Macro 2.4 & 2.5 Price Indices and Inflation & Costs of Inflation

Definitions of Inflation

• Inflation: General increase in average prices throughout an entire economy, affecting many goods and services.

• Deflation: Decrease in average prices for goods and services throughout an economy.

• Disinflation: A reduction in the rate of inflation (e.g., decreasing from 8% to 5%).

Nominal vs. Real Values

• Nominal Values: Values not adjusted for inflation; they typically rise faster.

• Real Values: Values adjusted for inflation; they provide a more accurate economic picture.

• The difference between nominal and real values represents inflation.

Measuring Inflation with CPI

• Consumer Price Index (CPI): Primary measure of inflation in the U.S.; tracks price changes in a market basket of goods and services.

• The market basket consists of over 80,000 typical goods purchased by urban households.

• Calculation of CPI involves:

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

CPI Calculation Example

• Sample Market Basket Items: Milk, chicken, shoes

  • For 2012:

    • Prices: Milk ($3), Chicken ($5), Shoes ($25)

    • Quantities: 10 gallons milk, 8 chickens, 2 pairs shoes

    • Market Basket Value in 2012 = (10×3) + (8×5) + (2×25) = $120

    • CPI = (120 / 120) × 100 = 100

  • For 2022:

    • Prices: Milk ($5), Chicken ($6), Shoes ($26)

    • Market Basket Value in 2022 = (10×5) + (8×6) + (2×26) = $150

    • CPI = (150 / 120) × 100 = 125

Inflation Rate Calculation

• Formula: (New CPI - Old CPI) / Old CPI × 100

• Example: CPI in 1997 = 160, CPI in 1999 = 176

  • Inflation Rate = (176 - 160) / 160 × 100 = 10%

Limitations of CPI

• Substitution Bias: Consumers substitute goods when prices increase, which can skew the CPI.

• Quality Change Bias: Quality improvements in products might not be reflected accurately in the CPI.

• New Products Bias: New products take time to be included in the CPI market basket, which can distort inflation readings.

Costs of Inflation

• Real Wages Impact: Inflation negates the real value of wages if they don’t keep pace with inflation.

  • Example: If nominal wage increases by 5% but inflation is at 7%, purchasing power decreases by 2%.

• Purchasing Power: Inflation reduces the ability of money to buy goods and services, decreasing its real value.

Who is Affected by Inflation?

• Borrowers: Unexpected inflation benefits borrowers since they repay loans with less valuable dollars.

• Lenders: Banks and lenders are hurt by inflation as they receive less in real terms.

• Savers: Inflation erodes the value of savings, as the purchasing power of saved dollars declines.

Conclusion

• Understanding the CPI and the costs of inflation is crucial for economic awareness and exam preparation.

• For further study resources, visit ReviewEcon.com for the Total Review Booklet.