Economics 201

Introduction to Macroeconomics

Mark Witte

Northwestern University

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Price Levels & Inflation

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The macroeconomy

In the long run, we think the economy tends to settle down to a level of output that is consistent with an unemployment rate of 4-5%.

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Why?

Y_P = Equilibrium RGDP

P_E = Price level

AD = Aggregate Demand

SRAS = Short run aggregate supply

LSAS = Long run AS

Eliud Kipchoge

Eliud Kipchoge,1:59:40 for the marathon distance

2019

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Averaged 4:33 per mile for 26.2 miles

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At any point, could he have gone faster?

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His personal best for the mile is 3:50, so….

Real World Record: Kelvin Kiptum, Chicago 2023

The macroeconomy

• Equilibrium:  Production = Spending
• In the SHORT RUN, this can happen anywhere
• At any unemployment rate
• In the LONG RUN, this will be at Full Employment, Potential RGDP
• Sustainable level of output and employment

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Shifting SR and LR Aggregate Supply

• LRAS moves with our Long Run increase in our ability to produce
• More workers, better education, more capital, better technology
• SRAS is a lot like a supply curve:  It shifts with cost of production
• SRAS shifts to the right (more production for a given price level) if:
• Commodity prices fall (energy, food)
• Nominal wages fall (VERY IMPORTANT!)
• Productivity rises 
• We get smarter, new technologies
• We remove bad regulations and high tax rates

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Shifting AD - Recession, Economic Boom

Deflation and rising unemployment Inflation, falling unemployment

Shifting SRAS - Stagflation, Supply-Side Miracle

Rising inflation and unemployment Deflation, falling unemployment

Federal Reserve Target for Inflation, Unemployment

2%

4%

Price growth versus wage growth

Almost 30 years ago Shiller, after a careful survey, found that “People do not tend to see inflation as a process that naturally tends to affect wages and salaries as well as goods prices.” Stantcheva has confirmed that result. They attribute wage gains to their own efforts, and don’t see any connection with price increases.

Prices & Wages (Using a price index)

• Goal in 1945:  Earn $30K/year
• If he could do that, then he should have no financial problems!
• What was the purchasing power of $30,000 1945$ in terms of today's prices?  
• Consumer Price Index in 1945 = 18, CPI now = 324

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Nominal wage growth

Doing the math….

• Goal in 1945:  Earn $30K/year
• What was the purchasing power of $30,000 1945$ in terms of today's prices?  
• Prices now are about 18 times as high now as in 1945 (324/18)
• $30,000 1945$ * (CPI_Now/CPI₁₉₄₅) = $30,000*18

= $540,000

• Rich?  
• In long run, wages grow with opportunity costs
• Generally keep up with inflation due to competing offers...on the average ...

for most people

• Your mileage may vary, particularly these days

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What is the highest grossing animated film in history?

Math

Math

Examples of Price Indexes (they behave similarly)

• There is no true price index. Various approaches have their strengths
• Consumer Price Index ("Cost of Living")
• GDP Deflator
• Personal Consumption Expenditure Deflator, called the "PCE Deflator"
• The part of the GDP Deflator that deals with consumer spending
• Complicated to compute, but fewer biases than CPI
• Favorite of the Federal Reserve these days

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Consumer Price Index

We don’t care about the level!

What if we switched our currency to be the penny? Or the $20?

Consumer Price Index

• We do care about the rate of change
• Inflation (or deflation)

Consumer Price Index

• Inflation = % growth in a price index (like 2.4% per year)
• Disinflation = Reduction in the inflation rate 

        = Slowing rate of growth of the price index (inflation slows from 9% to 2.4%)

= Prices rise more slowly on the average

• Deflation = % reduction in the price index

= Negative inflation

(-4% inflation = 4% deflation = Prices fall by 4% on average)

Bad! Actually bad!

Computing the CPI

1. Pick an arbitrary year (call it the "base year")
2. Figure out the average spending of a household in that year (the “basket”)
3. Take that as the benchmark
4. See what it would cost to buy that set of goods in other years
5. Set the spending in the base year to be 100
6. Scale spending in other years proportionately

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Wrigley Field Price Index

Baseball game purchases

Growth of the cost of going to a baseball game = (New-Old)/Old

= ($100.75 - $72)/72 = 40%!

But...is this the right way to do it?

Baseball CPI - To compare P’s, keep Qs the same!

Growth of the cost of going to a baseball game = (New-Old)/Old

= ($80 - $72)/72 = 11%

The only thing that has changed is prices, not quantities

Cost of going to a baseball game over time

Making a price index (proportional to 100 in base year)

Dec. 2023 to Dec. 2024

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(318-309)/309 = 2.9%

Joel Mokyr, some guy, Robert Gordon

Biases in the CPI

• Bias = A consistent form of error (i.e. being usually too high)

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1. New Product Bias:  CPI ignores new products until they become cheap enough to be popular
• Causes CPI to overestimate inflation
2. Quality Improvement Bias:  If the price of a product goes up because it's better, then it's no inflation
• Causes CPI to overestimate inflation
3. Substitution Bias:  People switch between substitutes in response to high or low prices
• Causes CPI to overestimate inflation

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Other measures of average prices

Chained CPI

• Measure basket of average spending in 2023
• Use 2023 basket to compute CPI for 2023 to 2024, compute resulting inflation rate (6% for example)
• Measure basket of average spending in 2024
• Use 2024 basket to compute CPI for 2023 to 2024, compute resulting inflation rate (3% for example)
• Average these two CPI measures (4.5% here)
• Repeat this process for each year and scale up price index proportionately

CPI versus Chained CPI: Pretty similar

Measuring Inflation: Core versus Headline

The Federal Reserve likes to measure inflation with the PCE Deflator without Food or Energy

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• HUH?!  WHY?!
• "Core Inflation Rate" computed from PCE deflator without Food & Energy prices
• These are the elements where monetary policy has some degree of control over time
• "Headline Inflation Rate" computed from PCE deflator including Food & Energy prices
• Seriously, why?  
• Food and energy prices are affected by the weather and Putin!

NU’s Robert Gordon came up with the idea of core inflation

Headline jumpier than Core with no LR difference

Commodity prices are crazy!

Commodity prices driven more by supply & demand shifts than inflation

But does higher inflation lead to hyperinflation?

But does higher inflation lead to hyperinflation?

Hyperinflation is rapidly rising inflation, typically measuring more than 50% per month, cumulatively raising the price level by 1,000% or more.

What was going on with US inflation?

What was going on with US inflation?

• Inflation is the % rise in the weighted price of the goods in the basket
• We’re interested in it for (at least) two reasons
• 1) Higher inflation means, ceteris paribus, lower real income
• 2) Higher inflation now, might lead to even higher inflation in the future
• And really high inflation is terrible! (Low inflation is trivial)
• What if inflation were 5%, and that was because the price of every good in the basket was up by 5%?
• What if inflation were 5% because

one good was up by like one

billion % and everything else was

the same price as before?

Next up!

Unemployment!