1. Inflation Measuring the Cost of Living
IB Economics

2. Inflation Defined
A sustained upward movement in the average level of prices
DEFLATION is therefore a sustained downward movement in the average level of prices
Price stability is an economic policy objective
A price index is used to measure the average level of prices or a price level

3. The Consumer Price Index
The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by typical consumers.
The Bureau of Labor Statistics reports the CPI each month. 2

4. What’s in the CPI’s Basket?5% 5%
Housing
Food/Beverages
Transportation
Medical Care
Apparel
Recreation
Other
Education and
communication 6% 5% 6%
40%
17%
16% 10

5. What goods and services does the Consumer Price Index (CPI) cover?
Answer: The CPI represents all goods and services purchased for consumption by the reference population (Consumer Price Index for All Urban Consumers or Consumer Price Index for Urban Wage Earners and Clerical Workers). The Bureau of Labor Statistics (BLS) has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:
FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals and 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, cable television, 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).
Also included within these major groups are various government-charged user fees, such as water and sewerage charges, auto registration fees, and vehicle tolls. The CPI also includes taxes, such as sales and excise taxes, that are directly associated with the prices of specific goods and services. However, the CPI excludes taxes, such as income and Social Security taxes, not directly associated with the purchase of consumer goods and services.
The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance. (These items relate to savings and not to day-to-day consumption expenses.)
For each of the more than 200 item categories, BLS has chosen samples of several hundred specific items within selected business establishments frequented by consumers, using scientific statistical procedures, to represent the thousands of varieties available in the marketplace. For example, in a given supermarket, BLS may choose a plastic bag of golden delicious apples, U.S. extra fancy grade, weighing 4.4 pounds to represent the "Apples" category.
Source: bls.gov

6. How the Consumer Price Index Is Calculated
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. 5

7. How the Consumer Price Index Is Calculated
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.
Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. 7

8. How the Consumer Price Index Is Calculated
CPI=
Current year’s price level
X 100
Base year price level 7

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

10. That’s all for today folks!
Now a cheesy video on inflation

11. Inflation Part Two A bit of inflation humor to start the day . . .
Warm-up:
Is inflation always bad? Who is hurt and who benefits from inflation?

12. Hurt by inflation:
Fixed income earners – seniors, land lords with long leases, public sector employees on fixed pay schedules
Lenders-
Savers-

13. Helped by inflation: Borrowers with fixed rate loans
Flexible income receivers

14. The Babe Ruth Problem
In 1931 Babe Ruth made $80,000. In 2003 a baseball star was paid $1,000,000. Who really made the most?
The CPI (using base years) in 1931 was 15.2 and was in 2003
In 1931, Ruth’s tax rate was 15%; in 2003 the Star’s tax rate was 40%
Question: What was the real disposable income of both players? In other words, who made more?

15. How did you solve the problem?

16. Problems in Measuring CPI
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. 12

17. Problems in Measuring the Cost of Living
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 CPI overstates inflation by about 1 percentage point per year. 18

18. Are you beating inflation or is inflation beating you?
Keeping up with inflation: real income stays constant.
Not keeping up with inflation: real income falls.
More than keeping up with inflation: real income rises.

19. Costs of Inflation Uncertainty Resource Cost
Impacts firms willingness to invest
Resource Cost
Menu costs
Shoe-leather costs
Functions of Money are Eroded
Destroys value of money
Destroys incentive to save or life-savings
Redistribution Costs

20. Costs of Inflation (Continued)
Redistribution Costs
Role of prices is to co-ordinate market activity
Inflation distorts price system
Resources become redistributed arbitrarily, rather than responding methodically to values and scarcities
Examples
People on fixed incomes suffer a fall in real income
Borrowers will gain at the expense of lenders
Export prices will change relative to import prices

21. Anticipated & Unanticipated Inflation
Unanticipated inflation hurts
Fixed-income receivers
Savers
Creditors
Unanticipated inflation helps
Flexible-income receivers
Debtors
What about anticipated inflation?

22. Summary
The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year.
The index is used to measure the overall level of prices in the economy.
The percentage change in the CPI measures the inflation rate.

23. Summary
The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality.
Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.