Inflation Basics Dr. D. Foster – ECO 285

Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise in prices. What is the “general price level”? Price level is shown by a Price Index Hold quantities constant over time Use old (“base year”) quantities Use new quantities Allow some quantity change Laspeyres; CPI Paasche Chained CPI & GDP deflator

Laspeyres & Paasche price indexes PI0 = 100 and PI1 = ??? ∑(P1*Q0) ∑(P0*Q0) $456.00 $441.25 = Laspeyres: = 103.34 x 100 x 100

Laspeyres & Paasche price indexes PI0 = 100 and PI1 = ??? ∑(P1*Q1) ∑(P0*Q1) $447.00 $440.50 = Paasche: = 101.48 x 100 x 100

Laspeyres & Paasche price indexes PI0 = 100 and PI1 = ??? The CPI uses a Laspeyres index like this, so showing inflation of 3.34%. ∑(P1*Q0) ∑(P0*Q0) $456.00 $441.25 = Laspeyres: = 103.34 x 100 x 100 ∑(P1*Q1) ∑(P0*Q1) $447.00 $440.50 = Paasche: = 101.48 x 100 x 100

The Consumer Price Index(es) CPI-U: All urban consumers A fixed-weight index: consumption patterns rigid. Market basket is updated every two years. Represents about 87% of U.S. population. Used to adjust income tax brackets to account for inflation. Monthly, 60,000 prices are collected. Goods & services comprise 200 groups. Eight broad categories:

The Consumer Price Index(es) CPI-U: All urban consumers A fixed-weight index: consumption patterns rigid. Market basket is updated every two years. Represents about 87% of U.S. population. Used to adjust income tax brackets to account for inflation. Monthly, 60,000 prices are collected. Goods & services comprise 200 groups. Eight broad categories: FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks) HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture) APPAREL (men's shirts and sweaters, women's dresses, jewelry) TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance) MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) RECREATION (televisions, toys, pets and pet products, sports equipment, admissions); EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

CPI-U from 1947, 1970 and 2000 Jan. 2018 +2.14%

The Consumer Price Index(es) CPI-W: Urban wage earners & clerical workers A fixed-weight index. Represents about 32% of U.S. population. Half of HH income from clerical, craft, service. Excludes salaried, part-time, self-employed … Records average spending on 80,000 items in 87 geographical areas around the country. Used to adjust Social Security payments to keep up with cost of living (COLAs).

The Consumer Price Index(es) C-CPI-U: Chained CPI, all consumers A variable-weight index. Designed to account for “substitution bias.” When the price of pork rises, people buy more fish. CPI-U only accounts for narrow substitution, e.g., if the price of Granny Smith apples rise relative to Red Delicious. Designed to be a better measure of the cost of living. Records consumer expenditures each month and allows for changing composition of the basket.

Chained CPI-U from 2000

Comparing CPI-U with C-CPI-U Chained CPI

It depends on what happened to prices over this time. Using Price Indexes Convert nominal values into real values. Example: Your income in 2013 is $32,000 and in 2014 it is $33,100. Q - Are you “better off?” Convert to “real income” by looking at CPI: Say it was 172.2 in 2013 and 179.9 in 2014 It depends on what happened to prices over this time. ( )  = 100 x ( )  = 100 x

Features of Price Indexes Must choose a base year (where index = 100) Must choose a market basket of goods and services. Comparisons across short periods of time are more reliable than across long periods of time. Inflation rate is [CPI2 – CPI1]/CPI1 Average annual rate over “N” years is given as follows:   CPI2003 = 184 CPI2013 = 233 Inflation = (233-184)/184 = 26.6% Approx. annual inflation = 2.66% (10 years) Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%

Features of Price Indexes Must choose a base year (where index = 100) Must choose a market basket of goods and services. Comparisons across short periods of time are more reliable than across long periods of time. Inflation rate is [CPI2 – CPI1]/CPI1 Average annual rate over “N” years is given as follows:   CPI2003 = 184 CPI2013 = 233 Inflation = (233-184)/184 = 26.6% Approx. annual inflation = 2.66% (10 years) Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%

Calculating the C-CPI-U   shown and “s” refers L: 103.34 P: 101.48

Inflation Basics Dr. D. Foster – ECO 285

Comparing CPI-U with C-CPI-U, annual %∆ 2006 - 2016