Chapter 9 Inflation: Tracking, Measurement, Problems, and Indexing
9.1 Tracking Inflation
Inflation: Refers to a general and ongoing rise in the level of prices across an entire economy. This implies widespread pressure for prices to increase in most markets.
Distinction from Relative Price Changes: Inflation is not merely a change in individual or relative prices (e.g., the price of apples rising while oranges fall). It signifies an overall increase in the aggregate price level.
Measuring Inflation: The primary challenge is determining how to accurately calculate and track this general rise in prices.
9.2 Measuring Changes in the Cost of Living (Price Indices)
Price Indices
Definition: We typically use an inflation or price index to quantify price level changes.
Index Number: A unit-free numerical value derived from the price level over multiple years. Its unit-free nature (no dollar signs or other units) simplifies the computation of inflation rates.
Base Year: An arbitrary year whose price level is defined as 100 for the purpose of the index. All other years' index numbers are then relative to this base year.
Inflation Calculation Formula: The rate of inflation between two periods can be calculated using the price index numbers:
\text{Inflation rate} = \frac{\text{Index}{\text{year } 2} - \text{Index}{\text{year } 1}}{\text{Index}{\text{year } 1}} \times 100
Example Inflation Calculation
Given Data:
Index in 2016: 103.2
Index in 2017: 106.8
Base year: 2015
Calculation: The inflation rate between 2016 and 2017 is:
\text{Inflation rate} = \frac{106.8 - 103.2}{103.2} \times 100 = 3.493\% (approximately 3.49\%%)
Origin of Price Indices: The "Basket of Goods and Services"
Concept: Price indices are often constructed using a hypothetical "basket of goods and services" that an average household consumes. This basket represents the typical spending patterns of consumers.
Composition of the Basket: It includes a diverse range of items that consumers regularly purchase, such as food, housing, transportation, healthcare, education, clothing, and entertainment. The specific items and their weights in the basket are determined by surveying households on their expenditures.
Tracking Prices: Government statisticians collect price data for each item in the basket at various retail outlets across different regions over time.
Calculating the Index: The cost of the entire basket is calculated for a base year and then for subsequent years. The price index for any given year is then determined by dividing the cost of the basket in that year by the cost of the basket in the base year, and multiplying by 100.
Formula for the Price Index:
\text{Price Index} = \frac{\text{Cost of Basket in Current Year}}{\text{Cost of Basket in Base Year}} \times 100
Relevance: This method allows economists to track changes in the cost of living over time, providing a clear measure of inflation and its impact on consumers' purchasing power.
9.3 Common Price Indices
9.3.1 Consumer Price Index (CPI)
Definition: The most widely used measure of inflation, calculated by the U.S. Bureau of Labor Statistics (BLS).
Purpose: Measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Scope: Covers approximately 87\% of the U.S. population, including professionals, the self-employed, the poor, the unemployed, and retired people, but not those in the military or institutionalized persons.
Uses: Often used to adjust social security payments, pension benefits, and wage agreements (COLA – Cost of Living Adjustments).
9.3.2 Producer Price Index (PPI)
Definition: Measures the average change over time in the selling prices received by domestic producers for their output.
Scope: Covers all commodities produced in the U.S., encompassing goods, services, and construction.
Significance: Can be an indicator of future inflation in consumer prices, as increases in producer prices often get passed on to consumers.
9.3.3 GDP Deflator
Definition: A measure of the level of all new, domestically produced, final goods and services in an economy.
Calculation:
\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100
Difference from CPI: The GDP deflator includes all goods and services produced domestically, while the CPI includes goods and services bought by consumers, including imports. Also, the CPI uses a fixed basket, while the GDP deflator's basket changes over time as the composition of GDP changes.
9.4 Problems with Measuring Inflation
Substitution Bias: The CPI uses a fixed basket of goods and services. When prices for items in the basket rise, consumers often substitute away from those items to cheaper alternatives not in the basket, or to items whose prices have not risen as much. The CPI overstates the true cost of living increase because it doesn't account for this substitution.
Quality/New Goods Bias: Over time, goods and services improve in quality (e.g., cars become safer, computers become faster). New goods also enter the market (e.g., smartphones). The CPI struggles to account for these quality improvements and the introduction of new products, which often lead to higher utility per dollar for consumers, effectively lowering the cost of living. This can cause the CPI to overstate inflation.
Outlet Bias: As consumers shift purchases from traditional retail stores to discount stores or online retailers, the CPI basket may not capture the lower prices available at these alternative outlets, further overstating inflation.
Core Inflation Index: To address the volatility caused by certain fluctuating prices, economists often look at a "core inflation index" which excludes volatile economic categories, typically food and energy prices, to provide a clearer signal of underlying inflationary trends.
9.5 Types and Causes of Inflation
Demand-Pull Inflation: Occurs when aggregate demand in an economy outpaces aggregate supply. Too much money chases too few goods, leading to upward pressure on prices. Often associated with strong economic growth and low unemployment.
Cost-Push Inflation: Occurs when the cost of producing goods and services increases, leading suppliers to raise prices. This can be due to rising wages, increased raw material costs (e.g., oil shocks), or higher import prices. It often leads to a decrease in aggregate supply and can result in stagflation.
9.6 Consequences of Inflation
Redistribution of Income:
Creditors and Debtors: Unexpected inflation tends to benefit debtors at the expense of creditors, as the real value of future debt repayments decreases.
Fixed Incomes: People on fixed incomes (e.g., retirees whose pensions are not indexed to inflation) see their purchasing power erode.
Blurred Price Signals: High and volatile inflation can make it difficult for producers and consumers to distinguish between changes in relative prices (due to supply and demand shifts for specific goods) and changes in the overall price level, leading to inefficient resource allocation.
Menu Costs: Firms incur costs when they have to frequently update their prices, such as printing new menus, catalogs, or updating price tags. While seemingly small, these costs can add up across an economy.
Shoe-Leather Costs: The resources wasted when inflation encourages people to reduce their money holdings. People spend more time and effort converting money to interest-bearing assets and back, literally wearing out their shoes on trips to the bank.
Uncertainty and Reduced Investment: High and unpredictable inflation creates uncertainty about future costs and revenues, discouraging long-term investment and economic growth.
Tax Distortion: Inflation can distort the impact of taxes, particularly on capital gains and interest income. For instance, if capital gains taxes are not adjusted for inflation, individuals might pay taxes on nominal gains that are not real gains in purchasing power. Similarly, nominal interest income is taxed, even if part of it merely compensates for inflation, effectively taxing away real returns for savers.