Lecture 5 Measuring Inflation

Outline The price level and inflation Measuring the rate of inflation The construction of the consumer price index (CPI) The construction of the GDP deflator

Inflation What is it?

Inflation Inflation is a situation in which economy’s overall price level is rising. Inflation rate is the % change in the price level from the previous period Why important?

Inflation Inflation is a situation in which economy’s overall price level is rising. Inflation rate is the % change in the price level from the previous period Why important? Rising prices and purchasing power Standard of living

The Consumer Price Index Consumer price index (CPI) Measure of the overall level of prices Measure of the overall cost of goods and services Bought by a typical consumer

Calculating CPI Fix the basket Find the prices Which prices are most important to the typical consumer Different weights If customers buy more yam than cassava, then this is weighted more heavily in the CPI basket Find the prices At each point in time Compute the basket’s cost Same basket of goods each year

Calculating CPI  

Mathematical Illustration

Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

Interpretations of Price Levels and Inflation rates Price level in 2011 = 175 This means that the price of the basket in 2011 is 175 percent of its price in the base year. Put differently, a basket of goods that costs $100 in the base year costs $175 in 2011. Price level in 2012 = 250 Interpretation?

Interpretations of Price Levels and Inflation rates Inflation rate in 2011 = 75% Prices increased at a rate of 75% between 2010 and 2011 Inflation rate in 2012 = 43% Interpretation?

The Consumer Price Index CPI measures price level Inflation rate measures how fast this price level is changing It is possible to calculate the inflation rate for an entire economy Also possible to calculate for small geographical areas What is the inflation rate in Ghana?

The Consumer Price Index The goal of the consumer price index is to measure changes in the cost of living. In other words, the consumer price index tries to gauge how much incomes must rise to maintain a constant standard of living. The consumer price index, however, is not a perfect measure of the cost of living. Three problems with the index are widely acknowledged but difficult to solve.

The Consumer Price Index Substitution bias Prices do not change proportionately Consumers buy less of the goods whose prices have risen by relatively large amounts and by buy more of the goods whose prices have risen less or perhaps even have fallen If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution Therefore, overstates the increase in the cost of living from one year to the next.

The Consumer Price Index Introduction of new goods As new goods are introduced, consumers have more choices Yet because the consumer price index is based on a fixed basket of goods and services, it does not reflect the increase in standard of living that arises from the introduction of new goods If CPI not revised to include introduction of new goods, citizen’s wellbeing will be understated

The Consumer Price Index Unmeasured Quality Changes If the quality of a good changes, without a corresponding change in its price, then the calculated CPI statistic not an accurate reflection of consumer well-being If quality increases, consumers better off If quality decreases, consumers worse off

Uses of the CPI As a Policy Target Index payments Price stability is an important goal in macroeconomics. CPI used to gauge inflation Index payments

Applications Example: Your father graduated from school and took his first job in 1972, which paid a salary of Ghc70. Given CPI in 1972 and 2009 as 41.8 and 214.5, respectively, what is this salary worth in 2009 Ghc?

GDP Deflator  

Computing Inflation Using the GDP Deflator Step 1- Collect prices and quantities of all goods and services produced within the year Step 2- Calculate nominal GDP (???) Step 3- Calculate real GDP (???) Step 4- Calculate GDP deflator Ratio of nominal to real GDP, times 100 Step 5- Calculate the inflation rate

GDP Deflator This table shows how to calculate real GDP, nominal GDP, and the GDP deflator for a hypothetical economy that produces only hot dogs and hamburgers.

GDP Deflator  

Calculating Inflation rates Using CPI Using GDP

GDP deflator vs. CPI Why does GDP deflator diverge from CPI in measurement of inflation?

GDP deflator vs. CPI Why does GDP deflator diverge from CPI in measurement of inflation? Composition of goods and services included Weighting of various prices

GDP deflator versus CPI Composition of goods and services GDP deflator Reflects prices of all goods & services produced domestically CPI Reflects prices of goods & services bought by consumers

GDP deflator versus CPI Weighting of various prices GDP deflator Compares the price of currently produced goods and services CPI Compares price of a fixed basket of goods and services

Discussion Questions Suppose the Ghana government buys a Boeing plane. This transaction shows up in Ghana’s GDP deflator, but not in the Consumer Price Index. True/ False? Why? If Ama buys Kofi’s used 2001 Toyota, this transaction may be captured in the CPI, but not in the GDP deflator. True/False. Why?

Discussion Question Henry Ford paid his workers $5 a day in 1914. If the consumer price index was 10 in 1914 and 218 in 2010, how much is the Ford pay check worth in 2010 dollars?

Take-home Problem A small nation of 10 people idolizes the TV show Mentor. All they produce and consume are karaoke machines and CD’s in the following amounts: Using the Consumer Price index, compute the percentage change in the overall price level. Set 2011 as base year, and fix the basket at 1 karaoke machine and 3 CDs Using the GDP deflator, compute the percentage change of the overall price level. Set 2011 as base year Is the inflation rate in 2012 the same using the two methods? Explain why or why not? Karaoke Machines CDs Quantity Price (Ghc) Price (ghc) 2011 10 40 30 2012 12 60 50

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