1. The Price Level and Inflation
CHAPTER
The Price Level and Inflation
Chapter 7

2. Measuring Price Level and Inflation
Price Level - average of the prices of all good and services in the economy
Price Index – a measure of the price level
GDP deflator is a price index used to track rise and fall in the price level over time.
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟= 𝑁𝐺𝐷𝑃 𝑅𝐺𝐷𝑃 x 100

3. Index in General
Index - A series of numbers used to track a variable’s rise or fall over time
An index number is calculated as:

4. Example: Index Number for House Prices
Year
House Price
Index of House Price 1
$105,000
100.00 2
$110,000
104.76 3
$125,000
119.05 4
$135,000
128.57
Note: $110,000/$105,000 =
$135,000/$105,000 =
The convention is to multiply by 100.
Which year is the base period?

5. The Consumer Price Index
Consumer Price Index (CPI)
An index of the cost over time of a market basket of goods purchased by a typical household
CPI includes
the part of GDP that consumers purchase as final users
household purchases of used goods such as used cars or used computers
household purchases of imports

6. The Consumer Price Index
CPI does not include
Goods and services purchased by anyone other than consumers
Prices of assets, such as stocks, bonds, and homes
CPI market basket
The collection of goods and services that the typical consumer buys

7. Broad Categories and Relative Importance in the CPI, December 2010

8. Calculating the Consumer Price Index
define a market basket
(2) determine how much it would cost to
purchase the market basket in the current
year and in the base year
(3) divide the dollar cost of purchasing the
market basket in the current year by the
dollar cost of purchasing the market basket
in the base year
(4) multiply the quotient by 100.

9. Calculating the Consumer Price Index

10. Calculating the Consumer Price Index
Market Basket using 2011 as the Base Year

11. CPI in 2012 using 2011 as the based period

12. Consumer Price Index, December, selected years, 1970–2010
1983 = 100

13. From Price Index to Inflation Rate
Percentage change in the price level from one period to the next
Deflation
A decrease in the price level from one period to the next

14. Consumer Price Index, December, selected years, 1970–2010
Rate of Inflation
2006
2007
2008
2009
2010

15. Consumer Price Index: 1940 - 2014

16. The Rate of Inflation Using the Consumer Price Index, 1950–2014

17. Three Way the CPI Is Used
(1) As a policy target; (2) To index payments; (3) To translate from nominal to real values
Policy target
One macroeconomic goal is stable prices
Index payments
A payment that is periodically adjusted in
proportion with a price index such as
Social Security retirement income.

18. Translate from Nominal to Real Values
Nominal wage
Number of dollars you earn
Real wage
Purchasing power of your wage

19. Nominal and Real Weekly Earnings (December of Each Year)
$ $337

20. How the CPI Is Used When comparing dollar values over time
We care not about the number of dollars, but about their purchasing power
Translate nominal values into real values

21. There are Many price indexes
The GDP price index measures the prices of all final goods and services that are included in U.S. GDP
The CPI measures the prices of all goods and services bought by U.S. households including used goods and imports

22. CPI vs. GDP Deflator Prices of capital goods (Investment):
included in GDP deflator (if produced domestically)
excluded from CPI
Prices of imported consumer goods:
included in CPI
excluded from GDP deflator
The basket of goods:
CPI: fixed
GDP deflator: changes every year

23. The Costs of Inflation The inflation myth
“Inflation, by making goods and services more expensive, erodes the average purchasing power of income in the economy”
Inflation does not directly decrease the average real income in the economy
because people’s income increase during inflations. Prices and income tend to rise together. Not really hurt.

24. The CPI and Average Hourly Earnings, 1965-2009
900
$20
800
Real average hourly earnings in 2009 dollars, right scale
700
$15
600
1965 = 100
500
Hourly wage in May 2009 dollars
$10
400
Nominal average hourly earnings, (1965 = 100)
The CPI has risen tremendously over the past 45 years. However, nominal wages have risen by a roughly similar magnitude.
If the common misperception were true, then the real wage should show exactly the opposite behavior as the CPI. It doesn’t. While the real wage is not constant - it varies within the range of $15 to $20 – it exhibits no downward long-term trend.
(We, of course, wouldn’t expect the real wage to be constant over the long run – we would expect it to change in response to shifts in the labor supply and MPL curves.)
If you taught with the previous edition of my PowerPoint slides for Mankiw, please note that the nominal wage here is measured as an index (1965=100) rather than in the more natural units of current dollars (as in the previous edition). The reason for the change is so that both series (nominal wage and CPI) are now measured in the same units and can be shown along the same vertical axis, which makes it possible to compare the magnitude of the increase in both series. The real wage, however, is measured in the more natural units of 2009 dollars (May 2009 dollars, to be precise) along the right-hand (secondary) vertical axis.
source: BLS
Obtained from:
(AHETPI = average hourly earnings: total private industries)
300 $5
200
CPI (1965 = 100)
100 $0
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010

25. The Costs of Inflation
But, Inflation changes the distribution of income.
People living on fixed incomes are particularly hurt by inflation.
And the poor have not fared so well. Welfare benefits are relatively fixed and have not kept pace with inflation.

26. Benefits Indexed to Inflation
To address the distribution problem, benefits received by many retired workers, including social security, are fully indexed to inflation.
when prices rise, benefits rise.
If inflation is correctly anticipated
and if both parties take it into account, then inflation will not redistribute purchasing power

27. Interest Rates Nominal interest rate Real interest rate
The actual interest rate borrower’s pay and lender’s earn from making a loan
Real interest rate
The nominal interest rate adjusted for
inflation
Calculation:
- real interest rate = nominal interest rate - inflation

28. Example:
I borrow $100 from a lender and agree to pay $105 after one year:
Loan amount = $100
Interest payment = $5
Nominal Interest rate = $5/ $100 = 5%
The lender now has $105
Suppose inflation is 2%. What cost $100 a year earlier now cost $102.
The lender’s purchasing power increases by $3 not $5.
The real interest rate is 5% - %2 = 3%
= Nominal interest rate - Rate of inflation

29. The Costs of Inflation
The real interest rate represents the increase in purchasing power to the lender and the real cost of the loan to the borrower.
If borrowers and lenders know the rate of inflation, they know the real cost and purchasing power of the loan
Unexpected inflation shifts purchasing power

30. The Costs of Inflation Inflation rate higher than expected
Harms those awaiting payment (lenders)
Benefits the payers (borrowers)
Inflation rate lower than expected
Harms the payers (borrowers)
Benefits those awaiting payment (lenders)

31. Is the CPI Accurate? Sources of bias in CPI Substitution bias
New technologies
Changes in quality
Growth in discounting

32. Is the CPI Accurate? Substitution bias New technology
Quantity is fixed
New technology
CPI: as new products are introduced, CPI overstates inflation
Changes in quality
CPI: fails to fully account for quality improvements in the goods and services in its market basket
Overestimates the price of the basket of goods and services

33. Is the CPI Accurate? Growth in discounting
CPI: does not recognize that a new discount outlet lowers the prices on many items
As discount outlets expand into new areas, the CPI overstates the inflation rate
Food, electronic appliances, clothing, and other items sold there

34. Is the CPI Accurate? Consequences of CPI bias
Errors in calculating real wages
Errors in indexing
Retirement benefits, wages, interest payments, or federal tax brackets

35. The Controversy Over Indexing Social Security Benefits
Social Security system
Benefits to about 60 million retired workers in U.S.
One of the largest and most expensive of all federal government programs
More than $770 billion in 2012
Estimated to grow to $1,400 billion in 2023
Payments are indexed to CPI

36. Because the CPI overstate inflation
The Controversy …
Because the CPI overstate inflation
Nominal payment rises by more than the actual rise in the price level
Benefits payments in real terms increase over time
Purchasing power is automatically shifted toward those who are indexed and away from the rest of society

37. Indexing and “Overindexing” Social Security Benefits