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. general price level What is the “general price level”? Price Index 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 Paasche: Q0 ∑(P1*Q0) Q0 ∑(P0*Q0) Q1 ∑(P1*Q1) Q1 ∑(P0*Q1) = $ $ = $ $ = = The CPI uses a Laspeyres index like this, so showing inflation of 3.34%. x 100 PI 0 = 100 and PI 1 = ??? Laspeyres:

The Consumer Price Index(es) CPI-U 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 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 FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks) HOUSING HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture) APPAREL APPAREL (men's shirts and sweaters, women's dresses, jewelry) TRANSPORTATION TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance) MEDICAL CARE MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) RECREATION RECREATION (televisions, toys, pets and pet products, sports equipment, admissions); EDUCATION AND COMMUNICATION EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); OTHER GOODS AND SERVICES OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

CPI-U from 1947, 1970 and 2000

The Consumer Price Index(es) CPI-W 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 C-CPI-U: Chained CPI, all consumers – A variable-weight index. substitution bias – 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

Using Price Indexes Converts nominal values into real values: Example: Q - Are you “better off?” 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 in 2013 and in 2014

Features of Price Indexes CPI 2003 = 184 CPI 2013 = % Inflation = ( )/184 = 26.6% Approx. annual inflation = 2.66% (10 years) 2.39% Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39% 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 [CPI 2 – CPI 1 ]/CPI 1 Average annual rate over “N” years is given as follows:

Features of Price Indexes CPI 2003 = 184 CPI 2013 = % Inflation = ( )/184 = 26.6% Approx. annual inflation = 2.66% (10 years) 2.39% Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39% 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 [CPI 2 – CPI 1 ]/CPI 1 Average annual rate over “N” years is given as follows:

Calculating the C-CPI-U L: P:

Inflation Basics Dr. D. Foster – ECO 285