Chapter 5 Part 2 Inflation

Transcription

1 Chapter 5 Part 2 Inflation The price level is the average level of prices. Inflation is a persistently rising price level. Deflation is a persistently falling price level. We are interested in the price level because we want to 1. Measure the inflation rate or the deflation rate 2. Distinguish between money values and real values of economic variables. From the Price Level to the Inflation Rate inflation Percentage increase in the overall price level. hyperinflation A period of very rapid increases in the overall price level. deflation A decrease in the overall price level. dis-inflation a decrease in the rate of increase in the overall price level 1

2 Why Inflation and Deflation Are Problems Low, steady, and anticipated inflation or deflation is not a problem. Unpredictable inflation or deflation is a problem because it Changes the distribution on income Shifts purchasing power At its worst, inflation becomes hyperinflation: 20, 30+ percent per month inflation rate that is so rapid that workers are paid twice a day because money loses its value so quickly. A few examples of hyperinflation country period CPI Inflation % per year CPI Inflation % per month Israel % 28% Brazil % Bolivia % Ukraine % Argentina % 225% Dem. Republic of Congo / Zaire % Angola % Peru % Zimbabwe % 440% How to Measure the Price Level The Consumer Price Index - CPI The CPI, measures the average of the prices paid by consumers for a fixed basket of goods and services. The CPI is defined to equal 100 for the reference base period. Currently, the reference base period is That is, for the average of the 36 months from January 1982 through December 1984, the CPI equals 100. In November 2016, the CPI was This number tells us that the average of the prices paid by consumers for a fixed basket of goods was percent higher in November 2016 than it was during the base period. 2

3 How the CPI is Calculated Three stages: Selecting the CPI basket Conducting a monthly price survey Calculating the CPI The CPI Basket The CPI basket is based on a Consumer Expenditure Survey, which is undertaken infrequently. The CPI basket today is based on data collected in the Consumer Expenditure Survey of The CPI Basket Housing is the largest component 41.4%. Transportation and food and beverages are the next largest components -31.3%. All other components account for 27.3 percent of the basket. How the CPI is Calculated The Monthly Price Survey Every month, BLS employees check the prices of the 80,000 goods in the CPI basket in 30 metropolitan areas. Calculating the CPI 1. Find the cost of the CPI basket at base-period prices. 2. Find the cost of the CPI basket at current-period prices. 3. Calculate the CPI for the current period. 3

4 How the CPI is Calculated Let s work an example of the CPI calculation. Assume a simple economy where people consume only oranges and haircuts and the CPI basket is 10 oranges and 5 haircuts. Suppose the prices in the base period (2014) are $1.00 and $8.00. The cost of the CPI basket in the base period is $50. How the CPI is Calculated Part (b) of Table 5.1 shows the prices of the basket in 2015 $2.00 and $ Oranges doubled in price and haircuts increased by 25%. The cost of the CPI basket at current-period prices is $70. How the CPI is Calculated The CPI is calculated using the formula: CPI = (Cost of basket at current-period prices Cost of basket at base-period prices) 100. Using the numbers for the simple example, CPI = ($70 $50) 100 = 140. The CPI is 40 percent higher in the current period than it was in the base period. 4

5 Measuring the Inflation Rate The major purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The inflation formula is: CPI this year CPI last year Inflation rate =( ) X 100 CPI last year Consumer Price Index, December, selected years, Year Rate of Inflation This figure shows the relationship between the price level (CPI) and the inflation rate. The inflation rate is High when the price level is rising rapidly and Low when the price level is rising slowly. Negative when the price level is falling 5

6 U.S. Annual Inflation Rate, In most years, the inflation rate has been positive. During some periods (after World War II, and a few years in the 1970s and early 1980s), the U.S. experienced double-digit inflation. For the last two decades the U.S. inflation rate has been very low % in June The Biased CPI The CPI is not a perfect measure of the price level and can overstate the true inflation rate for four reasons: New goods bias Quality change bias Commodity substitution bias Outlet substitution bias New Goods/New Technology Bias New goods that were not available in the base year appear and, if they are more expensive than the goods they replace, they put an upward bias into the CPI. Quality Change Bias Quality improvements occur every year. Part of the rise in the price is payment for improved quality and is not inflation. The CPI counts all the price rise as inflation. 6

7 Commodity Substitution Bias The market basket of goods used in calculating the CPI is fixed and does not take into account consumers substitutions away from goods whose relative prices increase. Outlet Substitution Bias As the structure of retailing changes (discount outlets), people switch to buying from cheaper sources, but the CPI, as measured, does not take account of this outlet substitution. The Magnitude of the Bias Estimates say that the CPI overstates inflation by 1.1 percentage points a year. Some Consequences of the Bias Increases government outlays (close to a third of federal government outlays are linked to the CPI). A bias of 1 percent is small, but over a decade adds up to almost $1 trillion of additional expenditure. Alternative Price Indexes Alternative measures of the price level are Chained CPI (Skip) GDP deflator Personal consumption expenditure deflator 7

8 GDP Deflator GDP deflator includes the prices of all final goods and services (C,I,G, net exports)that are counted in GDP. The GDP deflator equals: (Nominal GDP Real GDP) 100 Personal Consumption Expenditure Deflator The PCE deflator includes only the prices of C included in GDP The PCE deflator equals: (Nominal consumption expenditure Real consumption expenditure) 100 In Tables 4.3(b) and (c) from chapter 4, we calculated nominal GDP (NGDP) and real GDP (RGDP) for The GDP deflator for 2014 is calculated as GDP Deflator = NGDP 2014 x100 RGDP 2014 GDP Deflator = 300 x 100 = What is the value of the GDP Deflator in 2009, the base year? GDP Deflator Now You Try It P Q P Q P Q good A $ $31 1,000 $36 1,050 good B $ $ $ Compute nominal GDP in each year Compute real GDP in each year using 2009 as the base year. 8

9 Calculation of Nominal and Real GDP Nominal GDP multiply Ps & Qs from same year 2009: $46,200 = $ $ : $51,400 = $31 x $102 x : $58,300 = $36 x $100 x 205 Real GDP multiply each year s Qs by 2005 Ps 2009: $46,200 = $30 x $100 x : $50,000 = $30 x $100 x : $52,000 = $ $ GDP Deflator GDP Deflator = NGDP RGDP x 100 Exercise Nominal GDP Real GDP GDP deflator inflation rate 2009 $46,200 $46,200 n.a ,400 50, ,300 52,000 Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2009 to 2010, and from 2010 to

10 CPI vs. GDP Deflator The GDP price index measures the prices of all final goods and services that are included in U.S. GDP The CPI measures the prices of all goods and services bought by U.S. households including used goods and imports 31 CPI vs. GDP Deflator Prices of capital goods (Investment): included in GDP deflator (if produced domestically) excluded from CPI Prices of imported consumer goods: included in CPI excluded from GDP deflator The basket of goods: CPI: fixed GDP deflator: changes every year Core Inflation The figure shows the CPI inflation rate. The core inflation rate is the CPI inflation rate excluding the volatile elements (of food and fuel). The core inflation rate attempts to reveal the underlying inflation trend. 10

11 The Real Variables in Macroeconomics We use a price index to deflate nominal variables to find their real values. For example, Real wage = (Nominal wage CPI) 100 Real GDP = (Nominal GDP GDP Deflator) 100 Note: the real interest rate is different. How the CPI Is Used When comparing dollar values over time - We do not care about the number of dollars, but about their purchasing power Translate nominal values into real values Nominal Value Real Value= Price Index Nominal and Real Weekly Earnings (December of Each Year) 2014 $ $