Chapter 4
Measuring Price Level and Inflation
(Part II)
Chapter Outline
4.1 What is Inflation?
4.2 Causes of Inflation
4.3 Costs of Inflation
4.4 Measures of Inflation
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4.3 Costs of Inflation
• The real cost of inflation stems from its effect on the
value of money.
• If inflation is unpredictable, then a rise in the inflation
rate will decrease the value of money.
• In case of rising inflation, the most negatively
affected are the lenders and those with fixed
incomes like employees.
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• In addition, the unpredicted inflation will result in
wasted investment opportunities.
4.4 Measures of Inflation
• In order to measure inflation, we need a measure of
the overall price level in any economy, and this
measure is called the price index.
• A price index is an average of prices of goods and
services.
• Consumer price index (CPI) is considered the most
widely used price index.
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4.4 Measures of Inflation
• CPI is a price index that measures the average of
the prices paid for a fixed basket of consumer goods
and services.
• The inflation rate will be calculated as the rate of
change in CPI from one time period to another.
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4.4 Measures of Inflation
Steps of Constructing CPI
1- Select the components of CPI basket.
2- Conduct the monthly price survey for CPI basket.
3- Calculate the cost of CPI basket using the current
year and base year prices.
4- Calculate the CPI for the current year as follows:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒𝑠
× 100 5
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒𝑠
4.4 Measures of Inflation
• If the current year is the base year, then the CPI
should be equal to 100; that is, CPI is 100 in the
base year.
• The inflation rate for the time period (t) will then be
calculated by the following equation:
𝐶𝑃𝐼𝑡 − 𝐶𝑃𝐼𝑡−1
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑡 = × 100
𝐶𝑃𝐼𝑡−1
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4.4 Measures of Inflation
Example: (Page 59)
The following table shows the consumption data for a
certain country assuming that this country is
consuming only chocolate and clothing, and the base
year is 2015:
Prices in Prices in
Item CPI Basket
2015 2016
Chocolate 250 L.E. 3 L.E. 4
Clothing 500 L.E. 12 L.E. 13
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Calculate the inflation rate in 2016
4.4 Measures of Inflation
Solution:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡2016
= (𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐ℎ𝑜𝑐𝑜𝑙𝑎𝑡𝑒2016 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑐ℎ𝑐𝑜𝑙𝑎𝑡𝑒2016 )
+ (𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑙𝑜𝑡ℎ𝑖𝑛𝑔2016 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑐𝑙𝑜𝑡ℎ𝑖𝑛𝑔2016 )
= 4 × 250 + 13 × 500 = 𝐿. 𝐸. 7500
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡2015
= 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐ℎ𝑜𝑐𝑜𝑙𝑎𝑡𝑒2015 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑐ℎ𝑐𝑜𝑙𝑎𝑡𝑒2015
+ 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑙𝑜𝑡ℎ𝑖𝑛𝑔2015 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑐𝑙𝑜𝑡ℎ𝑖𝑛𝑔2015
= 3 × 250 + 12 × 500 = 𝐿. 𝐸. 6750
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4.4 Measures of Inflation
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡 2016 7500
𝐶𝑃𝐼2016 = × 100 = × 100 = 111.1
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑃𝐼 𝑏𝑎𝑠𝑘𝑒𝑡 2015 6750
𝐶𝑃𝐼2015 = 100, since 2015 is the base year
𝐶𝑃𝐼2016 − 𝐶𝑃𝐼2015
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒2016 = × 100
𝐶𝑃𝐼2015
111.1−100
= × 100 = 𝟏𝟏. 𝟏%
100