Ch. 16: Inflation and the Price Level

Inflation makes it difficult to compare past and present.

It also makes it difficult to do long-term planning.

We will discuss how to measure the price level and inflation using the Consumer Price Index.

I. Measuring the Price Level with the CPICPI: Consumer Price Index

-a measure of the average of the prices paid by urban consumers for a fixed “basket” of consumer goods and services relative to the costs of the same basket in the base year.

- The CPI basket is suppose to represent the consumption of a typical family of four living in a typical American city. It is based on surveys of family expenditures.

- BLS checks prices of 80,000 goods and services each month.

The CPI Basket

The figure illustrates the CPI basket. Housing is the largest component. Transportation and food and beverages are the next largest components. The remaining components account for 26 percent of the basket.

Note: when calculating real GDP, we picked a base year for prices and used prices from that year to value output in every year.

With CPI, it is the reverse: we use the quantities from a base year and use them to weight prices in other years.

CPI = (cost of fixed CPI basket at current year prices/ cost of fixed CPI basket at base year prices)×100

Calculating the CPI

Item 2000 2013

Rent – 2 bedroom apt $1,000$1,500Clothes - 5 outfits $ 200 $ 250Food – fixed amount $ 400 $ 470

total $1,600 $2,220

Suppose 2000 is the base yearCPI in 2013 = (2,220/1,600)×100 = 139, so cost of

living increased by 39% between 2000 and 2013

Base year always equals 100 (or 1). BLS base year CPI is 100.

• CPI is not itself the price of a specific good or service

• CPI has no units of measurement at all – it is an index

• The value of an index in a particular year has only meaning in comparison with the value of that index in another year

• There are other price measures widely used to track economy-wide price changes (Producer Price Index, GDP Deflator)

Inflation measures the change in average level of prices

Inflation Rate = 100 x (CPI this year – CPI last year)/CPI last year

CPI Inflation Rate

Nov. 2008 212.4Nov. 2009 216.3Nov. 2010 218.8Nov 2011 226.2Nov 2012 230.2Nov 2013 233.1Note: when inflation > 0, prices are rising. When inflation

< 0 (deflation) prices are falling. If inflation is positive and falling, prices are still rising.

1.8%1.1%3.4%1.8%1.2%

II. Inflation

Inflation(% change in CPI from year ago)

III. Adjusting for inflation1. Deflating a nominal quantity – example with one good.

Suppose in 1974, I spent $12.50 for paperback books

In 2009, I spent $67.50 for paperback books

What were the real quantities?

1974: price of a paperback was $1.25, thus Q = 10

2009: price was $7.50 Q = 9

2. Deflating a nominal quantity - example with Income

Example : starting salaries for a certain profession

1987: $35,000

2010: $120,000

Nominal salaries have increased over this period by 243%. Have real starting salaries also increased?

To compare, we need to put both salaries in same dollar terms.

CPI is in avg 1982-84 dollarsCPI in 1987: 1.136 (= 1987$/1982-84$)CPI in 2009: 2.169 (= 2010 $/1982-84$)

Lets express both salaries in base-period $: 1987 salary in base-period $ = $35,000 /cpi in 1987 = 35,000 / 1.136 = $30,8102010 salary in base-period $ = $120,000 / cpi in

2010= 120,000 / 2.169 = $55,325

So real salaries have increased by 79.6%($55,325 - $30,810) / $30,810 = 0.796

Now, lets put 1987 salary in 2010 $ ($35,000 /cpi in 1987 ) x cpi in 2010 = = ($35,000 /1.136) x 2.169 = $66,827Real salary in 1987, stated in 2010 $, was $66,827

2010 salary in 2010 $ = $120,000

So, so real salaries have increased by 79.6% ($120,000 - $66,827) / $66,827 = 0.796

3. Indexing to maintain buying power

Many payments are tied, or “indexed” to the CPI, meaning that the amounts paid rise or fall when CPI rises or falls.

For example, Social Security payments are adjusted each year to offset any increase in the consumer prices over the previous year.

Indexing – Practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index, preventing inflation from eroding purchasing power

3. Indexing to maintain buying powerExample:

The minimum wage is not indexed to inflation. If it had been, what would minimum wage be in 2013? Federal

Minimum Wage CPI

1950 $0.75 0.2412013 ? 2.330

Increase in cost of living between 1950 and 2013

CPI in 2013 / CPI in 1950 = 2.181 / 0.233 = 9.668

The cost of living in 2010 was 9.668 times what it was in 1950.Indexed minimum wage would have been 9.668 x $0.75 = $7.25 in 2013

IV. Does the CPI Measure “True” Inflation

This is a really important issue because significant amounts of government spending are linked to the CPI (e.g. Social Security cost of living increases)

Biases:1. Quality adjustment bias – explain

2. Commodity substitution bias – explain

3. Outlet substitution bias - explain

V. Inflation and interest ratesThe newspaper reports nominal interest rates Current 10 year Treasury Bond: 2.64% per year

In Sept. 1981, it was 15.3%. Why so much higher?Part of the reason is inflation

When someone lends you money, they care about the real value of what they get back.

Suppose you lend someone a 100 dollars. You give up consumption of goods and services when you lend money. Thus, a year later you want to get back at least an amount that will allow you to purchase the same amount of goods and services you could have purchased with the amount you lent.

Inflation and interest rates – example with real goods

Suppose you lend someone 100 bags of seed corn and they pay back 105 bags one year later.

The real return (or real interest rate) is r = (105 – 100)/100 = 0.05 or 5%Suppose we wanted to write the contract in $ but wanted to

maintain r = 5%.

Suppose that the price of seed corn is $1 in 2014 and expected to be $1.03 in 2015.

So, $ value of loan = 100 x $1 = $100.$ value of payback = 105 x $1.03 = $108.15Return in $ = (108.15 – 100)/100 = .0815 or 8.15%

Inflation and interest rates – example with real goods continued

Return in $ is the nominal interest rate.

Note that the nominal interest rate (i = 8.15%) is approximately equal to the real interest rate ( r = 5%) plus the inflation rate (π = 3%).

This is true generally:i ≈ r + π (The Fisher Effect)

Inflation and Interest Rates

• i ≈ r + π

Lenders do best when the real interest rate is high. If lenders want a real interest rate of 2% for example, the lender will seek to write a loan contract with a nominal rate equal to 2% plus his/her expected rate of inflation.

An unexpected surge in inflation is bad for lenders and good for borrowers.

Nominal vs. Real Treasury Bond Rates

1/5/00

4/27/0

0

8/17/0

0

12/8/

004/3

/01

7/25/0

1

11/19

/01

3/14/0

27/5

/02

10/25

/02

2/20/0

3

6/12/0

3

10/2/

03

1/28/0

4

5/19/0

4

9/10/0

41/4

/05

4/27/0

5

8/17/0

5

12/9/

054/4

/06

7/26/0

6

11/15

/06

3/12/0

7

6/29/0

7

10/22

/07

2/14/0

86/6

/08

9/26/0

8

1/22/0

9

5/14/0

99/3

/09

12/29

/09

4/21/1

0

8/11/1

0

12/3/

10

3/28/1

1

7/19/1

10

1

2

3

4

5

6

7

8

Real Interest Rates "Nominal Interest Rates"

VI. Costs of Inflation

• Shoe Leather Costs

• “Noise” in the Price System

• Distortions of the Tax System

• Unexpected Redistribution of Wealth

• Interference with Long Run Planning

MEASURES OF GERMANY HYPERINFLATION

Percentage Change in Various Measures of Inflation

Dates Internal Prices Price of Dollars Cost of Living*Feb 1920 to May 1921 4.6% -37.2% 39.2%May 1921 to July 1922 634.6% 692.2% 417.9%July 1922 to June 1923 18094% 22201% 13573%July 1923 to Nov 20 1923

854,000,000,000%

381,700,000,000%

560,000,000,000%

*food until June 1923, thereafter based on all items. These data were calculated by the Statistical Bureau of the Reich. All data are from The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany by Costantino Bresciani-Turroni (Augustus Kelley), pp. 30, 33, 35-6.

Example of one of the highest inflations ever

Highest Monthly Inflation Rates in History

CountryMonth with highest inflation rate

Highest monthly inflation rate

Equivalent daily inflation rate

Time required for prices to double

Hungary July 1946 1.30 x 1016% 195% 15.6 hours

ZimbabweMid-November 2008 (latest measurable)

79,600,000,000% 98.0% 24.7 hours

Yugoslavia January 1994 313,000,000% 64.6% 1.4 days

Germany October 1923 29,500% 20.9% 3.7 days

Source: Prof. Steve H. Hanke, February 5, 2009.

Life in Zimbabwe’s hyperinflation