Principles of Macroeconomics

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Principles of Macroeconomics

• Economics 202
• Ryan Herzog

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Outline

• Assignment 2
• Due Wednesday by 1159pm
• Long Run Growth
• Output per Worker
• Capital Per Worker
• Unemployment
• Definition
• Concerns

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Unemployment

• Definitions
• Un Rate Unemployed / (Employed Unemployed)
• LFPR Labor Force / Working age population
• Discouraged Worker Effect
• Types of Unemployment
• Structural, Frictional, Cyclical

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Inflation

• Definitions
• Inflation Increase in the overall price level
• Some prices may decrease, but relatively more
  prices have increased
• Deflation Decrease in the overall price level
• Some prices may increase, but relatively more
  prices have declined
• Disinflation A reduction in the inflation rate
• Prices are still increasing but at a lower rate

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Inflation
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Inflation

• Recessions
• Inflation tends to decrease during recessions
• Early 1990s and 2000s inflation decreased
• Expansions
• Inflation tends to increase during expansions

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Inflation and Recession
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Inflation and Expansion
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Price Indexes

• Used to measure overall price levels
• Consumer Price Index
• Constructed after WWI
• Computed by the BLS each month
• Designed to represent the market basket purchased
  by the typical consumer
• 71,000 goods and services

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Consumer Price Index
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Consumer Price Index

• CPI versus GDP deflator
• GDP deflator measures price changes of all goods
  and services
• CPI compares a fixed basket of goods over time
  meanwhile the GDP deflator compares prices to
  those in a base year

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Consumer Price Index

• Calculating the CPI (5 steps)
• 1. Fix the basket of goods we are interested in
  only price changes so the quantities of all goods
  must be held constant.
• 2. Find the prices, in order to calculate the CPI
  we need to know the prices of each good
• 3. Compute the baskets cost (price x quantities)
• 4. Chose a base year and compute the index
  (Prices for year X / divided by prices from base
  year) multiplied by 100
• The CPI for the base year is 100
• 5. Calculate inflation Inflation in year 2 is
  (CPI year 2) (CPI year 1) / (CPI year 1)

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Calculating CPI

• Example
• Follow the 5 steps

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Consumer Price Index

• Concerns
• Can overstate the change in the cost of living
• Consumers tend to substitute away from high price
  goods, thus CPI overstates cost of living
• Depends on elasticity of goods
• Introduction of new products
• Quality and price change over time
• Electronic equipment improve over time and
  decrease in price

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Producer Price Index

• The PPI is a measure of the cost of a basket of
  goods and services bought by firms
• This is a strong indicator for increases in the
  CPI
• When firms experience higher input prices this
  period, the follow periods they will raise output
  prices

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Inflation

• Current values can be found at
• www.bls.gov
• Can find different measures for CPI
• Also shows average prices of goods

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Costs of Inflation

• Inflation changes the distribution of income
• During periods of inflation those on fixed
  incomes are worse off
• Social Security payments are indexed to inflation
• Welfare payments are not
• Indexation wages/prices are tied to inflation
  rate
• Increased risk and slower growth
• Unanticipated inflation increases the risks
  associated with investment

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Costs of Inflation

• Shoeleather costs
• Inflation erodes the value of money, thus you
  hold less money
• This increases the number of trips to the bank
• The resources wasted when inflation encourages
  people to reduce their money holdings

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Cost of Inflation

• Menu Costs
• The cost of changing prices
• During periods of inflation firms must change
  prices more frequently
• Relative Prices and Misallocation of Resources
• Inflation distorts relative prices of goods
• This distorts consumers decisions
• Confusion and Inconvenience
• Money is a yardstick used to measure value, when
  inflation increase the yardstick becomes distorted

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Costs of Inflation

• Inflation Induced Tax Distortions
• Lawmakers do not account for inflation in their
  policies
• Alternative Minimum Taxes
• Designed to force those with high incomes and
  high deductions to pay a given tax
• In 1970 1,900 families paid the AMT now more than
  4 million
• Most families with children in school will fall
  into this category
• Income greater than 75,000 with some deductions

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Inflation and Interest Rates

• Inflation distorts interest rates
• Future interest rates are set based on future
  expectations
• Recall nominal versus real
• Real Interest Rates Nominal Interest Rate
  Expected Inflation
• Nominal Interest Rate advertised rates

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Inflation and Interest Rates

• When inflation is higher than expected borrowers
  gain
• Wages increases and thus their loans decrease in
  value
• When inflation is lower than expected lenders
  gain
• Wages have not increased as expected, the real
  interest rate has increased

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Correcting for Inflation

• We can also use CPI to calculate relative prices
• I remember when a soda cost a quarter
• Example Your father graduated from school and
  took his first job in 1972, which paid a salary
  of 7,000. What is this salary worth in 2005
  dollars?

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Inflation Misconceptions

• Is inflation bad?
• The inflation fallacy
• Most individuals believe that a major problem
  caused by inflation is that inflation lowers the
  purchasing power of a persons income
• Wages are index to inflation through cost of
  living adjustments
• Interest rates are set based on expected future
  inflation

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Inflation Misconceptions

• When is inflation bad?
• When it is unexpected
• Real interest rates change
• Wages dont adjust as expected
• When it is out of control
• During periods of hyperinflation
• Generally inflation is not bad

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Next Class

• Review Assignment 2
• Ch 18 Long Run Growth
• Talk about Exam 1