1. Lecture 5 Measuring Inflation

2. 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

3. Inflation
What is it?

4. 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?

5. 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

6. 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

7. 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

8. Calculating CPI

9. Mathematical Illustration

10. 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.

11. 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.

12. 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 = 250
Interpretation?

13. 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?

14. 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?

15. 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.

16. 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.

17. 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

18. 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

19. 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

20. 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?

21. GDP Deflator

22. 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

23. 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.

24. GDP Deflator

25. Calculating Inflation rates
Using CPI
Using GDP

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

27. 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

28. 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

29. 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

30. 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?

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

32. 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

33. Next Class Unemployment Definition and Measurement
Types of Unemployment