Measuring the Price
Level and Inflation
MB
MC
MB MC
Introduction

What Do You Think?

Could you retire in thirty years if you have
$1 million at that point?
Chapter 6: Measuring the Price Level and Inflation
Slide 2
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
The Consumer Price Index:
Measuring the Price Level
Consumer Price Index (CPI)

For any period, CPI measures the cost in
that period of a standard basket of goods
and services relative to the cost of the
same basket of goods and services in a
fixed benchmark year, called the base year
Chapter 6: Measuring the Price Level and Inflation
Slide 3
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
The Consumer Price Index:
Measuring the Price Level
Constructing the CPI

CPI for current year = 100 x
current cost of the base-year basket
------------------------------------------------------- .
base-year cost of the base-year basket

The CPI is a price index.
Chapter 6: Measuring the Price Level and Inflation
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Cost of Reproducing the 1995 (Base-Year)
Basket of Goods and Services in Year 2000
Expenditures of a Hypothetical Household
Item
Cost in 2000
Cost in 1995
$630
$500
60 Hamburgers
150
120
10 Movie tickets
70
60
$850
$680
Rent, two-bedroom apartment
Total expenditure
CPI for 2000 = 100x($850/$680) = 125
CPI for 1995 = 100x($680/$680) = 100
Living cost rose by 25% from 1995 to 2000.
Chapter 6: Measuring the Price Level and Inflation
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Inflation

CPI


Inflation


Measures the average level of prices
relative to prices in the base year
Measures how fast the average price level
is changing over time
Inflation Rate

Is the percentage change in the price level
Chapter 6: Measuring the Price Level and Inflation
Slide 6
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Calculating Inflation
Rates: 1972 - 1976
Year
CPI
1972
0.418
1973
0.444
1974
0.493
1975
0.538
1976
0.569
Inflation rate : 1972 - '73 
0.444 - 0.418
 0.062 x 100  6.2%
0.418
Inflation rate : 1973 - '74 
0.493 - 0.444
 0.110 x 100  11.0%
0.444
Chapter 6: Measuring the Price Level and Inflation
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Calculating Inflation
Rates: 1929 - 1933
Year
CPI
1929
0.171
1930
0.167
1931
0.152
1932
0.137
1933
0.130
Inflation rate : 1929 - '30 
0.167 - 0.171
 - 0.023 x 100  - 2.3%
0.171
Inflation rate : 1930 - '31 
0.152 - 0.167
 - 0.090 x 100  - 9.0%
0.167
Chapter 6: Measuring the Price Level and Inflation
Slide 8
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Inflation

Deflation

A situation in which the prices of most
goods and services are falling over time so
that inflation rate is negative
Chapter 6: Measuring the Price Level and Inflation
Slide 9
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Adjusting for Inflation

Deflating a Nominal Quantity

Nominal Quantity
A
quantity that is measured in terms of its
current dollar value

Real Quantity
A
quantity that is measured in physical terms -for example, in terms of quantities of goods and
services
Chapter 6: Measuring the Price Level and Inflation
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Adjusting for Inflation

Deflating a Nominal Quantity

A process of dividing a nominal quantity by
a price index (such as the CPI) to express
the quantity in real terms
Chapter 6: Measuring the Price Level and Inflation
Slide 11
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Comparing the Real Values of a
Family’s Income in 1995 and 2000
Year
Nominal family
income
CPI
Real family income =
Nominal family income/CPI
1995
$20,000
1.00
$20,000/1.00 = $20,000
2000
$22,000
1.25
$22,000/1.25 = $17,600
What deflating does here is to transform the $22,000
nominal income of year 2000 into a real quantity that is
comparable to year 1995’s income $20,000. The last
column of the table above shows that in real terms, the
family’s income dropped by 12%, though in nominal
terms, it went up by 10%.
Chapter 6: Measuring the Price Level and Inflation
Slide 12
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Adjusting for Inflation

Example: Home run hitters drive Cadillacs
 1930
Babe Ruth’s salary was $80,000
 1998 Mark McGwire’s salary was $8.3 million
Who was earning more?
 CPI (1982 - 84 = 1.00)
o 1930 = 0.167
o 1998 = 1.64
o Babe Ruth’s real salary = $80,000/0.167 =
$479,000
o Mark McGwire’s real salary = $8.3 million/1.64
= $5.06 million
Chapter 6: Measuring the Price Level and Inflation
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Adjusting for Inflation

Real Wage

The wage paid to workers measured in
terms of real purchasing power

The real wage for any given period is
calculated by dividing the nominal (dollar)
wage by the CPI for that period
Chapter 6: Measuring the Price Level and Inflation
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Adjusting for Inflation

Real Wages of U.S. Production Workers
Nominal Wages
CPI (1982 - 84 = 1.00)
Real Wage
1970
$3.23
0.388
$3.23/0.388 = $8.32
1990
$10.01
1.307
$10.01/1.307 = $7.66
Chapter 6: Measuring the Price Level and Inflation
Slide 15
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Nominal and Real Wages for
Production Workers’ 1960 - 2001
Chapter 6: Measuring the Price Level and Inflation
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Adjusting for Inflation

Indexing
The practice of increasing a nominal
quantity each period by an amount equal to
the percentage increase in a specified
price index
 Indexing prevents the purchasing power of
the nominal quantity from being eroded by
inflation

Chapter 6: Measuring the Price Level and Inflation
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Adjusting for Inflation

Indexing to Maintain Buying Power

An example:
Social Security Payment Inflation
2000
$1,000/month
2000 - 2005 = 20%
2005
$????/month if indexed to inflation
Chapter 6: Measuring the Price Level and Inflation
Slide 18
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Adjusting for Inflation

Economic Naturalist
Every few years there is a well-publicized
battle in Congress over whether the minimum
wage should be raised.
 Why do these heated debates recur so
regularly?

Chapter 6: Measuring the Price Level and Inflation
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Does the CPI Measure
“True” Inflation?

1996 report by the Boskin Commission
estimated that the CPI overstates inflation by
as much as 1 to 2 percentage points a year.

Overstating Inflation


Would unnecessarily increase government
spending
Underestimate the improvements in the standard
of living
Chapter 6: Measuring the Price Level and Inflation
Slide 20
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
Does the CPI Measure
“True” Inflation?
Two Causes of the CPI Overestimation
of Inflation
Quality adjustment bias
 Substitution bias

Chapter 6: Measuring the Price Level and Inflation
Slide 21
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
Does the CPI Measure
“True” Inflation?
Substitution Bias -- An Example
A consumer likes coffee and tea equally well
Items (quantities)
Expenditure
by 1995 Prices
by 2000 Prices
Coffee (50 cups)
$1/cup =
$50
$2/cup =
$100
Tea (50 cups)
$1/cup =
$50
$1/cup =
$50
Scones (100)
$1each= $100
Total
$1.50ea. = $150
$200
$300
Inflation 1995 ~ 2000 = $300/$200 – 1 = 50%
Chapter 6: Measuring the Price Level and Inflation
Slide 22
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
Does the CPI Measure
“True” Inflation?
Substitution Bias -- An Example
Item (Yr. 2000 quantity w/substitution)
Expenditure
Coffee (0 cups at $2/cup)
$0.00
Tea (100 cups at $1/cup)
$100.00
Scones (100 at $1.50 each)
$150.00
Total
$250.00
Inflation
1995 ~ 2000 w/substitution
= $250/$200 –1 = 25%
Chapter 6: Measuring the Price Level and Inflation
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
Does the CPI Measure
“True” Inflation?
Economic Naturalist

Why is inflation in the health care sector
apparently high?
Chapter 6: Measuring the Price Level and Inflation
Slide 24
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
Price Level


The Costs of Inflation:
Not What You Think
A measure of the overall level of prices at a
particular point in time as measured by a
price index such as the CPI
Relative Price

The price of a specific good or service in
comparison to the prices of other goods
and services
Chapter 6: Measuring the Price Level and Inflation
Slide 25
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
The Costs of Inflation:
Not What You Think
Observations
Changes in relative price do not
necessarily imply a significant amount of
inflation.
 Inflation can be high without affecting
relative prices.

Chapter 6: Measuring the Price Level and Inflation
Slide 26
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
The Costs of Inflation:
Not What You Think
Observations
To counteract relative price changes,
government policy would have to affect the
market for specific goods.
 To counteract inflation, the government
must use monetary and fiscal policy.

Chapter 6: Measuring the Price Level and Inflation
Slide 27
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
The Costs of Inflation:
Not What You Think
The Price Level, Relative Prices, and
Inflation
CPI
% change in oil prices
Inflation
Relative price of oil
2000 1.20
8% (2000 ~2001)
10%
-2%
8% (2001 ~ 2002)
6%
+2%
2001 1.32
2002 1.40
Chapter 6: Measuring the Price Level and Inflation
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The True Costs of Inflation

“Shoe-Leather” Costs

The use of resources to economize on
holding cash during periods of high
inflation
Chapter 6: Measuring the Price Level and Inflation
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The True Costs of Inflation

Shoe-Leather Costs at Woodrow’s
Hardware
Need $5,000 cash/day
 May withdraw $25,000 on Monday or
$5,000/day
 Cost of a withdraw = $4/trip

Chapter 6: Measuring the Price Level and Inflation
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The True Costs of Inflation

Shoe-Leather Costs at Woodrow’s
Hardware

When there is no inflation,
 Withdraw
$25,000 every Monday
 Shoe-leather cost = $4/week or $200/year
(if assuming 50 weeks/year)
Chapter 6: Measuring the Price Level and Inflation
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The True Costs of Inflation

Shoe-Leather Costs at Woodrow’s
Hardware

With 10% inflation per year,
 If
withdrawing $25,000 every Monday,
o Average cash holding/day = $15,000
o Cost of holding cash = $15,000 x 10% = $1,500/year
o Shoe-leather cost = $200/year
Chapter 6: Measuring the Price Level and Inflation
Slide 32
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The True Costs of Inflation

Shoe-Leather Costs at Woodrow’s Hardware

With 10% inflation a year,
 If
withdrawing $5,000 daily, instead of $25,000 every
Monday
o Average cash holding/day = $5,000
o Cost of holding cash = $5,000 x 10% = $500/year
o Shoe-leather cost = $4/trip x 250 trips (50 wks)
= $1000/year
Marginal Benefit of going daily = $1,000 saved on costing
of holding cash
Marginal Cost of going daily = $800 increase in shoeleather cost
So the choice is to bank daily, which increases the shoeleather cost
Chapter 6: Measuring the Price Level and Inflation
Slide 33
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The True Costs of Inflation

“Noise” in the Price System

With high inflation, producers have greater
difficulty telling whether the changes in the prices
of their goods or services are changes in relative
prices or just a reflection of the general price
inflation.

As such, high inflation obscures the information
transmitted by prices and reduces the efficiency of
the market system
Chapter 6: Measuring the Price Level and Inflation
Slide 34
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The True Costs of Inflation

Distortions of the Tax System

Inflation, Indexation, and -- Bracket
creep
 Capital depreciation allowance
Chapter 6: Measuring the Price Level and Inflation
Slide 35
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The True Costs of Inflation

Observation

Inflation may distort the incentives provided
by the tax system for people to work, save,
and invest and reduce economic growth.
Chapter 6: Measuring the Price Level and Inflation
Slide 36
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The True Costs of Inflation

Unexpected Redistribution of Wealth
From workers to employers if wages are
not indexed to inflation
 From lenders to borrowers

Chapter 6: Measuring the Price Level and Inflation
Slide 37
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The True Costs of Inflation

Interference with Long-Run Planning
Retirement planning
 Investment and business strategies

Chapter 6: Measuring the Price Level and Inflation
Slide 38
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Hyperinflation

Cost of Hyperinflation

Fischer, Sahay, and Vegh examined 133
market economies 1960 - 96
 45
episodes of high inflation (100% +) in 25
countries
o Real GDP/person fell by an average of 1.6%/yr
o Real consumption/ person fell by an average of
1.3%/yr
o Real investment/person fell by an average of 3.3%/yr
Chapter 6: Measuring the Price Level and Inflation
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Inflation and Interest Rates

Nominal (market) Interest Rate
The annual percentage increase in the nominal value
of a financial asset

Real Interest Rate
The annual percentage increase in the
purchasing power of a financial asset. It
equals the nominal interest rate on that
asset minus the inflation rate.
Chapter 6: Measuring the Price Level and Inflation
Slide 40
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Inflation and Interest Rates

Inflation and the Real Interest Rate
Real Interest Rate (r )  nominal interst (i ) - the inflation rate( )
r  i -
Chapter 6: Measuring the Price Level and Inflation
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Inflation and Interest Rates
Year
Real Interest
1970
1975
1980
1985
1990
1995
2000
0.80
-3.3
-2.0
3.9
2.1
2.7
2.2
=
Nominal Interest
6.5
5.8
11.5
7.5
7.5
5.5
4.7
Chapter 6: Measuring the Price Level and Inflation
-
Inflation
5.7
9.1
13.5
3.6
5.4
2.8
2.5
Slide 42
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The Real Interest Rate in the
United States, 1960 - 2001
Chapter 6: Measuring the Price Level and Inflation
Slide 43
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Inflation and Interest Rates

Fisher-Effect

The tendency for nominal interest rates to
be high when inflation is high and low
when inflation is low
Chapter 6: Measuring the Price Level and Inflation
Slide 44
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Inflation and Interest Rates in the
United States, 1960 - 2001
Chapter 6: Measuring the Price Level and Inflation
Slide 45