 Inflation  Inflation refers to a rising general level of prices.  It does not mean that all prices are rising. Even during periods of rapid inflation, some prices may be relatively constant and others falling. inflation rate  The inflation rate is the percentage change in the price level from the previous period.

 Inflation is measured using price indices such as the Consumer Price Index (CPI), the Producer Price Index (PPI), the GDP deflator etc.  Inflation can be calculated on monthly or yearly.

 A price index measures the combined price of a particular collection of goods and services, called “market basket” in a specific period relative to the combined price of an identical (or highly similar) group of goods and services in a reference period.  The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.  The Ghana Statistical Service reports the CPI each month as well as for the year.  It is used to monitor changes in the cost of living over time.

 When the CPI rises, the typical family has to spend more cedis to maintain the same standard of living.  In Ghana, the Consumer Price Index (CPI) measures changes over time in the general price level of goods and services that households acquire for the purpose of consumption, with reference to the price level in 2012, the current base year, which has an index of 100.

 Fix the Basket: Determine what prices are most important to the typical consumer. ◦ The Ghana Statistical Service (GSS) identifies a market basket of goods and services the typical consumer buys. The consumer basket for Ghana is made up of the following: CPI_Bulletin_2013_January.pdf CPI_Bulletin_2013_January.pdf ◦ The basket for Ghana now contains 267 consumer items, after an update from a previous basket of 242 consumer items. ◦ The GSS conducts consumer surveys to set the weights for the prices of those goods and services. Weights are assigned reflect the importance of the individual items being combined.

16% Food and beverages 17% Transportation Medical care 6% Recreation 6% Apparel 4% Other goods and services 4% 41% Housing 6% Education and communication

 Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.  Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

 Choose a Base Year and Compute the Index: ◦ Designate one year as the base year, making it the benchmark against which other years are compared. The base year for Ghana was 2002 but was revised recently making 2012 the new base year. ◦ Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

 Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.  The Inflation Rate ◦ The inflation rate is calculated as follows:

 Assuming the consumer basket is made up of 2 bags of rice and 3 loaves of bread.  Supposing price of a bag of rice in 2003 was Ghc15 and a loaf of bread was Ghp50.  In 2004, price of a bag of rice was Ghc20 and a loaf of bread was Ghc1. Calculate the CPI and inflation rate over the period, using 2002 as the base year.  In 2005, price of a bag of rice was Ghc21 and price of a loaf of bread was Ghc1.2

Costs of the basket  2003: 15(2) + 0.5(3)=31.5  2004: 20(2) + 1(3)=43  2005: 21(2) + 1.2(3)=45.5  2003 CPI=(31.5/31.5) * 100 =100  2004 CPI=(43/31.5) * 100 =136.5  2005 CPI=(45.5/31.5)*100=144.8  Inflation was: 23% between 2003 and 2004, and 30% between 2003 and 2005.

 Yearly inflation for 2004 was: 36.5%  Yearly inflation for 2005 was:  Note: Inflation rate fell from 36.5% to 6.1%. As you can see, this does not mean that prices are falling (contrary to the belief on the airwaves!!!).

 The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. ◦ Substitution bias ◦ Introduction of new goods ◦ Unmeasured quality changes

 Substitution Bias ◦ The basket does not change to reflect consumer reaction to changes in relative prices.  Consumers substitute toward goods that have become relatively less expensive.  The index overstates the increase in cost of living by not considering consumer substitution.

 Introduction of New Goods ◦ The basket does not reflect the change in purchasing power brought on by the introduction of new products.  New products result in greater variety, which in turn makes each cedi more valuable.  Consumers need fewer cedis to maintain any given standard of living.

 Unmeasured Quality Changes ◦ If the quality of a good rises from one year to the next, the value of a cedi rises, even if the price stays the same. ◦ If the quality of a good falls from one year to the next, the value of a cedi falls, even if the price of the good stays the same.

 The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. ◦ The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices.

 The GDP deflator is calculated as follows:

 The GSS calculates other prices indexes: ◦ The index for different regions within the country. ◦ The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

 Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising.  There are two important differences between the indexes that can cause them to diverge.

 The GDP deflator reflects the prices of all goods and services produced domestically, whereas...  …the consumer price index reflects the prices of all goods and services bought by consumers.

 The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the GSS change the basket)...  …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

 Headline Inflation vs Core Inflation  Headline inflation is inflation rate calculated using all the items in the consumer baskets.  Core inflation rate, is the CPI inflation rate excluding volatile elements such as food and fuel.  This is done in order to determine the trend in the inflation rate.  Inflation can also be calculated for different categories of goods and services.  For instance; Food inflation, Producer Inflation etc

 Demand-pull factors: factors that cause excess of spending beyond economy’s capacity to produce. Example is increase in money supply, increase in general consumer income.  Cost-push/supply side factors: These are factors that raise per unit cost of production. Rise in per unit cost of factors of production.

 Inflation causes redistribution of income. It redistribute income between debtors and creditors. Unexpected inflation benefits debtors (borrowers) at the expense of creditors (lenders).  Inflation hurts savers. It reduces the value of fixed incomes. Examples include savings accounts, insurance policies, annuities, and other fixed-value paper assets.

 Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times.

 When some cedi/dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation.  E.g. Labour unions include Cost-Of-Living Adjustment clauses in contracts. Such agreements automatically raise workers’ nominal incomes when inflation occurs.

 Interest represents a payment in the future for a transfer of money in the past. It is the cost of capital.  Commercial Banks’ Lending rate  Deposit rate  Policy rate  Treasury bill rate  Etc.

 The nominal interest rate is the interest rate usually reported and not corrected for inflation. ◦ It is the interest rate that a bank pays.  The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

 You borrowed Ghc1,000 for one year.  Nominal interest rate was 15%.  During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5%

1965 Interest Rates (percent per year) 15 Real interest rate – Nominal interest rate Copyright©2004 South-Western