Week 3 - Inflation

24 - Menu costs, 24.1 Measuring inflation, 24.2 Different measures of inflation, 24.3 Adjusting for the effects of inflation, 24.4 The role of money and costs of inflation

What is the cost of price changes called?

Menu costs

What is the association between menu costs and inflation?

The problem is, when inflation is high, flexible prices will rise while “sticky” prices (or benefits / wages) don’t adjust. 

Big distributional costs, or prices could be below marginal costs, causing shortages / decreasing quality.

For some firms, it is easy to change prices (or wages).

For others, it is very difficult. Universities for example cannot change their tuition fee without legislation.

Benefits like Universal Credit are difficult to adjust.

Define inflation

Generalised increase in overall level of prices, not just individual price. When inflation rise, some prices increase or decrease. Inflation can also be described as a rise in the cost of living. As a result, inflation is also a decline in the purchasing power of money

What is the most relevant measure of inflation?

The consumer price index (or CPI for short). 

The CPI measures the average prices people pay over time for the goods and services they buy in their everyday lives. 

The office for national statistics tracks the prices of a basket of goods and services that are commonly bought.

How is CPI constructed?

Step one: Find out what people typically buy.

Step two: Collect prices from the stores where people do their shopping.

Step three: Tally up the price of the basket of goods and services.

Step four: Calculate the inflation rate.

Inflation rate = (Price level this year - Price level last year)/Price level last year x 100

What are some challenges in measuring the true cost of living?

Quality improvements can hide price decreases

New products can make you better off, therefore reducing the cost of living. Introduction of a new product is equivalent to a large decrease in price (you cannot buy a product before it is introduced). But in inflation data, this does not show up as a price decrease. The product only enters the basket data once it is available.

You can save yourself money without sacrificing much - When we calculate inflation, we hold the consumption basket constant. But in reality, as relative prices change, we substitute consumption from rising price to falling price goods. This substitution reduces the effect of inflation on our living standards.

What are the different measures of inflation?

• Consumer Prices Index (CPI)

• Consumer Prices Index including Owner-Occupied Housing (CPIH)

• CPIH excl energy, food, alcohol & tobacco (See also Core CPI, Trimmed mean CPI)

• Retail Prices Index (RPI)

• Producer Prices Index (PPI)

• GDP Deflator

What is CPI?

• Harmonised methodology, supports international comparisons.

• Targeted by the Bank of England. 

  • CPI inflation target is 2%.

  • If CPI inflation is less than 1%, or greater than 3%, then the Bank of England governor is required to write a letter to the Chancellor to explain the discrepancy.

What is CPIH?

• CPI is based on households’ consumption purchases. Housing costs are captured in CPI through expenditure on rents.

• Rents can sometimes move in different ways from mortgage costs.

• CPIH also includes owner occupied costs (incl. mortgage spending), and also council tax. 

• In doing so, CPIH better reflects the cost of living for most UK households.

What is CPIH excl energy, food, alcohol & tobacco?

• (Also referred to as Core CPI, Trimmed mean CPI)

• Some components of the CPI basket have volatile prices, and are sensitive to one-off shocks like tax changes.

• Policymakers often focus on a trimmed CPI, with some more volatile goods and services excluded.

• By focusing on the more stable prices, can get a better measure of inflationary pressure in the economy.

What is RPI?

• The Retail Prices Index (RPI) was historically UK’s main measure of the price level. 

• RPI tracks a similar bundle of goods as the CPI.

• But it uses a statistical formula that generates biases in the inflation rate.

• Specifically, if a price rises, then falls by the same amount, this would generate positive inflation in the RPI, when the true inflation rate is zero.

• CPI fixes this problem.

• But, many contracts are linked to RPI, including some UK government bonds and private sector wage contracts / pensions.

• So RPI is still calculated, still important.

What is PPI?

• The PPI measures the prices paid by businesses for intermediate inputs used in production (PPI input) and also the prices received by businesses for their outputs “at the factory gate” (PPI output).

• Often more volatile than consumer prices, as retailers try to keep retail prices more stable.

• So, can be a predictor of consumer prices.

What is GDP Deflator?

• Measures the prices of goods and services produced in the UK.

• Excludes imports, which are not produced in the UK.

• Includes public services (in the UK and few other countries), which consumers don’t pay for.

What are real and nominal variables?

Real variables adjust for inflation.

A nominal variable is measured in pounds, but the value of a pound changes over time. 

Nominal variables can rise or fall due to either changing quantities or inflation.

Real variables aren’t affected by changing prices; they change only in response to changes in physical quantities.

What is the formula to adjust prices for inflation, and bring prices into a common base year?

Real value in 2012 dollars = nominal value in year t dollars x Price level in 2012/ Price level in year t

What is the formula for the real interest rate?

Real interest rate ≈ Nominal interest rate − Inflation rate

What are the effects of money illusion?

• Can distort decisions

• Can lead to mis-pricing

• Creates normal wage rigidity

Draw the graph illustrating normal wage rigidity

In summary page notes

What are the functions of money?

1. Money is a medium of exchange

2. Money is a unit of account

3. Money is a store of value

How does inflation affect the productive benefit of money?

When inflation is high or unpredictable, problems emerge. 

Money is also a less effective unit of account when its value is uncertain, because a price denominated in dollars is less informative when you aren’t sure what a dollar is worth. 

Skyrocketing inflation can undermine the role of money as a medium of exchange, undermines the productive benefit of money.

What are the costs of hyperinflation?

When inflation is high or unpredictable, problems emerge. 

Money is also a less effective unit of account when its value is uncertain, because a price denominated in dollars is less informative when you aren’t sure what a dollar is worth. 

Skyrocketing inflation can undermine the role of money as a medium of exchange.

Makes many aspects of life harder - banks constantly run out of money, atms need to be filled every 3 hours for a bus rides, backpacks used to carry money instead of wallets.

What are the costs of expected inflation?

Creates menu costs of sellers

Creates shoe-leather costs for clients - The time and effort it takes to manage cash, and to shop around as prices change, are called shoe-leather costs,  because they arise from running around town (which wears down the leather on your shoes).

Inflation confuses the signal that prices send

Inflation redistributes - When people borrow and lend, they agree an interest rate taking into account expected inflation.

If inflation is higher than expected, then the real value of loan repayments will be less than what the borrower and lender expected when they agreed the loan.

This will favour the borrower, and hurt the lender.

What is the inflation rate?

The inflation rate is the percentage change in the price of a fixed basket of goods. The inflation rate is the annual percentage increase in the average price level,

Is every price increase a sign of inflation?

Not every price change is a sign of inflation. You should distinguish the macroeconomic phenomena of inflation, which is a generalized rise in prices, from the microeconomic phenomena of relative price adjustment, in which the price of individual goods rises or falls relative to other prices as their specific supply and demand ebbs and flows. In reality, when there is inflation, there are also often relative price changes that are happening at the same time.

What is substitution bias?

Substituting low-inflation goods and services for high-inflation ones is a good strategy. But the CPI measures the prices of a fixed basket of goods, so it effectively assumes that people keep buying the same number of bananas no matter how expensive they get. It doesn’t capture substitution across items. This leads measured inflation to outpace changes in people’s actual cost of living. This is called substitution bias—the overestimate of the cost of living that occurs because people substitute toward goods and services whose prices rise by less.

What is the inflation adjustment formula?

Today’s dollars = another time’s dollars x price level today/price level another time

What is the nominal and real interest rate?

he nominal interest rate measures the return in dollars. he nominal interest rate measures the return in dollars.

What is the inflation fallacy?

The inflation fallacy is the mistaken belief that inflation destroys purchasing power.