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ECON 2105, Week 7 Notes

by: Randi

ECON 2105, Week 7 Notes ECON 2105

GPA 4.0

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About this Document

These notes cover chapter 6 lecture material.
Class Notes
CPI, growthrate, Substitutioneffect, chainedcpi, moneyillusion, GDP, GDPdeflator, inflation, priceconfusion
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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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