Inflatio
n
Inflatio
n
• Cost of
living
• Cause
• Effects
Inflatio
n
• Inflation means a sustained increase
in the aggregate or general price level
in an economy. Inflation means there
is an increase in the cost of living.
• “inflation means that your money
won’t buy as much today as you
could yesterday. ”
The Consumer Price Index
(CPI)
• measures the typical consumer’s cost of
living
• the basis of cost of living adjustments
(COLAs) in many contracts and in Social
Security
MEASURING THE
COST OF
4
How the CPI Is
Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS)
surveys consumers to determine what’s
in the typical consumer’s “shopping
basket.”
2. Find the prices.
The BLS collects data on the prices of
all the goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of
MEASURING THE
COST OF
5
How the CPI Is
4. Choose a base year and compute
Calculated
the index.
The CPI in any
equals
cost year
of basket
in current
100
x
year cost of basket in
base year
5.
Compute the inflation rate.
The percentage change in the CPI
from the preceding period.
Inflation
rate
=
MEASURING THE
COST OF
CPI this year – CPI last
year CPI last
year6
x
100%
basket:
EXAMP
10price
lattes}
LE
price
year
2007
of
pizza
$10
of
latte
$2.00
2008
$11
$2.50
{4 pizzas,
cost of basket
$10 x 4
+
$2 x 10
=
$60
$11 x 4
+ $2.5 x 10 =
$69
$12Inflation
x 4 2007
+ base
$3 x 10
using
rate:
=
$78
115 –
Compute
year
2009 CPI
$12in each
$3.00
2007: 100 x ($60/$60) =
100
year: =
15
100 10
%
0–
130
13% =
115 11
5
2008: 100 x ($69/$60) =
115
MEASURING THE
2009:
COST OF 100 x ($78/$60) =
7
x
100%
x
100%
ACTIVE
NG
1
LEARNI
Calculate the CPI
CPI basket:
{10 lbs beef,
20 lbs chicken}
price price of
of beef chicken
2004
$4
$4
2005
$5
$5
$9
$6
The CPI basket cost
2006
$120 in 2004, the
base year.
A. Compute the CPI in 2005.
B. What was the CPI inflation rate from 20052006?
8
ACTIVE
NG
1
LEARNI
Answers
CPI basket:
{10 lbs beef,
20 lbs chicken}
price price of
of beef chicken
2004
$4
$4
2005
$5
$5
$9
$6
The CPI basket cost
2006
$120 in 2004, the
base year.
A.
Compute the CPI in 2005:
Cost of CPI basket in 2005
= ($5 x 10) + ($5 x 20)
$150
=
CPI in 2005 = 100 x ($150/$120) =
9
ACTIVE
NG
1
LEARNI
Answers
price price of
of beef chicken
CPI basket:
{10 lbs beef,
20 lbs chicken}
2004
$4
$4
2005
$5
$5
The CPI basket cost
2006
$9
$120 in 2004, the
base year.
B. What was the inflation rate from 2005-
$6
2006? Cost of CPI basket in 2006
= ($9 x 10) + ($6 x 20) =
$210
CPI in 2006 =
=
175
100 x ($210/$120)
CPI inflation rate
=
(175 –
10
What’s in the CPI’s
Basket?
4% 3%
Housing
6%
Transportation
6%
Food & Beverages
43%
6%
Medical care
Recreation
Education and
communication
Apparel
15%
17%
MEASURING THE
COST OF
Other
11
ACTIVE
NG
2
LEARNI
Substitution
biasbasket:
CPI
{10# beef,
20# chicken}
2004-5:
Households
bought CPI
basket.
cost of CPI
beef chicken
basket
2004
$4
$4
$120
2005
$5
$5
$150
2006
$9
$6
$210
2006: Households bought
chicken}.
{5 lbs beef, 25 lbs
A. Compute cost of the 2006 household basket.
B. Compute % increase in cost of household
12
ACTIVE
NG
2
LEARNI
Answer
s basket:
CPI
{10# beef,
20# chicken}
Household
basket in
2006:
{5# beef,
25# chicken}
cost of CPI
beef chicken
basket
2004
$4
$4
$120
2005
$5
$5
$150
2006
$9
$6
$210
A. Compute cost of the 2006 household
basket. ($9 x 5) +
$195
($6 x 25)
=
13
ACTIVE
NG
2
LEARNI
Answer
s basket:
CPI
{10# beef,
20# chicken}
Household
basket in
2006:
{5# beef,
25# chicken}
cost of CPI
beef chicken
basket
2004
$4
$4
$120
2005
$5
$5
$150
2006
$9
$6
$210
B. Compute % increase in cost of household
basket over 2005-6, compare to CPI inflation
rate.
Rate of increase:
($195 – $150)/$150
14
•
•
•
•
Problems with the
Substitution Bias
CPI:
Over time, some prices rise faster than
others.
Consumers substitute toward goods
that become relatively cheaper.
The CPI misses this substitution because it
uses a fixed basket of goods.
Thus, the CPI overstates increases in
the cost of living.
MEASURING THE
COST OF
15
Problems with the CPI:
Introduction of New Goods
• The introduction of new goods
increases variety, allows consumers
to find products that more closely
meet their needs.
• In effect, dollars become more valuable.
• The CPI misses this effect because it
uses a fixed basket of goods.
• Thus, the CPI overstates increases in
the cost of living.
MEASURING THE
COST OF
16
Problems with the
CPI problems causes the
• Each of these
CPI to overstate cost of living
increases.
• The BLS has made technical
adjustments, but the CPI probably still
overstates inflation by about 0.5 percent
per year.
• This is important because Social Security
payments and many contracts have
COLAs tied to the CPI.
MEASURING THE
COST OF
18
Contrasting the CPI and GDP
Deflator
Imported
consumer goods:
– included in CPI
– excluded from GDP
Capital goods:
deflator
▪ excluded from CPI
▪ included in GDP deflator
The basket:
(if
produced
▪ CPI uses fixed
domestically)
▪ basket
GDP deflator uses basket of
currently produced goods &
services
This matters if different prices
are
changing by different
MEASURING THE
20
COST OF
amounts.
ACTIVE
LEARNING
3 GDP
CPI vs.
deflator
In each scenario, determine the effects on
the CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
21
Correcting Variables for Inflation:
Comparing Figures from Different
• Times
Inflation makes it harder to compare amounts
from different times.
• Example: the minimum wage
– Php 6 in April1965
– Php 491 in March 2017
• Did min wage have more purchasing
power in April 1965 or March 2017?
• To compare, use CPI to convert 1965 figure into
“today’s peso”…
MEASURING THE
COST OF
24
Correcting Variables for Inflation:
Comparing Figures from Different
▪
Times
Amount
Amount
in year
in today’s
T Php
=
Phpexample,
In our
▪ year T = 4/1965,
Price level
x
today Price level
in year T
“today” =
3/2017
▪ Min wage = 6 in year T
▪ CPI = 1.42 in year T,
The minimum
147.5 today
wage in 1965
was 623.24
in today’s
(2017)
MEASURING
THE
COST OF
peso.
CPI =
Php
623.24=
26
Php 6
x
147.
5
1.42
Correcting Variables for Inflation:
Comparing Dollar Figures from Different
Times
• Researchers, business analysts and policymaker
often use this technique to convert a time
series of current- dollar (nominal) figures into
constant-dollar (real) figures.
• They can then see how a variable has
changed over time after correcting for
inflation.
• Example: the minimum wage, from Jan 1950 to
Dec 2007…
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27
Correcting Variables for
Inflation: Real vs. Nominal
The nominal
interest
Interest
Rates
rate:
– the interest rate not corrected for inflation
– the rate of growth in the dollar value
of a deposit or debt
The real interest rate:
– corrected for inflation
– the rate of growth in the purchasing power
of a deposit or debt
Real interest rate
= (nominal interest rate) – (inflation
MEASURING THE
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32
Correcting Variables for
Inflation: Real vs. Nominal
Exampl Interest Rates
e:– Deposit $1,000 for one year.
– Nominal interest rate is 9%.
– During that year, inflation is 3.5%.
– Real interest rate
= Nominal interest rate – Inflation
=
9.0% –
3.5% =
5.5%
– The purchasing power of the $1000
deposit has grown 5.5%.
MEASURING THE
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33
CHAPTER
• The Consumer Price Index is a measure of the
SUMMARY
cost of
living.
The CPI tracks the cost of the typical
consumer’s “basket” of goods & services.
• The CPI is used to make Cost of Living
Adjustments and to correct economic variables
for the effects of inflation.
• The real interest rate is corrected for inflation
and is computed by subtracting the inflation rate
from the nominal interest rate.
35
Causes of
inflation
• Inflation means there is a sustained increase in the price level. The main
causes of inflation are either excess aggregate demand (economic
growth too fast) or cost push factors (supply-side factors).
1. Demand-pull inflation
• If the economy is at or close to full employment, then an increase in AD
leads to an increase in the price level. As firms reach full capacity, they
respond by putting up prices leading to inflation. Also, near full
employment with labour shortages, workers can get higher wages which
increase their spending power.
• AD can increase due to an increase
in any of its components C+I+G+X-M
• We tend to get demand-pull inflation if
economic growth is above the longrun trend rate of growth. The long run
trend rate of economic growth is the
average sustainable rate of growth
and is determined by the growth in
productivity.
2. Cost-push
inflation
• If there is an increase in the costs of
firms, then businesses will pass this
on to consumers. There will be a shift
to the left in the AS.
Cost-push inflation can be caused by many
factors
1.Rising wages
If trades unions can present a united front then they can bargain for higher wages. Rising
wages are a key cause of cost push inflation because wages are the most significant cost
for many firms. (higher wages may also contribute to rising demand)
2.Import prices
• ne third of all goods are imported in the UK. If there is a devaluation, then import prices will
become more expensive leading to an increase in inflation. A devaluation / depreciation
means the Pound is worth less. Therefore we have to pay more to buy the same imported
goods.
3. Raw material prices
• The best example is the price of oil. If the oil price increase by 20% then this will have a
significant impact on most goods in the economy and this will lead to cost-push inflation. E.g.,
in early 2008, there was a spike in the price of oil to over $150 causing a temporary rise in
inflation.
4.
Profit push inflation
• When firms push up prices to get higher rates of inflation. This is more likely to occur
during strong economic growth.
5.
Declining productivity
• If firms become less productive and allow costs to rise, this invariably leads to higher prices.
6. Higher taxes
• If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices,
What else could cause
inflation?
1. Rising house prices
• Rising house prices do not directly cause inflation, but they can
cause a positive wealth effect and encourage consumer-led
economic growth. This can indirectly cause demand-pull
inflation.
2. Printing more money
• If the Central Bank prints more money, you would expect to see a
rise in inflation. This is because the money supply plays an
important role in determining prices. If there is more money
chasing the same amount of goods, then prices will rise.
Hyperinflation is usually caused by an extreme increase in the
money supply.
• However, in exceptional circumstances – such as liquidity
trap/recession, it is possible to increase the money supply without
causing inflation. This is because, in recession, an increase in the
money supply may just be saved, e.g. banks don’t increase
lending but just keep more bank reserves.
Some Effects of
Inflation
• No positive social effect
•
•
•
•
•
•
•
•
•
Increase in prices
Distorts relative prices
Creates risks and uncertainty
Income diffusion effect
Benefit the inflators
Hurts fixed income groups
Hurts creditors
Hurts all holders of money
Increases consumption investment
ratio
• Lowers national savings