5.1 PRICES

So we already know some concepts. We know how the Gov articulate fiscal policy: it elaborates the budget with more or less public expenditures and draft legislation to increase/decrease taxes.

We know how the Central Banks articulates monetary policies too, changing interests rates and so… so what? Here is where one of the most important concept appear: PRICES!!!

But… BCE or Fed or the authority in charge of issuing shells in Mozambique just can manage interest rates, then what does that BCE says the interest rate will increase with cocaine?

Basically prices are measured by a price index: a representative basket.

When we say representative means the price of articles we don’t usually use are not included. And, yes, soap and shampoo is included in that basket.

Let imagine that Eurostat or Bureau of Labor Statistics takes goods as a representation of the general price index: bread, gas, bus ticket, basmati rice, ibuprofen (and the hangover ones understand me), ketchup… and analyzing the movement of these prices the inflation rate is calculated.

As is funnier, let have a practical example!

An economy produces and consumes only gingerbread. Is funny thinking about a country where is only gingerbread produced… imagine now a thirsty inhabitant ;)

On 01/01/2010 gingerbread price was 5$/kg.

On 01/01/2011 gingerbread price was 5.25$/kg. hence the price increased in 5% (inflation)

Meanwhile, we deposit on 01/01/2010 100$ in GingerBank, yielding 10%. Thus on 1^st January 2011 we got $110

Mientras tanto, nosotros depositamos el 1 de enero de 2010 $100 en el Banco Polvorón, sabiendo que la rentabilidad es del 10%. El 1 de enero de 2011 tenemos 110$.

On 01/01/2010 we can buy 20 kg gingerbread but on 01/01/2011 we can buy 21 kg…

The diff between interest rate and inflation is the REAL interest rate and this is the one we mind.

r = i - π where r is real interest rate and π is the inflation rate

Did you think Greek letters were out of your life? NO! We have them in economics too!!

Therefore, the real interest rate is 10% - 5% = 5%.

Our real yield (5%) is actually lower than the nominal yield (10%)

	01/01/2010	01/01/2011	VARIACIÓN
Money ($)	100	110	+10%
Price ($/kg)	5	5,25	+5%
Gingerbread we can  purchase (kg)	20	21	+5%

At the end of the day what we really mind is the real interest rate, since it measures our REAL purchase power, moving away from the nominal figures the newspaper release.

Now we have to learn a bit of history… Good luck!