Chapter 5

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Chapter 5

Inflation and the Price Level

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Learning Objectives

1. Explain how the Consumer Price Index is constructed and use it to calculate the inflation rate

2. Show how the CPI is used eliminate the effects of inflation in economic data

3. Discuss the two most important biases in the CPI4. Distinguish between inflation and relative price

changes to find the true cost of inflation5. Understand the connections among inflation, nominal

interest rates, and real interest rates

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Measuring the Price Level Consumer Price Index (CPI) is a measure of changes

in prices. It measures: The cost of a standard basket of goods and

services in a given year Relative to the cost of the same basket of goods and

services in the base year CPI is: Not the price of a specific good or service An index, no units of measurement

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Calculating the CPI2000 Spending Monthly Cost in 2000Rent (2 bedroom apartment) $500Hamburgers (60 at $2 each) 120Movie tickets (10 at $6 each) 60Monthly expenditures $680

2005 Spending Monthly Cost in 2005Rent (2 bedroom apartment) $630Hamburgers (60 at $2.50 each) 150Movie tickets (10 at $7 each) 70Monthly expenditures $850

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Calculating the CPI CPI is the ratio of the cost of the basket of goods in

current year to the cost in the base year Base year cost $680 2005 cost $850

CPI = (850 / 680) (100) = 1.25 Cost of living in 2005 is 25% higher than in 2000 CPI for the base year is always 1 CPI for a given period is the cost of living in that

period relative to what it was in the base year

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Inflation The rate of inflation is the

annual percentage change in the price level

Inflation in 2004(1.889 – 1.840) / 1.840

= 0.027 = 2.7% Inflation in Great Depression Period of falling output

and prices Inflation rates are negative

Year CPI Inflation2003 1.840

2004 1.889 2.7%

2005 1.953 3.4%

2006 2.016 3.2%

2007 2.073 2.8%

Year CPI Inflation1929 0.171

1930 0.167 –2.3%

1931 0.152 –9.0%

1932 0.137 –9.9%

1933 0.130 –5.1%

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US Inflation Rates

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Adjusting for Inflation A nominal quantity is measured in terms of its current

dollar value A real quantity is measured in physical terms Quantities of goods and services

To compare values over time, use real quantities Deflating a nominal quantity converts it to a real

quantity Divide a nominal quantity by its price index to

express the quantity in real terms

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Family Income in 2000 and 2005 Can a family buy more with $20,000 in income in 2000

or with $22,000 in 2005? 2000 is the base year for the CPI Deflate nominal income in both years to get real

income Compare real income $20,000 in 2000 has the greater purchasing power

Year Nominal Income2000 $20,0002005 $22,000

CPI1.001.25

Real Income$20,000/1.00 = $20,000$22,000/1.25 = $17,600

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Real Wages Real wage is the purchasing power of worker's nominal

wages The real wage for any given period is calculated by

dividing the nominal wage by the CPI for that period US production worker wages CPI uses 1982 – 1984 as base year Real wages were higher in 1970

Year Average Wage1970 $3.402004 $15.68

CPI0.3881.889

Real Average Wage$3.40 / 0.388 = $8.76

$15.68 / 1.889 = $8.30

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Production Workers’ Wages, 1960 - 2006

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Indexing to Maintain Purchase Power Indexing increases a nominal quantity each period by

the percentage increase in a specific price index Indexing prevents the purchasing power of the

nominal quantity from being eroded by inflation

Example 1: Social Security benefits

Example 2: How indexing is included in labor contracts

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How indexing is included in labor contracts An indexed labor contract First year wage is $12 per hour

Real wages rise by 2% per year for next 2 years Relevant price index is 1.00 in first year, 1.05 in the

second, and 1.10 in the third Nominal wage is real wage times the price index

Year Real Wage1 $12.002 $12.243 $12.48

Price Index1.001.051.10

Nominal Wage$12.00$12.85$13.73

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CPI Quality Adjustment Bias One important bias in the CPI is its measurement of

price changes but not quality changes PC with 20% more memory has 20% higher price

Not the same PC as the one with less memory If not adjustment is made for quality, PC's

contribution to the CPI will be 20% Adjusting for quality is difficult due to large numbers of

goods Incorporating new goods is difficult No base year price for this year's new goods

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CPI Substitution Bias CPI uses a fixed basket of goods and services When the price of a good increases, consumers buy

less and substitute other goods. Failing to account for substitution overstates inflation.

Example: base year cost of market basket

Item 2000 price 2000 SpendingCoffee (50 cups) $1.00 $50.00Tea (50 cups) $1.00 $50.00Bread(100) $1.00 $100.00Total $200.00

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CPI Substitution Bias In 2005, coffee and scones are more expensive Buying exactly the same basket of goods costs $300,

compared to $200 in 2000 CPI = 300 / 200 = 1.50

Item 2005 price 2000 SpendingCoffee (50 cups) $2.00 $100.00Tea (50 cups) $1.00 $50.00Bread (100) $1.50 $150.00Total $300.00

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CPI Substitution Bias Actually, consumer substitutes tea for coffee Bread purchases constant

True CPI for consumer is 250 / 200 = 1.25 CPI estimate of 1.50 is 20% higher than the consumer's

experience

Item 2005 price 2000 SpendingCoffee (00 cups) $2.00 $0.00Tea (100 cups) $1.00 $100.00Bread (100) $1.50 $150.00Total $250.00

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Inflation vs. Relative Price Increase Price level is the overall level of prices at a particular

point in time Measured by a price index such as the CPI

Relative price of a specific good is a comparison to the prices of other goods and services Price of gas rise by 10%, other goods rise by 3% Price of gas rise by 3 %, other goods rise by 10%

Suppose we have a one-time doubling of the gas price Overall price level and inflation increase by a small

amount The increase in the relative price of gasoline is large

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Inflation and Relative Prices

Year CPI Inflation

2000 1.202001 1.32 10%2002 1.40 6%

Oil Price Change

8%8%

Relative Price of Oil

-2%2%

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Costs of Inflation “Noise” in the price system Distortions of the tax system, when provisions of tax

code are not indexed Shoe-leather cost Unexpected redistribution of wealth Interference with long-term planning

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Noisy Prices

Inflation creates static in the communication Buyers and sellers can't easily tell whether

The relative price of this good is increasing OR Inflation is increasing the price of this good and all

others Deciding these issues requires market participants

gather information – at a cost Response to changing prices is tentative and slow

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Unexpected Redistribution of Wealth Unexpected inflation redistributes wealth

Example: Unexpectedly high inflation benefits borrowers at theexpense of lenders Borrowers repay with dollars worth less than

anticipated

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Long-Run Planning Some decisions have a long time horizon Erratic inflation makes planning risky

Retirement planning requires an estimated cost for your desired life-style Erratic inflation makes estimation difficult Save too little and you live less well in the future Save too much and you live less well now

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Inflation and Interest Rates Unanticipated inflation helps borrowers and hurts

lenders Real interest rate is the annual percentage increase in

the purchasing power of financial assetsReal interest rate = nominal interest rate – inflation rate

r = i - Nominal interest rate is the annual percentage

increase in the dollar value of an asset Nominal interest rates are the most commonly stated

rates

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Inflation and Interest Rates

Interest rates on government bonds for selected years since 1970

Real interest rate is nominal interest rate minus inflation Real interest rate was

highest in 1985, 3.9% Real interest rate was

lowest in 1975, – 3.3% Financial investors and

lenders do best when the real interest rate is high

Year Interest Rate (%)

Inflation Rate (%)

1970 6.5% 5.7%

1975 5.8 9.1

1980 11.5 13.5

1985 7.5 3.6

1990 7.5 5.4

1995 5.5 2.8

2000 5.9 3.4

2004 1.4 2.7

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US Inflation and Interest Rates, 1960 - 2006