1. © OnlineTexts.com p.1 Chapter 5 Econ104 Parks Inflation

2. © OnlineTexts.com p.2 Measuring Inflation To measure inflation, we must first construct a price index. A price index is a device for measuring price level changes by tracking the price of a designated bundle of goods and services through time with respect to a base year. To measure inflation, we must first construct a price index. A price index is a device for measuring price level changes by tracking the price of a designated bundle of goods and services through time with respect to a base year.

3. © OnlineTexts.com p.3 Step to Construct a Price Index 1.Select a base year. The price index for the base year is set equal to 100. 2.Select a bundle of goods and services for which prices will be monitored over time. 3.Compute the cost of the bundle in the base year. 4.Compute the cost of the bundle in the year you wish to compare to the base year (year i). 5.Apply the following formula: 1.Select a base year. The price index for the base year is set equal to 100. 2.Select a bundle of goods and services for which prices will be monitored over time. 3.Compute the cost of the bundle in the base year. 4.Compute the cost of the bundle in the year you wish to compare to the base year (year i). 5.Apply the following formula:

4. © OnlineTexts.com p.4 Example of a “Movie” Price Index Base year is 1996. Bundle consists of two bags of popcorn, one movie ticket, and one soft drink.

5. © OnlineTexts.com p.5 http://econ124.wustl.edu/sp09/calc-relimport.xls

6. © OnlineTexts.com p.6 Weights – Relative Importance http://econ124.wustl.edu/sp09/calc- relimport.xlshttp://econ124.wustl.edu/sp09/calc- relimport.xls http://econ124.wustl.edu/sp09/cpi-rel- importance.xlshttp://econ124.wustl.edu/sp09/cpi-rel- importance.xls http://econ124.wustl.edu/sp09/calc- relimport.xlshttp://econ124.wustl.edu/sp09/calc- relimport.xls http://econ124.wustl.edu/sp09/cpi-rel- importance.xlshttp://econ124.wustl.edu/sp09/cpi-rel- importance.xls

7. © OnlineTexts.com p.7 Using a Price Index to Measure Inflation Once we create a price index, we can use that index to calculate the inflation rate. The inflation rate is the percentage change in the price index from one year to the next, or Once we create a price index, we can use that index to calculate the inflation rate. The inflation rate is the percentage change in the price index from one year to the next, or

8. © OnlineTexts.com p.8 Inflation at the Movies Inflation in 1997 is (108.8 - 100)/100 x 100 = 8.8% Inflation in 1998 = (114.7 - 108.8)/108.8 x 100 = 5.4% Inflation in 1997 is (108.8 - 100)/100 x 100 = 8.8% Inflation in 1998 = (114.7 - 108.8)/108.8 x 100 = 5.4%

9. © OnlineTexts.com p.9 Movie Price Index Recalculated Using Consumption Patterns from 1998 Base year is 1996. Bundle consists of one bag of popcorn, one movie ticket, and two soft drinks. Inflation rates are now 6.7% and 3.1%. Base year is 1996. Bundle consists of one bag of popcorn, one movie ticket, and two soft drinks. Inflation rates are now 6.7% and 3.1%.

10. © OnlineTexts.com p.10 A Problem with the Fixed-Weight Price Index Substitution bias occurs in a fixed-weight price index because consumers substitute away from those goods and services rising the most quickly, and purchase more of the relatively lower-cost items. –A fixed-weight price index tends to overstate the true cost of living. Substitution bias occurs in a fixed-weight price index because consumers substitute away from those goods and services rising the most quickly, and purchase more of the relatively lower-cost items. –A fixed-weight price index tends to overstate the true cost of living.

11. © OnlineTexts.com p.11 The Geometric Mean Price Index A geometric mean price index re-weights quantities in the price index each year for certain categories of the CPI. Therefore, changes in consumption patterns due to relative price changes are picked up quickly and the substitution bias is reduced.

12. © OnlineTexts.com p.12 The Geometric Mean Price Index The geometric mean of two numbers is the square root of their product.

13. © OnlineTexts.com p.13 Common Price Indices The CPI, PPI, and GDP Deflator are the three most common price indices in the U.S. economy. –Consumer Price Index (CPI) is composed of the bundle of goods and services that the typical urban household consumes. –Producer Price Index (PPI) consists of a bundle of goods traded at the wholesale level. –(Implicit) GDP deflator consists of the bundle of all newly produced final goods and services. The CPI, PPI, and GDP Deflator are the three most common price indices in the U.S. economy. –Consumer Price Index (CPI) is composed of the bundle of goods and services that the typical urban household consumes. –Producer Price Index (PPI) consists of a bundle of goods traded at the wholesale level. –(Implicit) GDP deflator consists of the bundle of all newly produced final goods and services.

14. © OnlineTexts.com p.14 Deflating Nominals to Reals Another important function of a price index is to compare prices across time. –A nominal value is not corrected for the effects of inflation. –A real value is the value of a good or service that is corrected for the effects of inflation. –Deflating is the process of deriving the real value of some nominal value by dividing by an appropriate price index. Another important function of a price index is to compare prices across time. –A nominal value is not corrected for the effects of inflation. –A real value is the value of a good or service that is corrected for the effects of inflation. –Deflating is the process of deriving the real value of some nominal value by dividing by an appropriate price index.

15. © OnlineTexts.com p.15 An Example Suppose that gasoline cost $1.45 in November 2002 but just $0.74 in November 1978. In which year was gasoline cheaper in real terms? –The CPI in Nov. 1978 was 67.5. –The CPI in Nov. 2002 was 181.5. –Real price of gasoline in 1978 was: $0.74/67.5 x 100 = $1.10 –Real price of gasoline in 2002 was: $1.45/181.5 x 100 = $0.80. Gas was much less expensive in 2002. Suppose that gasoline cost $1.45 in November 2002 but just $0.74 in November 1978. In which year was gasoline cheaper in real terms? –The CPI in Nov. 1978 was 67.5. –The CPI in Nov. 2002 was 181.5. –Real price of gasoline in 1978 was: $0.74/67.5 x 100 = $1.10 –Real price of gasoline in 2002 was: $1.45/181.5 x 100 = $0.80. Gas was much less expensive in 2002.

16. © OnlineTexts.com p.16 Economic data available at ECONOMAGIC.COM http://economagic.com

17. © OnlineTexts.com p.17 Inflation Inflation is a sustained increase in the price level. The price level is the weighted average of all prices in the economy (as measured by a given price index). Inflation is a sustained increase in the price level. The price level is the weighted average of all prices in the economy (as measured by a given price index).

18. © OnlineTexts.com p.18 U.S. Inflation Rates Inflation increased a bit in 2004 and 2005 due to higher energy prices.

19. © OnlineTexts.com p.19 U.S. CPI NSA AND SA

20. © OnlineTexts.com p.20 U.S. SA AND NSA Inflation Rates

21. © OnlineTexts.com p.21 U.S. Inflation Rates

22. © OnlineTexts.com p.22 Why Is Inflation Costly? When prices rise, wages don’t always keep up.

23. © OnlineTexts.com p.23 Other Costs of Inflation If inflation is anticipated, the costs include: –Shoe-leather costs –Menu costs –Tax costs If inflation in unanticipated, the costs include: –The arbitrary redistribution of income –Inflation uncertainty If inflation is anticipated, the costs include: –Shoe-leather costs –Menu costs –Tax costs If inflation in unanticipated, the costs include: –The arbitrary redistribution of income –Inflation uncertainty

24. © OnlineTexts.com p.24 Hyperinflation Hyperinflation is inflation that proceeds at exceptionally high rates. Some historical examples: –Germany Oct. 1923: 29,586%. –Nicaragua in 1988: 33,602% –Brazil 1990: 2,360%. The root cause is usually excessive money creation by the government to pay off debt. Hyperinflation is inflation that proceeds at exceptionally high rates. Some historical examples: –Germany Oct. 1923: 29,586%. –Nicaragua in 1988: 33,602% –Brazil 1990: 2,360%. The root cause is usually excessive money creation by the government to pay off debt.