PART 2 - 2.4-2.5 Inflation and CPI

Shortcomings Associated with CPI

1. Substitution Bias

2. Introduction of New Goods

3. Unmeasured Quality Changes

Substitution Bias

• FIXED BASKET - market basket doesn’t change to reflect consumer reaction to changes in relative prices

  • ex. consumer switches to cheaper goods

Introduction of New Goods

• Market Basket does not reflect change in purchasing power brought on by the introduction of new products.

New products → Greater variety → each $ is more valuable

• Consumers need fewer $ to maintain a given standard of living

  • ex. $10/month streaming service vs $1/download songs

Unmeasured Quality Changes

• If the quality of a good rises over time, the value of a dollar rises, even if the price of the good stays the same

  • ex. movies getting better over time

  • ex. automobiles over time

Why does it matter if the CPI understates or overstates the true inflation rate?

The government uses CPI to adjust gov. programs for inflation (make COLAs)

If CPI understates inflation, COLAs will be lower than they need to be

Types of Inflation

1. Demand Pull Inflation

2. Cost Push Inflation

3. Hyperinflation

Demand Pull Inflation

Inflation caused by rising demand

1. too many consumers chasing too few goods (Demand rising too fast)

2. Excessive spending in fear of future inflation

3. Too few unemployed and wages inflate due to competition

Cost Push Inflation

when inflation is caused by lower supply

1. Natural Disasters cut supply

2. Political actions, like boycotts or tariffs, cut the supply

3. Natural reduction of natural resources with no new discoveries

Hyperinflation

very high & accelerating inflation, typically caused by overprinting currency

• usually so government can pay for its spending without having to tax

Disinflation

an overall decrease in the inflation rate

• Generally wanted, but super hard to maintain

  • ex. 3% to 1% → still inflation, but less inflation

Deflation

an overall decrease in price level

• negative inflation, so things are cheaper than before

  • ex. -2%

Inflation’s Positive Effects- Who it helps!

1. Flexible-Income Receivers

2. Debtors/Borrowers

Flexible-Income Receivers

unaffected because businesses anticipate inflation (COLA)

Debtors/Borrowers

pay back loans with “cheap” dollars

lower interest rate than inflation %

Inflation’s Negative Effects- Who it hurts!

1. Fixed Income Receivers

2. Savers

3. Creditors/Lenders

Fixed Income Receivers

Elderly retirees, government workers, minimum wage workers, etc.

Savers

paper assets lose value over time when interest rate is lower than inflation rate

Creditors/Lenders

lenders are paid back in “cheaper” dollars and have a loss of “real” income