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Inflation
What is inflation?
• A rise in the general price level– $1.00 today does not buy as much as a dollar
from 1950.
– Example: The price of a pack of Wrigley’s gum recently increased from $.25 to $.30.
Why do we study inflation?
• Comparing different years:– Are we really better off?– Does our standard of living require more or less
money (which leads to more or less work)
• Monitoring the economy– Inflation helps us to know what is happening to our
standard of living right now.– The government adjusts policy in response to
inflation.
How do we measure inflation?
• A price index is a statistical series that can be used to measure changes in prices over time.– The Consumer Price Index is the most
commonly used.
• The Inflation Rate is the percentage change in the price index.
The Consumer Price Index
• The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.
– The Bureau of Labor Statistics reports the CPI each month.
– It is used to monitor changes in the cost of living over time.
The Consumer Price Index
When the CPI rises, the typical family has to spend more dollars (work more) to maintain the same standard of living.
How the Consumer Price Index is Calculated
1. Fix the basket. Determine what prices are most important to the typical consumer.
– The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys.
– BLS conducts monthly surveys to set the weights for the prices of those goods and services.
What is in the CPI’s Basket?
17%Transportation
15%Food and beverages
Medical care
6%
Recreation
6%
Apparel
4%
Other goodsand services
4%
42%Housing
6%Education and communication
How the Consumer Price Index Is Calculated
2. Find the prices. Find the prices of each of the goods and services in the basket for each point in time.
3. Compute the basket’s cost. Use prices to calculate the cost of the basket of goods and services at different times.
COMMON SENSE CHECKPOINT:
• The CPI is based on the cost of the same goods in different periods.
Price of:
In 2011
In 2010
In 2009
Price of:
Price of:
How the Consumer Price Index Is Calculated
4. Choose a base year and compute the index.
– Designate one year as the base year, against which other years are compared.
– Divide the basket price of a year by the price in the base year and multiply by 100.
100year basein basket of Price
services and goods ofbasket of Priceindex priceConsumer
How the Inflation is Calculated
5. Compute the inflation rate.
The inflation rate is the percentage change in the price index from the preceding period.
How the Inflation is Calculated
• The inflation rate is calculated as follows:
CPI in Year 2 CPI in Year 1Inflation Rate in Year 2= 100
CPI in Year 1
An Example
Calculating the Consumer Price Index and inflation rate:
– Base Year is 2007.
– Basket of goods in 2007 costs $1,200.
– The same basket in 2011 costs $1,236.
An Example
– CPI 2007 = ($1,200/$1,200) 100 = 100
– CPI 2011 = ($1,236/$1,200) 100 = 103
100year basein basket of Price
services and goods ofbasket of Priceindex priceConsumer
An Example
– The inflation rate = (103-100) * 100 = 3
100
– Prices increased 3 percent between 2007 and 2011.
CPI in Year 2 CPI in Year 1Inflation Rate in Year 2= 100
CPI in Year 1
The GDP Deflator versus the Consumer Price Index
• Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising.
• There are two important differences between the indexes that can cause them to diverge.
The GDP Deflator versus the Consumer Price Index
• The GDP deflator reflects the prices of all goods and services produced domestically, whereas...
• …the consumer price index reflects the prices of all goods and services bought by consumers.
The GDP Deflator versus the Consumer Price Index
• The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)...
• …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.
Figure 2 Two Measures of Inflation
1965
Percentper Year
15
CPI
GDP deflator
10
5
01970 1975 1980 1985 1990 20001995 2005
Problems in Measuring the Cost of Living
• Substitution Bias
• The basket does not change to reflect consumer reaction to changes in relative prices.
• Consumers substitute toward goods that have become relatively less expensive.
• The index overstates the increase in cost of living by not considering consumer substitution.
Problems in Measuring the Cost of Living
• Introduction of New Goods– The basket does not reflect the change in
purchasing power brought on by the introduction of new products.
– New products result in greater variety, which in turn makes each dollar more valuable.
– Consumers need fewer dollars to maintain any given standard of living.
Problems in Measuring the Cost of Living
• Unmeasured Quality Changes– If the quality of a good rises from one year to
the next, the value of a dollar rises, even if the price of the good stays the same.
– If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.
– The BLS tries to adjust the price for constant quality, but such differences are hard to measure.
Dollar Figures from Different Times
• Do the following to convert dollar values from different years into today’s dollars:
Amount intoday’s dollars
Amount in year X’s dollars
CPI Today
CPI in year X
Dollar Figures from Different Times
• Do the following to convert (inflate) President Hoover’s wages in 1931 to dollars in 2005:
Salary SalaryPrice level in 2005Price level in 1931
2005 1931
$75,.
$
000195152
19515
962,171
(Presidents Bush/Obama makes $400,000)
The GDP Deflator versus the Consumer Price Index
• REVIEW:
• The GDP deflator is calculated as follows:
G D P d efla to r =N o m in a l G D P
R eal G D P 1 0 0
Hyperinflation
• Hyperinflation is when prices rise at an uncontrollable rate.
• There is not a universally accepted definition, but 1923 Germany is the classic example.
• From January 1921 to November 1923, a newspaper increased in price from .30 marks to 70 million marks!!!
Price of a German Newspaper
DateMarks (German Dollars)
January, 1921 0.3
May, 1922 1
October, 1922 8
February, 1923 100
September, 1923 1000
October 1st, 1923 2000
October 15th, 1923 20000
October 29th, 1923 1 million
November 9th, 1923 15 million
November 17th, 1923 70 million
“Fun” Facts about Hyperinflation
• Some people wallpapered their house with money.
• A Man who had a whole life’s worth the retirement savings received a stamp in return because his account was too small.
• Workers were paid 3X per day, because what they got at breakfast could not provide lunch at noon.
• Germans ate bread made of potato skin and sawdust.
• People burned money because it was cheaper than buying wood.
• A man with a wheelbarrow full of money left it outside, and returned to find the wheelbarrow stolen, but the money dumped.
“Fun” Facts about Hyperinflation
• Banks took in money and added extra 0s, then sent it back out.
“Fun” Facts about Hyperinflation
Price Index and Inflation
• Hyperinflation in Germany 1922-1923
July 1914 1.0
Jan 1919 2.6
July 1919 3.4
Jan 1920 12.6
Jan 1921 14.4
July 1921 14.3
Jan 1922 36.7
July 1922 100.6
Jan 1923 2,785.0
July 1923 194,000.0
Nov 1923 726,000,000,000.0
Price Index
What’s the inflation rate between July and November 1923?
• 726,000,000,000 – 194,000
194,000
374,226,700 %
374 MILLION PERCENT IN LESS THAN 5 MONTHS!
X 100
