Methods of Measuring Inflation
Methods of Measuring Inflation
Inflation refers to a situation in which the economy’s overall price level is rising (sustained rise in the price level over a given period of time).The inflation rate is the percentage change in the price level from the previous period.
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. A country’s bureau of National Statistics reports the CPI each month. It is used to monitor changes in the cost of living over time.
When the CPI rises, the typical family has to spend more euros to maintain the same standard of living.
How the Consumer Price Index Is Calculated
• Fix the Basket: Determine what prices are most important to the typical consumer.
The nation’s bureau of National Statistics identifies a market basket of goods and services the typical consumer buys. The bureau conducts monthly consumer surveys to set the weights for the prices of those goods and services.
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• Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.
• Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.
• Choose a Base Year and Compute the Index:
• Designate one year as the base year, making it the benchmark against which other years are compared.
• Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.
• Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.
• The Inflation Rate
• The inflation rate is calculated as follows:
Calculating the Consumer Price Index and the Inflation Rate: An Example
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Calculate the rate of inflation between 2001 and 2002, and 2002 and 2003
Problems in Measuring the Cost of Living
The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
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.
Changes in relative prices lead consumers to change the items they buy. People cut back on items that become relatively more costly and increase their consumption of items that become relatively less costly.
For example, suppose the price of beef rises while the price of chicken remains constant. Now that beef is more costly relative to chicken, you might decide to buy more chicken and less beef. Suppose that you switch from beef to chicken, spend the same amount on meat as before and get the same enjoyment as before. Your cost of meat has not changed. But the CPI says that the price of meat has increased because it ignores your substitution between goods in the CPI basket.
In another arena, when confronted with higher prices, people use discount stores more frequently and non-discount stores less frequently. Suppose that petrol prices rise by 10 cents a litre. Instead of buying from your nearby petrol station for $1.50 a litre, you now drive farther to a petrol station that charges $1.40 a litre. Your cost of petrol has increased when you factor in opportunity cost but your cost has not increased by as much as the 10 cents a litre increase in the pump price.
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 euros to maintain any given standard of living.
If you compare the price level in 2015 with that of 1995 you must somehow compare the price of a digital camera today with a film camera in 1995. Because digital cameras do a better job than film cameras you are better off with the new technology if the prices were the same. But digital cameras are more expensive than film cameras. How much of the higher price is a sign of higher quality? As the statisticians are not sure, they simply consider the price increase as a non-qualitative increase.
Unmeasured Quality Changes
If the quality of a good rises from one year to the next, the value of a euro 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 euro falls, even if the price of the good stays the same. The Statistics bureau tries to adjust the price for constant quality, but such differences are hard to measure.
Cars and many other items get better every year. Central locking, airbags and antilock braking systems all add to the quality of a car. But they also add to the cost. Is the improvement in quality greater than the increase in cost? Or do car prices rise by more than can be accounted for by quality improvements? To the extent that a price rise is a payment for improved quality, it is not inflation. But the CPI probably counts too much of any price rise as inflation (overstates inflation).
Conclusion
• The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living.
• The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices.
• The CPI overstates inflation by about 1 percentage point per year.
The GDP Deflator versus the Consumer Price Index
• The GDP deflator is calculated as follows:
• 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 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.
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Inflation in the United States between 1965 and 2000
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Questions
1: Suppose that people consume only three goods as shown in the following table:
Tennis Tennis Lucozade
Balls Racquets
2007 price €2 €40 €1
2007 quantity 100 10 200
2008 price €2 €60 €2
2008 quantity 100 10 200
a) What is the percentage change in the price of each of the three goods? What is the percentage change in the overall price level?
b) Do tennis racquets become more or less expensive relative to Lucozade? Does the well-being of some people change relative to the well-being of others? Explain.
2: Suppose that the residents of Vegopia spend all of their income on cauliflower, broccoli and carrots. In 2007, they buy 100 heads of cauliflower for €200, 50 bunches of broccoli for €75, and 500 carrots for €50. In 2008 they buy 75 heads of cauliflower for €225, 80 bunches of broccoli for €120, and 500 carrots for €100. If the base year is 2007, what is the CPI in both years? What is the inflation rate in 2008?
3: From 1947 to 1997 the consumer price index in the United States rose 637%. Use this fact to adjust each of the following 1947 prices for the effects of inflation. Which items cost less in 1997 than in 1947 after adjusting for inflation? Which items cost more?
Item 1947 Price 1997 price
University of Iowa tuition $130 $2470
Gallon of gasoline $0.23 $1.22
3-min phone call for NY to LA $2.50 $0.45
1-day hospital stay in ICU $35 $2300
McDonald’s hamburger $0.15 $0.59
4: The New York Times cost $0.15 in 1970 and $0.75 in 1999. The average wage in manufacturing was $3.35 per hour in 1970 and $13.84 in 1999.
a) By what percentage did the price of a newspaper rise?
b) By what percentage did the wage rise?
c) In each year, how many minutes does a worker have to work to earn enough to buy a newspaper?
d) Did workers’ purchasing power in terms of newspapers rise or fall?
5: Income tax brackets were not indexed for inflation until 1985 in the USA. When inflation pushed up people’s nominal incomes during the 1970s, what do you think happened to real tax revenue?
6: When deciding how much of their income to save for retirement, should workers consider the real or the nominal interest rate that their savings will earn?
7: Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation turns out to be higher than they both expected.
a) Is the real interest rate on this loan higher or lower than expected?
b) Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?
c) Inflation during the 1970s was much higher than most people had expected when the decade began. How did this affect homeowners who obtained fixed rate mortgages during the 1960s? How did this affect the banks who lent the money?
The Short-run trade-off between inflation and unemployment
Society faces a short-run tradeoff between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.
Short-run Phillips Curve (SRPC)
The Phillips curve illustrates the short-run relationship between inflation and unemployment.
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The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.
• The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.
• A higher level of output results in a lower level of unemployment.
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The Short-Run Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.
Expectations and the Short-Run Phillips Curve
Expected inflation measures how much people expect the overall price level to change.
In the long run, expected inflation adjusts to changes in actual inflation. The central bank’s ability to create unexpected inflation exists only in the short run. Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.
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Question
Suppose the natural rate of unemployment (NAIRU) is 6%. On one graph, draw two Phillips Curves (SRPC & LRPC) that can be used to illustrate the four situations listed below. Label the point that shows the position of the economy in each case:
a) Actual inflation is 5% and expected inflation is 3%
b) Actual inflation is 3% and expected inflation is 5%
c) Actual inflation is 5% and expected inflation is 5%
d) Actual inflation is 3% and expected inflation is 3%
The Long-Run Phillips Curve
In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
• As a result, the long-run Phillips curve is vertical at the natural rate of unemployment (NAIRU – non-accelerating inflation rate of unemployment)
• Monetary policy could be effective in the short run but not in the long run.
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The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis. Historical observations support the natural-rate hypothesis.
• The concept of a stable Phillips curve broke down in the in the early ’70s.
• During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.
SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS
In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum.
• Fight the unemployment battle by expanding aggregate demand and accelerate inflation.
• Fight inflation by contracting aggregate demand and endure even higher unemployment.
THE COST OF REDUCING INFLATION
To reduce inflation, the Fed has to pursue contractionary monetary policy. When the central bank slows the rate of money growth, it contracts aggregate demand. This reduces the quantity of goods and services that firms produce. This leads to a rise in unemployment.
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To reduce inflation, an economy must endure a period of high unemployment and low output.
• When the central bank combats inflation, the economy moves down the short-run Phillips curve.
• The economy experiences lower inflation but at the cost of higher unemployment.
The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.
• An estimate of the sacrifice ratio is five.
• To reduce inflation in the United States from about 10% in 1979-1981 to 4% would have required an estimated sacrifice of 30% of annual output!
However, if expectations about the future course of inflation adjust quickly, then the sacrifice ratio would be much smaller.
Questions
1: Illustrate the effects of the following developments on both the SRPC and LRPC. Give the economic reasoning underlying your answers.
a) A rise in the natural rate of unemployment (NAIRU)
b) A decline in the price of imported oil.
c) A rise in government spending
d) A decline in expected inflation.
2: Suppose that a fall in consumer spending causes a recession.
a) Illustrate the changes in the economy using both an aggregate demand/aggregate demand diagram and a Phillips Curve diagram. What happens to inflation and unemployment in the short-run?
b) Now suppose that over time expected inflation changes in the same direction that actual inflation changes. What happens to the position of the SRPC? After the recession is over, does the economy face a better or worse set of inflation-unemployment combinations?
3: Suppose the economy is in long-run equilibrium.
a) Draw the economy’s short-run and long-run Phillips curves.
b) Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on your diagram in part(a).If the monetary authorities undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate?
c) Now suppose the economy is back in long-run equilibrium, and then the price of imported oil rises. Show the effect of this shock with a new diagram like that in part (a). If the central bank undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? If the central bank undertakes contractionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate?
4: Suppose the monetary authorities announced it would pursue contractionary monetary policy in order to reduce the inflation rate. Would the following conditions make the ensuing recession more or less severe? Explain.
a) Wage contracts have short durations.
b) There is little confidence in the monetary authorities’ determination to reduce inflation.
c) Expectations of inflation adjust quickly to actual inflation.
5: Some economists believe that the SRPC is relatively steep and shifts quickly in response to changes in the economy. Would these economists be more or less to favour contractionary policy in order to reduce inflation?
6: Imagine an economy in which all wages are set in three-year contracts. In this world, the central bank announces a disinflationary change in monetary policy to begin immediately. Everyone in the economy believes the central bank’s announcement. Would this disinflation be costless?
7: Suppose the monetary authorities believed that the natural rate of unemployment was 6% when the actual natural rate was 5.5%. If the monetary authorities based its policy decisions on this belief, what would happen to the economy?
8: Suppose the central bank policymakers accept the theory of the SRPC and the natural rate hypothesis and want to keep unemployment close to its natural rate. Unfortunately, because the natural rate of unemployment can change over time, they aren’t certain about the value of the natural rate. What macroeconomic variable do you think they should look at when conducting monetary policy?
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FYI: What’s in the CPI’s Basket?
16%
Food and
Beverages
17%
Transportation
Medical care
6%
Recreation
6%
Apparel
4%
Other goods
and services
4%
41%
Housing
6%
Education and
Communication
Copyright©2004 South-Western
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[pic]
Figure 2 Two Measures of Inflation
1965
Percent
per Year
15
CPI
GDP deflator
10
5
0
1970
1975
1980
1985
1990
2000
1995
Copyright©2004 South-Western
Figure 1 The Phillips Curve
Unemployment
Rate (percent)
0
Inflation
Rate
(percent
per year)
Phillips curve
4
B
6
7
A
2
Copyright © 2004 South-Western
Figure 2 How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
Quantity
of Output
0
Short-run
aggregate
supply
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate (percent)
0
Inflation
Rate
(Percent
per year)
Price
Level
(b) The Phillips Curve
Phillips curve
Low aggregate
Demand
High
Aggregate demand
(Output is
8,000)
B
4
6
(Output is
7,500)
A
7
2
8,000
(Unemployment
is 4%)
106
B
(Unemployment
is 7%)
7,500
102
A
Figure 5 How Expected Inflation Shifts the Short-Run Phillips Curve
Unemployment
Rate
0
Natural rate of
Unemployment
Inflation
Rate
Long-run
Phillips curve
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
1. Expansionary policy moves
the economy up along the
short-run Phillips curve . . .
2. . . . but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
C
B
A
Copyright © 2004 South-Western
Figure 3 The Long-Run Phillips Curve
Unemployment
Rate
0
Natural rate of
Unemployment
Inflation
Rate
Long-run
Phillips curve
B
High
Inflation
Low
Inflation
A
2. . . . but unemployment
remains at its natural rate
in the long run.
1. When the
Fed increases
the growth rate
of the money
supply, the
rate of inflation
increases . . .
Figure 4 How the Phillips Curve is related to Aggregate Demand and Aggregate Supply
Quantity
of Output
Natural rate
of output
Natural rate of
Unemployment
0
Price
Level
P
Aggregate
Demand,
AD
Long-run aggregate
supply
Long-run Phillips
curve
(a) The Model of Aggregate Demand and Aggregate Supply
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
2. . . . raises
the price
level . . .
- t´
$ % ) D ? ¼ Æ Ç â ã !#Db‹?·¸¹È
6
ƒ
1. An increase in
the money supply
increases aggregate
demand . . .
A
AD2
B
A
4. . . . but leaves output and unemployment
at their natural rates.
3. . . . and
increases the
inflation rate . . .
P2
B
Figure 10 Disinflationary Monetary Policy in the Short Run and the Long Run
Unemployment
Rate
0
Natural rate of
unemployment
Inflation
Rate
Long-run
Phillips curve
Short-run Phillips curve
with high expected
inflation
Short-run Phillips curve
with low expected
inflation
1. Contractionary policy moves
the economy down along the
short-run Phillips curve . . .
2. . . . but in the long run, expected
inflation falls, and the short-run
Phillips curve shifts to the left.
B
C
A
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