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

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

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:

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 = 1.0476 $135,000/$105,000 = 1.2857 The convention is to multiply by 100. Which year is the base period? http://research.stlouisfed.org/fred2/series/SPCS20RSA

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

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

Broad Categories and Relative Importance in the CPI, December 2010

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.

Calculating the Consumer Price Index

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

CPI in 2012 using 2011 as the based period  

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

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

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

Consumer Price Index: 1940 - 2014

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

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.

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

Nominal and Real Weekly Earnings (December of Each Year) 2014 $796 236.2 $337 http://www.bls.gov/news.release/wkyeng.t01.htm

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

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

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

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.

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: http://research.stlouisfed.org/fred2/ (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

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.

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

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

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

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

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)

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

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

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

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

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

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

Indexing and “Overindexing” Social Security Benefits