power from going down • CPI assumes you buy the same amount of goods every year… this is why the base year is constant
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