Inflation

Why a Dollar is not Worth a Dollar any More

Some Key Definitions
Inflation is an increase in the average price of goods and services over
time.
 
Deflation is a decrease in the average price of goods and services over
time.
 
Disinflation is a decrease in the rate of inflation.
 
Creeping inflation is a very slow increase in the average price of goods
and services over time.
 
Hyperinflation is a very rapid increase in the average price of goods
and services over time.
Where do We Stand?
From the website www.bls.gov
Consumer Price Index - All Urban Consumers

1-Month Percent Change

Series Id: CUSR0000SA0
Seasonally Adjusted
Area: U.S. city average
Item: All items
Base Period: 1982-84=100
What does it Mean?
At any point in time, some prices are rising, some are
falling, and some are not changing. So inflation means
that, on average, prices are rising.
The price level is a weighted average of the prices of
goods and services.
Calculating a Price Index
Inflation is measured in terms of the percentage
change in a price index over a given period of time.

 A price index is used to determine the average level of

prices at any given period of time. Specifically it is a
weighted average of the price of goods and services in
some predetermined market basket.
Calculating a Price Index
Any price index is a ratio of current prices to the prices
in some designated base year.
 
Current Value of the Market Basket
Price Index = ------------------------------------------ X 100
Base Value of the Market Basket
 
Note that the price index for the base year is always 100.
Also note that, for simplicity, the authors have chosen
not to multiply their ratios by 100.
Calculating a Price Index
There are two ways of calculating a price index.
Based Weighted Index
Current Weighted Index

 
The difference between the two approaches is which
quantities are used to calculate the values of the market
baskets.
Calculating a Price Index
To see how the approaches work, consider the
following information.

Year 1 Year 2
(base)
Quantity Price Quantity Price
Food 40 units $6 50 units $4
Clothing 20 $10 40 $10
Shelter 10 $25 10 $30
Calculating a Price Index
To calculate the price index using the base weighted
approach, the values of the numerator and denominator
are based on the base year quantities.

(4x40)+(10x20)+(30x10) 660
P.I. = ---------------------------------X100=------x100=95.6
(6x40)+(10x20)+(25x10) 690
Calculating a Price Index
To calculate the price index using the current weighted
approach, the values of the numerator and denominator
are based on the current year quantities.

Example: Using the same table we just used, calculate

the value of the current weighted index.
Calculating a Price Index
From these figures you can see that while the two
approaches are similar, they do not yield the same
results. Base weighted indexes tend to overstate
inflation. At the same time base weighted indexes are
easier and cheaper to calculate.
Important Price Indexes
There are four main price indexes that are used.
The consumer price index (CPI) measures prices at the
retail level for an urban family of four; base weighted
index.
The producer price index (PPI) measures prices at the
wholesale level; base weighted index.
The implicit price deflator (also called the GDP deflator)
measures the prices of all goods and services produced in
the economy; current weighted.
The personal consumption expenditure (PCE) price
index measures the prices of the goods that make up the
household spending portion of GDP; current weighted.
Measuring the Rate of Inflation
The rate of inflation is calculated as the percentage
change in the price index.

Rate of Inflation = [(P2 – P1)/P1] x 100

Example: P1 = 175 and P2 = 200

Rate of Inflation = [(200-175)/175] x 100 = 14.3%
Examples
Calculate the rate of inflation for the following sets of
price indexes.
1. P1 = 145 and P2 = 153

2. P1 = 210 and P2 = 215

Calculating Real Values
Deflating a nominal value refers to the process of
converting nominal values into real values by
removing the effects of price changes.
Nominal values are measured in terms of current dollars.

Real values are measured in terms of constant dollars.

  Real Value = (Nominal Value/Price Index) x 100

 
Example: Nominal Value = $150,000 and P = 150
Real Value = (150,000/150) x 100 = $100,000
Examples
Use the following information to deflate the nominal
GDP. Assume the price index has a value of 130 and
the nominal GDP is $10.4 trillion.

Wesley earned $42,000 in wages last year and $44,000

in wages this year. If the price index was 110 last year
and 115 this year, determine the change in the real
wage that Wesley received.
Biases in Measuring Inflation
As with unemployment, there are a number of biases
in the measurement of the price level and inflation.
the Qualitative Bias
the Market Basket Bias
the Substitution Bias
The Purchase Location Bias
Biases in Measuring Inflation
The qualitative bias arises from the fact that products
today are qualitatively better than products in the base
year. These qualitative changes affect prices, but are
not reflected in the inflation rate.

The market basket bias is the result of the fact that the
CPI is designed to measure the cost of living for an
urban household of four people. If you do not fall into
this group, the CPI is not a good measure of your cost
of living.
Biases in Measuring Inflation
The substitution bias tells us that we no longer buy the
same types of products in the same proportions as we
did in the base year. This is because price changes
affect your buying decisions. These changes in buying
patterns are not reflected in the base weighted indexes.

Another general problem is that changes in consumer

behavior in terms of where they make their purchases
are not reflected in the indexes.
Biases in Measuring Inflation
To properly interpret inflation data, we must look for
the trends over time.
Costs of Inflation
There are four main costs associated with inflation.
Inflation creates an arbitrary redistribution of income.
Because of inflation, there is lost production.
Inflation generates “shoe leather” costs.
Inflation reduces the purchasing power of money and
wealth.
Costs of Inflation
Inflation creates an arbitrary set of winners and losers.

For example debtors gain at the expense of lenders

when there is unexpected inflation.
Before the Fact:
Nominal Interest = Desired Real Interest + Expected
Inflation
After the fact:

  Actual Real Interest = Nominal Interest – Actual

Inflation
Costs of Inflation
Examples:
1. Suppose that the desired real rate of interest is 4% and
the expected rate of inflation is 1%. Calculate the
nominal rate of interest.
Nominal Rate = 4% + 1% = 5%
2. Using the nominal rate of interest you determined in
the first example, calculate the actual real interest if the
actual rate of inflation is 3%.
Actual Real Rate = 5% - 3% = 2%
Costs of Inflation
Examples: Suppose that inflation was less than
expected. In each of the following cases, determine
who wins and who loses.
Home owners vs. Renters
People on Fixed Incomes vs. Workers
Mortgage Lenders vs. Home Owners
Costs of Inflation
There is lost production for two main reasons.
uncertainty reduces borrowing and investment
wasted resources

 
Shoe leather costs also arise from the uncertainty.
People can no longer evaluate the information
transmitted by prices. People must search out
additional information to determine if a given price is a
good price or not.
Types of Inflation
We recognize that there are two possible sources of
inflation.
Demand Pull Inflation
Cost Push Inflation (also known as Stagflation)

The effects of demand pull inflation are higher prices,

higher production, and a lower unemployment rate.

The effects of cost push inflation are higher prices,

lower production, and a higher unemployment rate.
Types of Inflation
Demand-Pull Inflation

Price Level
Demand-Pull
Inflation is the
AS1
result of an
increase in
P2 aggregate demand.

P1
AD2

AD1

Real GDP
Y1 Y2
Types of Inflation
Cost-Push Inflation

Price Level AS2

Cost-Push
Inflation or
AS1
Stagflation is the
result of a
P2 decrease in
aggregate supply.
P1

AD1

Real GDP
Y2 Y1
What does it All Mean?
Inflation is an increase in the average price level over
time.
We have to be very careful with the inflation statistics
because there are a number of biases in the
measurement.
Increases in the price level reduce the buying power of
things expressed in monetary terms.
The inflation that is usually associated with the
business cycle is demand-pull inflation.
Both expected and unexpected inflation can cause
problems for the economy