Importance of Stable Prices as a Macroeconomic Goal

Why Care About Inflation?

• Inflation affects purchasing power and living standards.
• Key question: Is your income keeping pace with inflation?
  • Ahead of Inflation: Income rises faster than inflation ➡️ improved living standard.
  • Keeping Pace: Income rises at the same rate as inflation ➡️ stable living standard.
  • Falling Behind: Income rises slower than inflation ➡️ decreased living standard.

Real Income vs. Nominal Income

• Nominal Income: Actual dollar amount earned.
• Real Income: Nominal income adjusted for inflation (Nominal Income / Consumer Price Index (CPI)).
  • CPI reflects consumer price changes.

Case Studies

Case 1: Income Rises Faster Than Prices

• Example:
  • Year 1: Income = $50,000, CPI = 100
  • Year 2: Income = $60,000, CPI = 110
• Nominal Income Increase: 20%
• Price Increase: 10%
• Real Income Calculation:
  • Year 1: Real Income = $50,000
  • Year 2: Real Income = $60,000 / 110 * 100 = $54,545.45
• Outcome: Real income increased; living standard improved.

Case 2: Income Equals Price Increase

• Example:
  • Year 1: Income = $50,000, CPI = 100
  • Year 2: Income = $55,000, CPI = 110
• Nominal Income Increase: 10%
• Price Increase: 10%
• Real Income Calculation:
  • Year 1: Real Income = $50,000
  • Year 2: Real Income = $55,000 / 110 * 100 = $50,000
• Outcome: Real income unchanged; living standard stable.

Case 3: Income Rises Slower Than Prices

• Example:
  • Year 1: Income = $50,000, CPI = 100
  • Year 2: Income = $52,000, CPI = 110
• Nominal Income Increase: 4%
• Price Increase: 10%
• Real Income Calculation:
  • Year 1: Real Income = $50,000
  • Year 2: Real Income = $52,000 / 110 * 100 = $47,272.73
• Outcome: Real income decreased; living standard declined.

Conclusion

• Importance of monitoring inflation relative to income increases.
• Real income is a critical measure of economic well-being.

Next Topic: Unemployment

• Introduction to unemployment and its implications.