1. Inflation Basics
Dr. D. Foster – ECO 285

2. 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

3. 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: =
x 100
x 100
∑(P1*Q1)
∑(P0*Q1)
$447.00
$440.50 =
Paasche: =
x 100
x 100

4. 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:

5. 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).

6. CPI-U from 1947, 1970 and 2000
Jan %

7. 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).

8. 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.

9. Chained CPI-U from 2000

10. Comparing CPI-U with C-CPI-U
Chained CPI

11. 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 in 2013 and in 2014
It depends on what happened to prices over this time. ( )  =
100 x ( )  =
100 x

12. 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 = ( )/184 = 26.6%
Approx. annual inflation = 2.66% (10 years)
Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%

13. 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 = ( )/184 = 26.6%
Approx. annual inflation = 2.66% (10 years)
Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%

14. Calculating the C-CPI-U
shown and “s” refers L: P:

15. Inflation Basics
Dr. D. Foster – ECO 285

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