New York Times, October 2008

Hyperinflation in Zimbabwe Lecture Notes: Inflation is not the prices of a certain good going up due to a shift in demand or supply for that good. Inflation is the increase in the price level (the price of all goods). Inflation by itself will decrease the purchasing power of your dollars.

Hyperinflation in Zimbabwe Lecture Notes: Inflation is not the prices of a certain good going up due to a shift in demand or supply for that good. Inflation is the increase in the price level (the price of all goods). Inflation by itself will decrease the purchasing power of your dollars.

Inflation in the United States May 2017: 1.9%

7 The CPI and the Cost of Living CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to 1 Explain what the Consumer Price Index (CPI) is and how it is used to measure inflation. 2 Explain the limitations of the CPI and describe other measures of the price level and inflation. 3 Adjust money values for inflation and calculate real wage rates and real interest rates. Notes and teaching tips: 9, 11, 15, 23, 40, and 43. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure. To enhance your lecture, check out the Lecture Launchers, Land Mines, and Class Activities in the Instructor’s Manual.

7.1 THE CONSUMER PRICE INDEX Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. The (Bureau of Labor Statistics) BLS calculates the CPI every month. Uses of CPI: Measuring inflation Measuring cost of living Comparing dollar amounts at different dates and locations

7.1 THE CONSUMER PRICE INDEX Reading the CPI Numbers The CPI is defined to equal 100 for a period called the reference base period. Reference base period is a period for which the CPI is defined to equal 100. Currently, the reference base period is 19821984.

7.1 THE CONSUMER PRICE INDEX

7.1 THE CONSUMER PRICE INDEX Period CPI Inflation since reference period 19821984 100 April 1985 107 7% May 2017 243.846 143.846% Calculating inflation between 𝑡 and 𝑡′ (% change in CPI between those periods): 𝐼𝑁 𝐹 𝑡− 𝑡 ′ = 𝐶𝑃 𝐼 𝑡 ′ −𝐶𝑃 𝐼 𝑡 𝐶𝑃 𝐼 𝑡

7.1 THE CONSUMER PRICE INDEX Constructing the CPI Three stages: Selecting the CPI basket Conducting the monthly price survey Calculating the CPI

7.1 THE CONSUMER PRICE INDEX The CPI Market Basket The relative importance of the items in the CPI basket is the same as in the budget of an average urban household. The CPI is calculated each month, but the CPI basket is not updated each month. The CPI basket in 2013 is based on information obtained from the Consumer Expenditure Survey conducted during 2011.

7.1 THE CONSUMER PRICE INDEX Figure 7.1 shows the CPI basket in May 2016. This shopping cart is filled with the items that an average household buys. Ask your students to make an estimate of their own baskets and compare them with the BLS basket.

7.1 THE CONSUMER PRICE INDEX The Monthly Price Survey Each month, BLS employees check the prices of the 80,000 goods and services in the eight large groups shown in the CPI basket in 30 metropolitan areas. Because the CPI measures price changes, it is important that the prices recorded refer to exactly the same items. Surveying college textbook prices might capture the students’ attention. (See the IM for a detailed discussion).

7.1 THE CONSUMER PRICE INDEX Finding the price index 𝐶𝑃 𝐼 𝑡 = 𝑃 𝑡 𝑃 𝑏 ×100 𝑃 𝑡 - price of the CPI basket in year t 𝑃 𝑏 - price of the CPI basket in base period Thus, the CPI in any period, is the relative price of the basket, to its price in the base period, normalized to 100 during the base period.

7.1 THE CONSUMER PRICE INDEX Calculating the CPI – simplified example Suppose base period is 2016. 𝐶𝑃 𝐼 2016 = 24 24 ×100=100 𝐶𝑃 𝐼 2017 = 30 24 ×100=125 CPI Basket 2016 2017 Good Quantity Price Cost Popcorn 2 $4 $8 $6 $12 Limeade Movie ticket 1 $10 Basket Price $24 $30

7.1 THE CONSUMER PRICE INDEX Calculating inflation 𝐼𝑁 𝐹 2016−2017 = 𝐶𝑃 𝐼 2017 −𝐶𝑃 𝐼 2016 𝐶𝑃 𝐼 2016 = 125−100 100 =0.25=25%

7.1 THE CONSUMER PRICE INDEX

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Cost of living index is a measure of changes in the amount of money that people would need to spend to achieve a given standard of living. The CPI is not an ideal measure of the cost of living because It does not measure all the components of the cost of living Some components are not measured exactly So the CPI is possibly a biased measure.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Sources of Bias in the CPI The potential sources of bias in the CPI are New goods bias Quality change bias Commodity substitution bias Outlet substitution bias The IM contains a detailed explanation of how you might illustrate substitution bias.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES New Goods Bias New goods are better than the old goods that they replace, but might cost more (e.g. DVD player vs VCR). The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate. Quality Change Bias Better cars and televisions cost more than the versions they replace. A price rise that is a payment for improved quality is not inflation but might get measured as inflation.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Commodity Substitution Bias If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. The CPI basket doesn’t change to allow for the effects of substitution between goods. Outlet Substitution Bias If prices rise more rapidly, people use discount stores more frequently (e.g. more Costco members) The CPI basket doesn’t change to allow for the effects of outlet substitution.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES The Magnitude of the Bias The Boskin Commission estimated the bias to be 1.1 percentage points per year. If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year. To reduce the bias, the BLS has increased the frequency of its Consumer Expenditure Survey and revises the CPI basket every two years. When the BLS revises the CPI basket, the reference base period does not change.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Two Consequences of the CPI Bias Two main consequences of the upward bias in the CPI are Distortion of private contracts Increases in government outlays and decreases in tax revenue Distortion of Private Contracts Many wage contracts are linked to the CPI. If the CPI is biased, these contracts might deliver an outcome different from that intended by the parties.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Suppose that the UAW and Ford sign a 3-year wage deal: In the first year, the wage will be $30 an hour and will rise by the inflation rate in the next two years. If the CPI-based inflation rate is 5% a year, the wage rises to $31.50 an hour in the second year and $33.08 an hour in the third year. But if the “true” inflation rate is 2% a year, the intended wages in the second and third years are $30.90 an hour and $31.83 an hour. The workers’ gain is Ford’s loss. With thousands of workers, Ford’s loss is millions of dollars over the 3 years.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Increases in Government Outlays and Decreases in Taxes Close to a third of federal government outlays are linked directly to the CPI. The CPI is used to adjust: 55 million Social Security recipients 45 million food stamp recipients 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses The budget for 3 million school lunches

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Tax brackets are linked to CPI. Inflation moves all the brackets (and deductions) upward. When lower brackets increase, bigger share of income is allocated to lower brackets, and tax liability decreases.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Alternative Measures of the Price Level and Inflation Rate Several alternative measures of the price level are available. Here we look at GDP price index (GDP deflator) Personal consumption expenditures (PCE) price index PCE price index excluding food and energy

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES GDP Price Index The GDP price index is an average of current prices of all the goods and services included in GDP expressed as a percentage of base-year prices. GDP price index = Nominal GDP Real GDP ×100 The GDP price index is a measure of the price level. The percentage change in the GDP price index is a measure of the inflation rate.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Two differences between the GDP price index and the CPI result in different estimates of the price level and inflation rate. 1. The GDP price index uses the prices of all the goods and services in GDP. The CPI uses prices of consumption goods and services. The GDP price index weights each item using information about current as well as past quantities. In contrast, the CPI weights each item using information from a past Consumer Expenditure Survey.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Because the GDP price index uses information on current year quantities, it includes new goods and quality improvements and even allows for substitution effects of both commodities and retail outlets. So in principle, the GDP price index is not subject to the biases of the CPI. However, the GDP price index includes goods that consumers don’t buy (capital goods bought by firms, military equipment bought by the government).

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES PCE Price Index The PCE price index is an average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices. The PCE price index, like the GDP price index, uses current information on quantities and prices and to some degree overcomes the sources of bias in the CPI. Because it focuses on consumption expenditure, it a possible measure of the cost of living.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES PCE Price Index Excluding Food and Energy Food and energy prices fluctuate much more than other prices, so their changes can obscure the underlying trends in prices. By excluding these highly variable items, the underlying price level and inflation trends can be seen more clearly. The percentage change in the PCE price index excluding food and energy is called the core inflation rate.

7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

7.3 NOMINAL AND REAL VALUES Dollars and Cents at Different Dates In 1907, the price of a stamp is 2 cents. In 2017, the price of a stamp is 49 cents. Q. Which is more expensive? A. Converting the 1907 price into 2017 dollars (adjusting for inflation): 𝐶𝑃𝐼1907 = 10, 𝐶𝑃𝐼2017 = 244 2 cents in 1907 are equivalent to 𝑋 cents in 2017. 2 𝐶𝑃 𝐼 1907 = 𝑋 𝐶𝑃 𝐼 2017 𝑋=2× 244 10 =48.8 cents Spend time helping students appreciate the distinction between real values and nominal values.

7.3 NOMINAL AND REAL VALUES Dollars and Cents at Different Dates In general, 𝑃𝑡 dollars at time 𝑡 are equivalent to 𝑋 𝑡 ′ = 𝑃 𝑡 × 𝐶𝑃 𝐼 𝑡 ′ 𝐶𝑃 𝐼 𝑡 dollars at time 𝑡 ′ . Spend time helping students appreciate the distinction between real values and nominal values.

7.3 NOMINAL AND REAL VALUES Nominal and Real Values in Macroeconomics Macroeconomics makes a big issue of the distinction between nominal values and real values: Nominal GDP and real GDP (Ch. 5) Nominal wage rate and real wage rate Nominal interest rate and real interest rate We studied the distinction between and the calculation of nominal and real GDP. Here we’ll look at the other two.

7.3 NOMINAL AND REAL VALUES Nominal Wage Rate and Real Wage Rate Nominal wage rate is the average hourly wage rate measured in current dollars. Real wage rate is the average hourly wage rate measured in the dollars of a given reference base year. 𝑟 𝑤 𝑡 = 𝑤 𝑡 𝐶𝑃 𝐼 𝑡 ×100 Real wage represents the purchasing power of nominal wage, in terms of the CPI consumption basket. Use the US President example to emphasize the difficulty of holding relevant factors constant to calculate a real wage.

7.3 NOMINAL AND REAL VALUES Suppose a worker earns $20.10 per hour in 2013. Calculate the real wage that he earns. Nominal wage rate in 2013 CPI in 2013 x 100 Real wage rate in 2013 = Real wage rate in 2013 = = $8.66 $20.10 232.1 x 100

7.3 NOMINAL AND REAL VALUES Jared's father earned a salary of $40,000 in 1990. Jared is earning $72,000 in 2017. Who earned higher real wage, the father or the son? 𝐶𝑃 𝐼 1990 =132.5, 𝐶𝑃 𝐼 2017 =244. 𝑟 𝑤 𝑓𝑎𝑡ℎ𝑒𝑟 = 40,000 132.5 ×100=$30,188.68 𝑟 𝑤 𝑠𝑜𝑛 = 72,000 244 ×100=$29,508.2

7.3 NOMINAL AND REAL VALUES Figure 7.4 shows nominal and real wage rates: 1980 to 2013. Since 1980, the real wage rate barely changed, … despite the increase in the nominal wage rate every year.

7.3 NOMINAL AND REAL VALUES Nominal Interest Rate and Real Interest Rate Nominal interest rate is the extra dollars amount earned per $1 loaned. Real interest rate is the extra consumption (goods and services) earned after saving 1 unit of consumption.

7.3 NOMINAL AND REAL VALUES Nominal Interest Rate and Real Interest Rate 𝑖 – nominal interest rate 𝑟 – real interest rate 𝜋 – inflation rate Exact formula: 1+𝑟= 1+𝑖 1+𝜋 Approximate formula (for small rates): 𝑟≈𝑖−𝜋

7.3 NOMINAL AND REAL VALUES Figure 7.5 shows real and nominal interest rates: 1973 to 2013. The real interest rate is usually positive, but during the 1970s it became negative. The gap between the nominal interest rate and the real interest rate equals the inflation rate.

Gone with the Wind is the answer. To get this answer, Box-Office Mojo calculates the amount that a movie really earns. Box-Office Mojo converts the dollars earned to their equivalent in current year dollars. But rather than use the CPI, it uses the average prices of movie tickets as its price index. 48

The Avengers, released in 2012, earned $623 million. Gone with the Wind was made in 1939 and rereleased in nine subsequent years. By 2012, it had earned a total box office revenue of almost $200 million in the United States. The Avengers, released in 2012, earned $623 million. The Avengers earned more than 3 times the dollars earned by Gone with the Wind. Which movie really earned more box office revenue? 49

To convert the Gone with the Wind revenues into 2012 dollars, … multiply the dollars received each year by the 2012 CPI and divide by the CPI for the year in which the dollars were earned. Box-Office Mojo has done such a calculation, but rather than use the CPI, it used the average prices of movie tickets. According to Box-Office Mojo, valuing the tickets for Gone with the Wind at 2012 movie-ticket prices, it has earned $1,604 million, about 2.6 times The Avengers’ revenue. 50

Because Box-Office Mojo uses average ticket prices, the real variable that it compares is the number of tickets sold. The average ticket price in 2012 was $7.96, so 202 million movie-goers have seen Gone with the Wind and 78 million have seen The Avengers. Gone with the Wind was the biggest hit because it was seen by the greatest number of people. 51

Question 1 Which of the following spending categories makes up the largest portion of the CPI market basket? Travel (includes paying for gas) Housing Entertainment Food Clicker Question Correct answer: B People often spend 35% or more of their income on rent or mortgage payments.

Question 2 If inflation is a general rise in the price level, why have consumer electronic prices fell over time? The demand for electronics has decreased Electronics are not counted in the CPI Electronics are getting smaller in size so the price is falling as well Increases in technology have greatly reduced production costs for these goods Clicker Question Correct answer: D Increases in technology shift the supply curve rightward (according to standard micro theory).

Question 3 Suppose that prices and wages both double next year. What is true about next year compared to this year? Nominal wages are higher and real wages remained constant Nominal wages and real wages are both higher Nominal wages are higher and real wages are lower Nominal wages increased and real wages decreased Clicker Question Correct answer: A If prices and wages both change at the same rate, nothing changes in real terms. However, they both went up, so that is a nominal (nonadjusted) increase.

Question 4 In 2012, John takes out a 30-year bank mortgage loan at a fixed interest rate. He buys a house with the loan. In 2014 to 2018, there is a large amount of inflation. Who is hurt and helped by this inflation, ceteris paribus? John is helped and the bank is hurt The bank is helped and John is hurt John and the bank are both hurt John and the bank are both helped Clicker Question Correct answer: A Explanation: Suppose John borrowed $200,000. He buys a house with that money. In the next few years, inflation causes housing prices to rise, and the value of money to fall. John’s house is now worth $250,000, but he still only owes the bank the original $200,000 that he borrowed (plus some interest). The bank is hurt because the money it receives in the future from John (when he pays back the loan) will be worth less than when they loaned it out to him.