Econ Chapter 9: Inflation

Inflation

Inflation is a general and ongoing rise in the level of prices in an entire economy.  

• Inflation does not refer to a change in relative prices. 

  - A relative price change occurs when you see that the price of tuition has risen, but the price of laptops has fallen.  

• Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the economy.

Disinflation

is a decrease in the inflation rate or a slowdown in the upward movement of prices for goods and services in the economy. 

Hyperinflation

is a very rapid rise in the overall price level; an extremely high rate of inflation.

Deflation

is severe negative inflation (decrease in price)

Consumer prince index (CPI)

• Definition: The CPI measures the average change over time in the prices paid by urban consumers for a fixed basket of goods and services.

• Purpose:

  • Tracks inflation and cost of living.

  • Guides wage adjustments, social security, and monetary policy.

• Formula:
  CPI = (Cost of Market Basket in Current Year / Cost of Market Basket in Base Year) × 100

• Notes:

  • A rising CPI = inflation; a falling CPI = deflation.

  • Does not account for changes in consumption patterns or new products immediately.

Personal consumption expenditure (PCE)

Measure the cost of all goods and services purchased by the entire personal sector, including those by third parties like employers.  

• PCE is going to have a much broader scope, including items like employer-paid healthcare and the expenditure weights are updated more frequently (monthly).

•  The Federal Reserve uses the Personal Consumption Expenditures price index as its primary inflation gauge to set monetary policy.  

• CPI is typically 0.3 to 0.4 percentage points higher on average. 

Producer price index (PPI)

Tracks the prices firms receive for goods and services at all stages of production.  

• The PPI includes the prices of intermediate goods, such as flour, yarn, steel, and lumber; and raw materials, such as raw cotton, coal, and crude petroleum.  

• If the prices of these goods rise, the cost to firms of producing final goods and services will rise, which may lead firms to increase the prices of goods and services purchased by consumers.  

• Changes in the PPI therefore can give an early warning of future movements in the CPI and PCE

Understand how CPI differs from PCE

• CPI: Fixed basket, urban consumers, higher inflation reading, used for wages & Social Security.

• PCE: Flexible basket, all consumers, lower reading, Fed’s preferred for monetary policy.

Understand how to take expenditures from a market basket and calculate CPI.

CPI=(Cost of Market Basket in Base Year/ Cost of Market Basket in Current Year)​×100

Understand how to solve for inflation using CPI.

Inflation Rate=(CPI Current Year−CPI BaseYear)/ CPI Base Year​×100

What are the biases regarding CPI that could cause it to overstate actual inflation?

• Substitution bias:  The BLS assumes that each month, consumers purchase the same amount of each product in the market basket. But consumers are likely to buy fewer of the products that increase the most in price and more of the products that increase the least in price  

• Increase in quality bias:  It is not uncommon for the quality of an item to improve over time. The increases in the prices of these products partly reflect their improved quality and partly reflect pure inflation.

• New product bias:  Because the basket is not updated frequently (it used to only be updated every 10 years) when new products are introduced, they are not included in the basket. . For example, the 1987 update took place before cellphones were introduced. Although millions of U.S. households used cellphones by the mid-1990s, they were not included in the CPI until the 1997 update.  

• Outlet bias:  The BLS collects price statistics from traditional full-price retail stores so when you purchases items from discount stores like Sam’s Club and Costco the CPI may not reflect prices consumers actually paid.

• Most economists believe these biases cause changes in the CPI to overstate the true inflation rate by 0.5 to 1 percentage point.

Understand how the market basket is created and how frequently it is updated.

• BLS Surveys 14,000 households nationwide

• Uses results to construct a market basket of 211 types of goods for a typical urban household of 4.

The basket is updated annually, with the weights reflecting consumer spending for two years prior.  

• The weights represent the share of total household spending that a specific good or service takes up

Use CPI values to adjust prices for inflation.

Value in Y dollars = Value in X dollars (Y/X)

What is the difference between nominal interest rates and real interest rates?

• Nominal Interest Rate (n): Stated rate on a loan or investment, does not account for inflation.

• Real Interest Rate (r): Adjusted for inflation to show the true change in purchasing power.

𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 (stated) 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

 𝑟 = n-i

(1+i)=(1+r)(1+pi)

i- nominal

r- real

pi- inflation rate