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Chapter 5Econ104 Parks

InflationInflation

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Measuring Inflation

• To measure inflation, we must first construct a price index.

• A price index is a device for measuring price level changes by tracking the price of a designated bundle of goods and services through time with respect to a base year.

• To measure inflation, we must first construct a price index.

• A price index is a device for measuring price level changes by tracking the price of a designated bundle of goods and services through time with respect to a base year.

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Step to Construct a Price Index

1. Select a base year. The price index for the base year is set equal to 100.

2. Select a bundle of goods and services for which prices will be monitored over time.

3. Compute the cost of the bundle in the base year.

4. Compute the cost of the bundle in the year you wish to compare to the base year (year i).

5. Apply the following formula:

1. Select a base year. The price index for the base year is set equal to 100.

2. Select a bundle of goods and services for which prices will be monitored over time.

3. Compute the cost of the bundle in the base year.

4. Compute the cost of the bundle in the year you wish to compare to the base year (year i).

5. Apply the following formula:

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Example of a “Movie” Price Index

Base year is 1996. Bundle consists of two bags of popcorn, one movie ticket, and one soft drink.

Base year is 1996. Bundle consists of two bags of popcorn, one movie ticket, and one soft drink.

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prices price inflation1996 4 7 21997 4.5 7.5 2 1.125 1.0714 1.00001998 5 7.5 2 1.25 1.0714 1.0000

quantaties2 1 1

expenditures Total CPI1996 8 7 2 17 1.00001997 9 7.5 2 18.5 1.08821998 10 7.5 2 19.5 1.1471

relative importance

1996 0.4706 0.4118 0.1176 1

1997 0.4865 0.4054 0.1081 1 0.5294 0.4412 0.1176 1.08821998 0.5128 0.3846 0.1026 1 0.5882 0.4412 0.1176 1.1471

relative importance times price inflation

http://econ124.wustl.edu/sp09/calc-relimport.xls

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Weights – Relative Importance

• http://econ124.wustl.edu/sp09/calc-relimport.xls

• http://econ124.wustl.edu/sp09/cpi-rel-importance.xls

• http://econ124.wustl.edu/sp09/calc-relimport.xls

• http://econ124.wustl.edu/sp09/cpi-rel-importance.xls

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Using a Price Index to Measure Inflation

• Once we create a price index, we can use that index to calculate the inflation rate.

• The inflation rate is the percentage change in the price index from one year to the next, or

• Once we create a price index, we can use that index to calculate the inflation rate.

• The inflation rate is the percentage change in the price index from one year to the next, or

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Inflation at the Movies

• Inflation in 1997 is (108.8 - 100)/100 x 100 = 8.8%• Inflation in 1998 = (114.7 - 108.8)/108.8 x 100 = 5.4%

• Inflation in 1997 is (108.8 - 100)/100 x 100 = 8.8%• Inflation in 1998 = (114.7 - 108.8)/108.8 x 100 = 5.4%

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Movie Price Index Recalculated Using Consumption Patterns from 1998

• Base year is 1996. Bundle consists of one bag of popcorn, one movie ticket, and two soft drinks.

• Inflation rates are now 6.7% and 3.1%.

• Base year is 1996. Bundle consists of one bag of popcorn, one movie ticket, and two soft drinks.

• Inflation rates are now 6.7% and 3.1%.

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A Problem with the Fixed-Weight Price Index

• Substitution bias occurs in a fixed-weight price index because consumers substitute away from those goods and services rising the most quickly, and purchase more of the relatively lower-cost items.– A fixed-weight price index tends to overstate

the true cost of living.

• Substitution bias occurs in a fixed-weight price index because consumers substitute away from those goods and services rising the most quickly, and purchase more of the relatively lower-cost items.– A fixed-weight price index tends to overstate

the true cost of living.

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The Geometric Mean Price Index

• A geometric mean price index re-weights quantities in the price index each year for certain categories of the CPI. Therefore, changes in consumption patterns due to relative price changes are picked up quickly and the substitution bias is reduced.

• A geometric mean price index re-weights quantities in the price index each year for certain categories of the CPI. Therefore, changes in consumption patterns due to relative price changes are picked up quickly and the substitution bias is reduced.

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The Geometric Mean Price Index

• The geometric mean of two numbers is the square root of their product.

• The geometric mean of two numbers is the square root of their product.

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Common Price Indices

• The CPI, PPI, and GDP Deflator are the three most common price indices in the U.S. economy.– Consumer Price Index (CPI) is composed of

the bundle of goods and services that the typical urban household consumes.

– Producer Price Index (PPI) consists of a bundle of goods traded at the wholesale level.

– (Implicit) GDP deflator consists of the bundle of all newly produced final goods and services.

• The CPI, PPI, and GDP Deflator are the three most common price indices in the U.S. economy.– Consumer Price Index (CPI) is composed of

the bundle of goods and services that the typical urban household consumes.

– Producer Price Index (PPI) consists of a bundle of goods traded at the wholesale level.

– (Implicit) GDP deflator consists of the bundle of all newly produced final goods and services.

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Deflating Nominals to Reals

• Another important function of a price index is to compare prices across time.– A nominal value is not corrected for the effects

of inflation.– A real value is the value of a good or service

that is corrected for the effects of inflation.– Deflating is the process of deriving the real

value of some nominal value by dividing by an appropriate price index.

• Another important function of a price index is to compare prices across time.– A nominal value is not corrected for the effects

of inflation.– A real value is the value of a good or service

that is corrected for the effects of inflation.– Deflating is the process of deriving the real

value of some nominal value by dividing by an appropriate price index.

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An Example

• Suppose that gasoline cost $1.45 in November 2002 but just $0.74 in November 1978. In which year was gasoline cheaper in real terms?– The CPI in Nov. 1978 was 67.5.– The CPI in Nov. 2002 was 181.5.– Real price of gasoline in 1978 was:

• $0.74/67.5 x 100 = $1.10

– Real price of gasoline in 2002 was:• $1.45/181.5 x 100 = $0.80.

• Gas was much less expensive in 2002.

• Suppose that gasoline cost $1.45 in November 2002 but just $0.74 in November 1978. In which year was gasoline cheaper in real terms?– The CPI in Nov. 1978 was 67.5.– The CPI in Nov. 2002 was 181.5.– Real price of gasoline in 1978 was:

• $0.74/67.5 x 100 = $1.10

– Real price of gasoline in 2002 was:• $1.45/181.5 x 100 = $0.80.

• Gas was much less expensive in 2002.

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Economic data available at ECONOMAGIC.COM

• http://economagic.com• http://economagic.com

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Inflation

• Inflation is a sustained increase in the price level.

• The price level is the weighted average of all prices in the economy (as measured by a given price index).

• Inflation is a sustained increase in the price level.

• The price level is the weighted average of all prices in the economy (as measured by a given price index).

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U.S. Inflation Rates

• Inflation increased a bit in 2004 and 2005 due to higher energy prices.

• Inflation increased a bit in 2004 and 2005 due to higher energy prices.

Inflation Rate

0

2

4

6

8

10

12

14

1970

1975

1980

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1995

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2005

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U.S. CPI NSA AND SA

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U.S. SA AND NSA Inflation Rates

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U.S. Inflation Rates

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Why Is Inflation Costly?

• When prices rise, wages don’t always keep up.• When prices rise, wages don’t always keep up.

Inflation and Compensation(%change)

0

2

4

6

8

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12

14

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Inf lation

Compensation

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Other Costs of Inflation

• If inflation is anticipated, the costs include:– Shoe-leather costs– Menu costs– Tax costs

• If inflation in unanticipated, the costs include:– The arbitrary redistribution of income– Inflation uncertainty

• If inflation is anticipated, the costs include:– Shoe-leather costs– Menu costs– Tax costs

• If inflation in unanticipated, the costs include:– The arbitrary redistribution of income– Inflation uncertainty

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Hyperinflation

• Hyperinflation is inflation that proceeds at exceptionally high rates.

• Some historical examples:– Germany Oct. 1923: 29,586%.– Nicaragua in 1988: 33,602%– Brazil 1990: 2,360%.

• The root cause is usually excessive money creation by the government to pay off debt.

• Hyperinflation is inflation that proceeds at exceptionally high rates.

• Some historical examples:– Germany Oct. 1923: 29,586%.– Nicaragua in 1988: 33,602%– Brazil 1990: 2,360%.

• The root cause is usually excessive money creation by the government to pay off debt.