Measuring price level and inflation

created: 2020-02-04 · modified: 2020-09-09

Measuring the Price Level and Inflation

Basic Terminology

  • Aggregate price level (APL): overall level of prices in an economy
  • Inflation: occurs when the average aggregate price levels increase
  • Deflation: occurs when the average aggregate price levels decrease

Consumer Price Index (CPI)

  • The consumer price index (CPI) measures the rate of change of the aggregate price level (APL), indicating inflation/deflation.
  • The CPI measure cost of a standard basket of goods and services (i.e. typical consumers consumption bundle) in a given period of time relative to the cost in a base year.

Formula

The CPI is given by CPI=Cost of base year basket in current yearCost of base year basket in base year\text{CPI} = \frac{\text{Cost of base year basket in current year}}{\text{Cost of base year basket in base year}}

Calculation

1. Fix the basket (set the base year)

  • Information on standard or market basket is collected from about 7000 families spending habits on eight major groups of items:
    1. Food and beverages
    2. Housing
    3. Apparel
    4. Transportation
    5. Medical Care
    6. Recreation
    7. Education and communication
    8. Other goods and services
  • Additional costs include govt charged user fees like water and sewage, auto registration, etc.
  • Doesn’t include purchase of stocks, bonds, real estate, or life insurance
  • Note: you can’t compare CPIs across areas, standard basket composition varies significantly across areas

2. Find the prices

  • Data collectors call thousands of retail stores and offices across the US and records prices for about 80k items per month
  • Adjustments are made according to size, quantity, quality, and other product features (i.e. normalization)

CPI as Cost of Living Index

  • CPI is best approximation we have to a cost of living index
  • True CLI should measure changes over time in amount that consumers must spend to reach a certain utility level or standard of living
    • This well being is often determined heavily by non-market factors like rights, environment, political climate, etc. and are difficult to measure

BLS Base Year

  • BLS sets an average index level for the 36-month period over 1982-1984 equal to 100
  • Measurement changes in certain years are computed according to that base of 100; index of 110 would imply 10% increase since base year

Other Price Measures

The follow two price measures are related to CPI in that they are measures of the rate of change of costs

Producer Price Index (PPI)

  • Producer Price Index is the like CPI but for producers
  • Measures costs of goods and services like steel, electricity, etc
  • PPI signal regarded as an early predictor of changes in retail prices

GDP Deflator

The GDP deflator for a particular year is defined as

GDP Deflator in Year=Nominal GDP in YearReal GDP in Year (relative to a base year)⋅100\text{GDP Deflator in Year} = \frac{\text{Nominal GDP in Year}}{\text{Real GDP in Year (relative to a base year)}} \cdot 100

Differences between the measures

  • CPI includes sales/excise taxes while PPI does not
  • GDP deflator includes defense equipment, while CPI and PPI don’t
  • Despite this, the three measures generally move closely together (PPI typically showing greater variability)

CPI Example

Consider the simple hotdog and hamburger economy:

Year Price of hot dogs Quantity of hot dogs Price of burgers Quantity of burgers
2008 $1 100 $2 50
2009 $2 150 $3 100
2010 $3 200 $4 150
  • GDP deflator in 2010 with base year of 2009: 3∗200+4∗1502∗200+3∗150=1200850=1.41\frac{3*200+4*150}{2*200+3*150} = \frac{1200}{850} = 1.41
  • CPI in 2010: 3∗150+4∗1002∗150+3∗100=850600=1.42\frac{3*150+4*100}{2*150+3*100} = \frac{850}{600} = 1.42
  • Note here the two are mirrors:
    • GDP deflator holds prices from the base year constant and allows quantities to vary from base to current year
    • CPI holds quantities (from the basket) from the base year constant and allows prices to vary from base to current year

Inflation

  • CPI measures average level of prices relative to base year prices
  • Inflation is the rate of change in average price over time measured by rate of change of CPI over time
  • Rate of inflation is annual percetange rate of change measured by annual percentage rate of change in CPI (or PPI or deflator)
  • Confusing terminology here but the the former is change in average price over some arbitrary time period, latter is change in average price year by yearA
  • Great Depression (1929-1933) was period of negative inflation, or deflation

Adjusting for Inflation - Deflating and Indexing

CPI is a useful tool for eliminating inflation effects from economic data.

  • Nominal quantity: measured in terms of its current dollar value
  • Real quanitiy: measured in physical terms (goods and services)
  • CPI converts current (nominal) dollar values into real by dividing nominal terms by CPI; said to deflate the nominal quantity
  • Increasing nominal quantities by percentage increase in price index like CPI to prevent erosion of purchasing power; known as indexing
    • Some contracts indexed by law e.g. social security payments, labor contracts, etc
    • Some contracts not automatically indexed e.g. minimum wages

Minimum Wage Example

  • Real minimum wage in 1950: $0.75/0.241=$3.11\text{\textdollar}0.75/0.241 = \text{\textdollar}3.11 in 1984 dollars
  • To maintain real value of $3.11, current minimum wage is $3.11⋅2.51≈$7.80\text{\textdollar}3.11 \cdot 2.51 \approx \text{\textdollar}7.80
  • Current Fed minimum wage is $7.25

Is the CPI Biased?

1996 report concluded that official CPI overstates true inflation rate by roughly 1-2% points a year. This would result in

  • Increased governnment spending because of indexed social security contracts
  • Underestimating living standard improvements

Two Reasons CPI Overstates Inflation Rate

  • CPI unable to account for all improvements in quality of products and introduction of new products (quality adjustment bias)
    • No internet or phones in 1985; innovations widen consumer choice and make fixed amount of money worth more
  • CPI unable for account for all ways in which consumer may substitute cheaper product for more expensive one (substitution bias)
    • Example: car pooling or driving more efficient cars as gas prices rise

Substitution Bias Example

CPI used fixed basket of goods/services; base year cost of market basket:

Item 2000 Price 2000 Spending
Coffee (50 cups) $1.00 $50.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.00 $100.00
Total $200.00

In 2005 coffee and scones become more expensive

Item 2000 Price 2000 Spending
Coffee (50 cups) $2.00 $100.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.50 $150.00
Total $300.00

But in reality, consumers substitute tea for coffee (assume purchased scones is same amount as before)

  • True CPI for consumer is 250/200 = 1.25
  • CPI estimate of 1.50 is 20% higher than consumer’s experience
Item 2000 Price 2000 Spending
Coffee (0 cups) $2.00 $0.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.50 $150.00
Total $250.00

Controlling Inflation

  • To counteract relative price changes, govt policy has to make changes in the market for that specific good/service
  • To counteract inflation, govt must use economy wide fiscal/monetary policy

True Costs of Inflation

  1. Noise in price system
  2. Distortions of tax system
  3. Shoe leather costs
  4. Menu costs
  5. Unexpected redistribution of wealth
  6. Interference with long run planning

1. Noise in price system

  • Prices transmit information about cost of production and marginal buyer value
  • Inflation creates static in the communication

2. Distortions of tax system

  • Bracket creep occurs when household moved into higher tax bracket due to increases in nominal but not real income
  • Income taxes are indexed
  • Taxes can distort people’s incentives to work, save, invest

3. Shoe leather costs

  • Cash lubricates economic transactions
  • Inflation reduces purchasing power and raises cost of holding cash

5. Unexpected redistribution of wealth

  • Unexpected inflation redistributes wealth
  • Unexpectedly high inflation hurts workers with non-indexed contracts and benefits employers; salaries remain fixed despite lost value of the dollar
  • Unexpectedly high inflation benefits borrowers at expense of lenders; borrowers repay with dollars worth less than anticipated i.e. don’t have to pay full inflated amount

6. Interference with long run planning

  • Some decisions have long-term horizon
  • Retirement requires planning for desired lifestyle

Hyperinflation

Hyperinflation is an extremely high inflation rate

Example

Two countries Alpha and Beta. Alpha has currency alphan, inflation expected to remain at zero, bank deposits pay 2% nominal annual interest; Beta has current betan, inflation expected to remain at 10%; bank deposits pay 10% nominal annual interest; which country has better deal for citizens

  • r=i−πr = i - \pi, where rr is real interest rate, ii is nominal interest rate, π\pi is rate of inflation
  • Real interest rate is annual percentage increasing in purchasing power of financial assets, nominal interest rate is annual percentage increase in nominal value of asset
  • At time of purchase for asset with fixed nominal rate, future inflation rates are unknown and thus expected rates are used