In-Depth Notes on Inflation and Money for Econ 1002

Inflation Overview

• Inflation: Generalized rise in overall prices.

  • Results in:

  • Increased cost of living.

  • Decreased purchasing power of money.

  • Not every price change is necessarily inflation.

Measuring Inflation

• Price Indices: Various measures of prices lead to different inflation measurements.

  • Consumer Price Index (CPI):

  • Tracks average prices consumers pay over time for a typical basket of goods/services.

  • Most relevant to everyday life.

  • Producer Price Index (PPI):

  • Tracks prices of inputs in production.

Inflation Rate Calculation

• Inflation Rate Formula: Inflation Rate = rac{(Pt - P{t-1})}{P_{t-1}} imes 100

  • Example: If the price level rose from 100 to 104:
    Inflation Rate = rac{(104 - 100)}{100} imes 100 = 4\%

  • Implications:

  • Costs of living increased by 4\%.

  • The dollar buys 4\% less than last year.

CPI Calculation Method

• CPI Calculation Steps:

  1. Determine what consumers buy (typical basket).

  2. Collect prices and calculate total cost monthly/yearly.

  3. Calculate CPI using:
     CPI = rac{Cost of basket in current year}{Cost of basket in base year} imes 100

CPI Example

• Assume typical basket calculation values:

  Year	Cost of Basket	CPI	Inflation (%)
  2010	25,500	100.0
  2011	26,650	104.5	4.51
  2012	27,000	105.9	1.31
  2013	27,500	107.8	1.85
  2014	27,650	108.4	0.55
  2015	27,000	105.9	-2.35

• Calculate CPI and % inflation for 2011:
  CPI_{2011} = rac{26650}{25500} imes 100 = 104.51

  • Inflation for 2011:
    Inflation{2011} = rac{CPI{2011} - CPI{2010}}{CPI{2010}} imes 100 = 4.51\%

Problems with CPI

• CPI can overstate true costs of living due to:

  1. Commodity Substitution Bias:

  • Consumers adjust consumption based on price changes, but CPI assumes fixed quantities.

    2. Introduction of New Goods:

  • New goods can lower living costs but not immediately reflected in CPI.

    3. Unmeasured Quality Changes:

       • Price increases might come from quality improvements, not just inflation.

Effects of Biases

• The Bank of Canada estimates biases can overstate cost of living by 0.5\% annually.

Different Measures of Inflation

• Key indices:

  • CPI Median: Tracks median price changes within CPI.

  • Core Inflation: Excludes food/energy prices.

  • GDP Deflator: Ratio of Nominal to Real GDP.

Adjusting for Inflation

• Updating dollar amounts for comparison:

  • Formula:
    Amount{today} = Amount{year T} imes rac{Price level{today}}{Price level{year T}}

  • Example:

  • 1957 gas price: 9.5 cents

  • Adjusted for 2014:
    9.5 ~ ext{cents} imes rac{CPI{2014}}{CPI{1957}} = 80.4 ext{ cents}

• Compared to nominal price 130 cents in 2014 (real price of 2014 value gas was lower).

Real vs. Nominal Variables

• Nominal Variables: Values measured in current dollars.

• Real Variables: Values adjusted for inflation.

  • Convert nominal into real by using specific base years:
    Real~value = Amount~in~year~t imes rac{Price~level~in~base~year}{Price~level~in~year~t}

  • Example of CN Railway revenue adjustments.

Real and Nominal Interest Rates

• Nominal Interest Rate: Stated rate not adjusted for inflation.

• Real Interest Rate: Adjusted for inflation:
  Real~interest~rate = Nominal~interest~rate - Inflation~rate

Example

• If 100 in a bank yields 5\% nominal interest with 3\% inflation:
  Real~interest = 5\% - 3\% = 2\%.

Money Illusion

• The (mistaken) tendency to focus on nominal dollar amounts instead of inflation adjusted amounts.

• Money Illusion: Focus on nominal values instead of adjusted amounts leading to:

  • Poor decision-making.

  • Example: Mispricing due to nominal wage rigidity.

Role of Money

• Functions:

  • Medium of exchange.

  • Unit of account.

  • Store of value.

Costs of Inflation

• Stable vs Unstable Inflation:

  • Low/stable allows functions to operate effectively.

  • High/unpredictable inflation can:

  • Lead to hyperinflation.

  • Distort price signals.

  • Redistribute wealth.

Hyperinflation Examples

• Notable historical examples: Venezuela, Hungary, Zimbabwe with extreme inflation rates.

Costs of Expected Inflation

• Consequences:

  • Menu costs (e.g., reprinting prices).

  • Shoe-leather costs (avoiding cash).

Costs of Unexpected Inflation

• Unexpected Inflation Consequences:

  • Distorts price signals.

  • Redistributions from savers to borrowers.

Inflation Fallacy

• Inflation Fallacy: The mistaken belief that inflation destroys purchasing power.

  • Many nominal prices, including wages, rise with inflation, leaving purchasing power relatively stable.