The Price Level and Inflation

CHAPTER

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Chapter 7

Measuring Price Level and Inflation• Price Level - average of the prices of all

good and services in the economy

• Price Index – a measure of the price level

• GDP deflator is a price index used to track rise and fall in the price level over time.

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x 100

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Index in General• Index - A series of numbers used to

track a variable’s rise or fall over time

• An index number is calculated as:

Example: Index Number for House Prices

Year House Price Index of House Price

1 $105,000 100.00

2 $110,000 104.76

3 $125,000 119.05

4 $135,000 128.57

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http://research.stlouisfed.org/fred2/series/SPCS20RSA

Note: $110,000/$105,000 = 1.0476 $135,000/$105,000 = 1.2857The convention is to multiply by 100.

Which year is the base period?

The Consumer Price Index• Consumer Price Index (CPI)

– An index of the cost over time of a market basket of goods purchased by a typical household

• CPI includes– the part of GDP that consumers

purchase as final users– household purchases of used goods

such as used cars or used computers– household purchases of imports

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The Consumer Price Index• CPI does not include

– Goods and services purchased by anyone other than consumers

– Prices of assets, such as stocks, bonds, and homes

• CPI market basket– The collection of goods and services that

the typical consumer buys

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Broad Categories and Relative Importance in the CPI, December 2010

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(1)define a market basket

(2) determine how much it would cost to purchase the market basket in the current year and in the base year

(3) divide the dollar cost of purchasing the market basket in the current year by the dollar cost of purchasing the market basket in the base year

(4) multiply the quotient by 100.

Calculating the Consumer Price Index

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Calculating the Consumer Price Index

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Calculating the Consumer Price Index

Market Basket using 2011 as the Base Year

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CPI in 2012 using 2011 as the based period

Consumer Price Index, December, selected years, 1970–2010

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1983 = 100

From Price Index to Inflation Rate

• Inflation rate – Percentage change in the price level from

one period to the next• Deflation

– A decrease in the price level from one period to the next

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Consumer Price Index, December, selected years, 1970–2010

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Year Rate of Inflation

2006

2007

2008

2009

2010

Consumer Price Index: 1940 - 2014

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The Rate of Inflation Using the Consumer Price Index, 1950–2014

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Three Way the CPI Is Used• (1) As a policy target; (2) To index

payments; (3) To translate from nominal to real values

• Policy target– One macroeconomic goal is stable prices

• Index payments – A payment that is periodically adjusted in

proportion with a price index such as

Social Security retirement income.17

Translate from Nominal to Real Values • Nominal wage

– Number of dollars you earn• Real wage

– Purchasing power of your wage

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Nominal and Real Weekly Earnings (December of Each Year)

19http://www.bls.gov/news.release/wkyeng.t01.htm

2014 $796 236.2 $337

How the CPI Is Used• When comparing dollar values over time

– We care not about the number of dollars, but about their purchasing power

– Translate nominal values into real values

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100Nominal ValueReal Value=

Price Index

There are Many price indexes

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• The GDP price index measures the prices of all final goods and services that are included in U.S. GDP

• The CPI measures the prices of all goods and services bought by U.S. households including used goods and imports

CPI vs. GDP DeflatorPrices of capital goods (Investment):

– included in GDP deflator (if produced domestically)

– excluded from CPI

Prices of imported consumer goods:– included in CPI– excluded from GDP deflator

The basket of goods:– CPI: fixed– GDP deflator: changes every year

The Costs of Inflation• The inflation myth

– “Inflation, by making goods and services more expensive, erodes the average purchasing power of income in the economy”

• Inflation does not directly decrease the average real income in the economy– because people’s income increase during

inflations. Prices and income tend to rise together. Not really hurt.

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The CPI and Average Hourly Earnings,

1965-2009

1965

= 1

00H

ourly wage in M

ay 2009 dollars

$0

$5

$10

$15

$20

0

100

200

300

400

500

600

700

800

900

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

CPI (1965 = 100)

Nominal average hourly earnings,

(1965 = 100)

Real average hourly earnings in 2009 dollars,

right scale

The Costs of Inflation

• But, Inflation changes the distribution of income.– People living on fixed incomes are

particularly hurt by inflation.

– And the poor have not fared so well. Welfare benefits are relatively fixed and have not kept pace with inflation.

Benefits Indexed to Inflation• To address the distribution problem,

benefits received by many retired workers, including social security, are fully indexed to inflation. – when prices rise, benefits rise.

• If inflation is correctly anticipated– and if both parties take it into account,

then inflation will not redistribute purchasing power

• Nominal interest rate The actual interest rate borrower’s pay and lender’s earn from making a loan

• Real interest rate The nominal interest rate adjusted for inflation• Calculation: - real interest rate = nominal interest rate - inflation

Interest Rates

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Example:I borrow $100 from a lender and agree to pay $105 after one year:

Loan amount = $100Interest payment = $5Nominal Interest rate = $5/ $100 = 5%The lender now has $105

Suppose inflation is 2%. What cost $100 a year earlier now cost $102.The lender’s purchasing power increases by $3 not $5.The real interest rate is 5% - %2 = 3% = Nominal interest rate - Rate of inflation

The Costs of Inflation• The real interest rate represents the

increase in purchasing power to the lender and the real cost of the loan to the borrower.

• If borrowers and lenders know the rate of inflation, they know the real cost and purchasing power of the loan

• Unexpected inflation shifts purchasing power

The Costs of Inflation• Inflation rate higher than expected

– Harms those awaiting payment (lenders)– Benefits the payers (borrowers)

• Inflation rate lower than expected – Harms the payers (borrowers)– Benefits those awaiting payment (lenders)

Is the CPI Accurate?• Sources of bias in CPI

– Substitution bias– New technologies – Changes in quality– Growth in discounting

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Is the CPI Accurate?• Substitution bias

– Quantity is fixed• New technology

– CPI: as new products are introduced, CPI overstates inflation

• Changes in quality– CPI: fails to fully account for quality

improvements in the goods and services in its market basket• Overestimates the price of the basket of

goods and services32

Is the CPI Accurate?

• Growth in discounting– CPI: does not recognize that a new

discount outlet lowers the prices on many items

– As discount outlets expand into new areas, the CPI overstates the inflation rate • Food, electronic appliances, clothing, and

other items sold there

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Is the CPI Accurate?

• Consequences of CPI bias

– Errors in calculating real wages– Errors in indexing

• Retirement benefits, wages, interest payments, or federal tax brackets

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The Controversy Over Indexing Social Security Benefits

• Social Security system– Benefits to about 60 million retired

workers in U.S.– One of the largest and most expensive of

all federal government programs• More than $770 billion in 2012• Estimated to grow to $1,400 billion in 2023

• Payments are indexed to CPI

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The Controversy …

• Because the CPI overstate inflation– Nominal payment rises by more than the

actual rise in the price level

– Benefits payments in real terms increase over time

– Purchasing power is automatically shifted toward those who are indexed and away from the rest of society

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Indexing and “Overindexing” Social Security Benefits

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