Inflation
ECON 3A. MACROECONOMICS
Inflation
Increase in the overall level of prices
Undesirability of inflation
People with fixed incomes
Benefits of pensioners
Creditors
Depreciation of purchasing power
Inflation gainers
People with flexible incomes
Speculators
buy goods at cheaper prices and sell them
at higher price
Debtors
Causes of Inflation
Demand-pull inflation
Rising demand, rising prices
Quantity theory of money
Elections
Causes of Inflation
Cost-push inflation
Rising costs, rising prices
Example: 1970s Oil Crisis
Oil prices
Rising wages
Monopolies – mark-up pricing
Currency devaluation (or depreciation)
Trade-off between Inflation and
Unemployment
Measures of Price Increases
1. Consumer Price Index
2. Retail Price Index
3. Wholesale Price Index
4. Stock Price Index
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
Calculating CPI
1. Fix the basket
Which prices are most important to the typical
consumer
Different weight
2. Find the prices
At each point in time
3. Compute the basket’s cost
Same basket of goods
Isolate the effects of price changes
Typical Basket of Goods and Services
Other goods This figure shows
Apparel (4%) and services
Recreation (3%) how the typical
(6%) consumer divides
Medical care his spending
(7%) among various
Education Housing (42%) categories of
and
communicatio
goods and
n (6%) services. The
Bureau of Labor
Statistics calls each
Food and
beverages percentage the
(15%) “relative
importance” of the
Transportation
(17%) category.
Calculating CPI
4. Choose a base year and compute the
CPI
Base year = benchmark
Price of basket of goods and services in current
year
Divided by price of basket in base year
Inflation
Timesin100year 2
CPI in year 2 – CPI in year 1
5. Compute the inflation rate
= X 100
CPI in year 1
Calculating the CPI and the
Inflation Rate
1. Survey consumers to determine fixed
basket of goods.
Basket = 4 hotdogs, 2 hamburgers
Calculating the CPI and the
Inflation Rate
2. Find the price of each good in each
year
Year Price of hotdogs Price of Hamburgers
2010 $1 $2
2011 2 3
2012 3 4
Calculating the CPI and the
Inflation Rate
3. Compute the cost of the basket of
goods in each year.
Year Cost of basket
2010 ($1 per hotdog X 4 hot dogs) + ($2 per
hamburger X 2 hamburgers) = $8 per basket
2011 ($2 per hotdog X 4 hot dogs) + ($3 per
hamburger X 2 hamburgers) = $14 per basket
2012 ($3 per hotdog X 4 hot dogs) + ($ 4 per
hamburger X 2 hamburgers) = $20 per basket
Calculating the CPI and the
Inflation Rate
4. Choose one year as a base year (2010)
and compute the consumer price index
Year CPI
2010 ($8 / $8) X 100 = 100
2011 ($14 / $8) X 100 = 175
2012 ($20 / $8) X 100 = 250
Calculating the CPI and the
Inflation Rate
5. Use the consumer price index to
compute the inflation rate from previous
year.
Year Inflation Rate
2010-2011 {(175 - 100) / 100} X 100 = 75%
2011-2012 {(250 - 175) / 175} X 100 = 43%
The Consumer Price Index
Inflation rate
Percentage change in the price index
From the preceding period
The Consumer Price Index
Problems in measuring the cost of living
1. Substitution bias
Prices do not change proportionately
Consumers substitute toward goods that
have become relatively less expensive
The Consumer Price Index
2. Introduction of new goods
More variety of goods
3. Unmeasured quality change
Changes in quality