1. Inflation and the Price Level
Chapter 16
McGraw-Hill/Irwin
Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.

2. Learning Objectives
Explain how the consumer price index (CPI) is constructed and use it to calculate the inflation rate
Show how the CPI is used to adjust dollar amounts to eliminate the effects of inflation
Discuss the two most important biases in the CPI
Distinguish between inflation and relative price changes to find the true costs of inflation
Summarize the connections among inflation, nominal interest rates, and real interest rates

3. Keeping up with Grandpa
Prices of goods change over time
Adjust values, incomes, or spending for change in prices
Constant purchasing power
Baseball salaries
Bruce Lee earned US$500,000 in 1973
Jackie Chan earned US$15 million in 2007
Inflation increases uncertainty when planning for the future
Consider costs of inflation

4. Measuring the Price Level
The Consumer Price Index (CPI) is a measure of the cost of living during a particular period
The CPI measures
The cost of a standard basket of goods and services in a given year
relative to the cost of the same basket of goods and services in the base year
Base year for the CPI changes periodically, normally it changes every five years

5. Calculating the CPI Monthly Cost in 2013 2013 Spending $500
Rent (2 bedroom apartment)
$500
Hamburgers (60 at $2 each)
120
Movie tickets (10 at $6 each) 60
Monthly expenditures
$680
2018 Spending
Monthly Cost in 2018
Rent (2 bedroom apartment)
$630
Hamburgers (60 at $2.50 each)
150
Movie tickets (10 at $7 each) 70
Monthly expenditures
$850

6. Calculating the CPI
CPI is the ratio of the cost of the basket of goods in the current year to the cost in the base year
Base year cost $680
2018 cost $850
CPI = (850 / 680) (100) = 1.25
Cost of living in 2018 is 25% higher than in 2013
CPI for the base year is always 1
CPI for a given period is the cost of living in that period relative to what it was in the base year
Statistical authorities around the world use CPI as a percentage – the ratio times 100

7. Cost of Living CPI = 1050 / 800 = 1.31 Monthly Cost in 2013
2013 Spending
Monthly Cost in 2013
Rent (2 bedroom apartment)
$500
Hamburgers (60 at $2 each)
120
Movie tickets (10 at $6 each) 60
Sweaters (4 at $30)
Monthly expenditures
$800
2018 Spending
Monthly Cost in 2018
Rent (2 bedroom apartment)
$630
Hamburgers (60 at $2.50 each)
150
Movie tickets (10 at $7 each) 70
Sweaters (4 at $50)
200
Monthly expenditures
$1,050

8. Price Index
A price index measures the average price of a given class of goods and services relative to the price of the same goods and services in a base year
CPI measures the change in consumer prices
Other indices
Core inflation is CPI without energy and food
Producer price index
Import / export price index

9. CPI of Selected Countries
Inflation
The rate of inflation is the annual percentage change in the price level
Inflation of China in 2012 = (2.68–2.61)/2.61 = = 2.7%
When inflation rates are negative there is deflation
CPI of Selected Countries
Year
China
Japan
Singapore
Thailand
United States
2008
2.41
1.02
0.99
0.94
2.15
2009
2.40
1.01
1.00
0.93
2010
2.48
1.03
0.96
2.18
2011
2.61
1.08
2.25
2012
2.68
1.13
2.30

10. Adjusting for Inflation
A nominal quantity is measured in terms of its current dollar value
A real quantity is measured in physical terms
Quantities of goods and services
To compare values over time, use real quantities
Deflating a nominal quantity converts it to a real quantity
Divide a nominal quantity by its price index to express the quantity in real terms

11. Family Income in 2013 and 2018
Can a family buy more with $40,000 in income in 2013 or with $44,000 in 2018?
2010 is the base year for the CPI
Deflate nominal income in both years to get real income
Compare real income
$40,000 in 2013 has the greater purchasing power
Year
Nominal Income
2013
$40,000
2018
$44,000
CPI
1.00
1.25
Real Income
$40,000/1.00 = $40,000
$44,000/1.25 = $35,200

12. Movie Stars Compare Bruce Lee’s earnings with Jackie Chan’s
Requires a CPI series that includes 1973 and 2007
U.S. CPI using 1982 – 1984 as base year
Jackie Chan had higher real salary
Does not convey information about relative incomes
Economic and Oil crisis in 1973
Multi-million dollar earnings common for move stars in 2007
Player
Year
Nominal Salary
Bruce Lee
1973
US$ 500,000
Jackie Chan
2007
US$ 15 Mn
CPI
0.444
2.073
Real Salary
US$ 1.13 Mn
US$ 7.24 mn

13. Real Wages
The real wage is the wage paid to the worker measured in terms of purchasing power
The real wage for any given period is calculated by dividing the nominal wage by the CPI for that period
US production worker wages
CPI uses 1982 – 1984 as base year
Real wages stayed the same between 1970 and 2010 despite the fact that the nominal wage in 2010 was 5.5 times the nominal wage in 1970
Year
Average Wage
1970
$3.40
2010
$19.00
CPI
0.39
2.18
Real Average Wage
$3.40 / 0.39 = $8.72
$19.00 / 2.18 = $8.72

14. Production Workers’ Wages, 1960 - 2010

15. Indexing
Indexing increases a nominal quantity each period by the percentage increase in a specified price index
Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation
Indexing automatically adjusts certain values, such as Social Security payments, by the amount of inflation
If prices increase 3% in a given year, the Social Security recipients receive 3% more
No action by Congress required
Indexing is sometimes included in labor contracts

16. Adjusting for Inflation
An indexed labor contract
First year wage is $12 per hour
Real wages rise by 2% per year for next 2 years
Relevant price index is 1.00 in first year, 1.05 in the second, and 1.10 in the third
Nominal wage is real wage times the price index
Year
Real Wage 1
$12.00 2
$12.24 3
$12.48
Price Index
1.00
1.05
1.10
Nominal Wage
$12.00
$12.85
$13.73

17. Minimum Wage
In some countries, the governments set the national minimum wage in nominal terms
Publicized debate results in periodic increases
Indexing would be simpler and less controversial
Politicians appear to benefit from the debate
In the United States, minimum wage increased 15 times between 1970 and 2008
Real minimum wage has decreased by about one-third in that period

18. CPI and Inflation
CPI and other indexes influence policy decisions and wage increases
1996 report said CPI overstates U.S. inflation by 1 to 2 percentage points a year
Unnecessarily increases government spending
Underestimates increase in the standard of living
Suppose CPI indicates 3% inflation when cost of living actually increases 2%
Real income increases 1%
Changes to calculations made since report to improve the quality of the CPI calculations

19. CPI Quality Adjustment Bias
One important bias in the CPI is its measurement of price changes but not quality changes
PC with 20% more memory has 20% higher price
Not the same PC as the one with less memory
If no adjustment is made for quality, PC's contribution to the CPI will be 20%
Adjusting for quality is difficult
Large numbers of goods
Subjective differences
Incorporating new goods is difficult
No base year price for this year's new goods

20. CPI Biases CPI uses a fixed basket of goods and services
When the price of a good increases, consumers buy less and substitute other goods
Failing to account for substitution overstates inflation
Example: base year cost of market basket
Item
2013 price
2013 Spending
Coffee (50 cups)
$1.00
$50.00
Tea (50 cups)
Donuts (100)
$100.00
Total
$200.00

21. CPI Substitution Bias In 2018, coffee and scones are more expensive
Buying exactly the same basket of goods costs $300, compared to $200 in 2013
CPI = 300 / 200 = 1.50
Item
2018 price
2018 Spending
Coffee (50 cups)
$2.00
$100.00
Tea (50 cups)
$1.00
$50.00
Donuts (100)
$1.50
$150.00
Total
$300.00

22. CPI Substitution Bias Actually, consumer substitutes tea for coffee
Scone purchases constant
True CPI for consumer is 250 / 200 = 1.25
CPI estimate of 1.50 is 20% higher than the consumer's experience
Item
2018 price
2018 Spending
Coffee (00 cups)
$2.00
$0.00
Tea (100 cups)
$1.00
$100.00
Donuts (100)
$1.50
$150.00
Total
$250.00

23. The Costs of Inflation
The price level is a measure of the overall level of prices at a particular point in time
Measured by a price index such as the CPI
The relative price of a specific good is a comparison of its price to the prices of other goods and services
Calculated as a ratio
Suppose we have a one-time doubling of the gas price
Overall price level and inflation increase by a small amount
The increase in the relative price of gasoline is large

24. Relative Prices
Relative prices can change markedly without corresponding changes in inflation
Summer prices
Higher
Beach hotels
Cruises
Gas prices
Lower
Fresh fruit and vegetables
Heating oil

25. Inflation and Relative Prices
Year
CPI
Inflation
2013
1.20
2014
1.32
10%
2015
1.40 6%
Oil Price Change 8%
Relative Price of Oil
-2% 2%

26. Noisy Prices Prices transmit information about
The cost of production and
The value buyers place on buying an additional unit
Inflation creates static in the communication
Buyers and sellers can't easily tell whether
The relative price of this good is increasing OR
Inflation is increasing the price of this good and all others
Deciding these issues requires market participants gather information – at a cost
Response to changing prices is tentative and slow

27. Indexing Avoids Distortions
Income taxes have been indexed to avoid bracket creep
Bracket creep occurs when a household is moved into a higher tax bracket due to increases in nominal but not real income
Higher tax brackets have a higher tax rate
Indexing income taxes matches tax rates to the real income level
Suppose the tax rate on $50,000 is 25% in 2010
CPI is 1 for 2010, 1.25 for 2015
Nominal income of $62,500 is taxed 25% in 2015

28. Distortions Caused by Taxes
Not all taxes are indexed
Capital depreciation allowance encourages purchase of capital goods
Allows firms to deduct a share of the purchase price as a business expense
Machine cost is $1,000 and its useful life is 10 years
Capital depreciation allowance of $100 per year
$100 in year 1 is worth more than $100 in year 10 because of inflation
In times of high inflation, investment in plant and equipment decreases

29. Distortions Caused by Taxes
US tax system is complex
Taxes are collected at the federal, state, and city levels
Conflicting incentives
Taxes that are not indexed distort the tax incentives for people to work, save, and invest
Lower savings and investment means lower economic growth – a real cost of inflation

30. Inflation Increases the Cost of Cash
If there is no inflation, cash holds its value over time
Some cash will be held for convenience
When inflation is high, cash loses value over time
Manage cash balances to limit losses
More frequent, smaller withdrawals cost consumers and businesses time, travel – a real cost of inflation
Banks process more transactions, increasing costs – another real cost of inflation
Costs of managing cash holding are called "shoe leather" costs, referring to the cost of frequent trips to the bank

31. Unexpected Redistribution of Wealth
Unexpected inflation redistributes wealth
Suppose workers' salaries are not indexed and inflation is higher than anticipated
Salaries lose purchasing power
Employers gain at the expense of workers
Similarly, unexpectedly high inflation benefits borrowers at the expense of lenders
Borrowers repay with dollars worth less than anticipated
Unexpected inflation confuses incentives

32. Interference with Long-Term Planning
Some decisions have a long time horizon
Erratic inflation makes planning risky
Retirement planning requires an estimated cost for your desired life-style
Save too little and you live less well in the future
Save too much and you live less well now
Given the costs of inflation, most economists agree that low and stable inflation promotes a healthy economy

33. Hyperinflation Hyperinflation is an extremely high rate of inflation
In 1923, German employers paid workers twice a day
Magnifies the costs of inflation
Minimize your cash holding
A study of market economies, 1960 – 1996 showed 45 episodes of high inflation (100+%) in 25 countries
Real GDP/person fell by an average of 1.6% per year
Real consumption/ person fell by an average of 1.3% per year
Real investment per person fell by an average of 3.3% per year

34. Inflation and Interest Rates
Unanticipated inflation helps borrowers and hurts lenders
The real interest rate is the annual percentage increase in the purchasing power of financial assets
Real interest rate = nominal interest rate – inflation
r = i - 
The nominal interest rate is the annual percentage increase in the dollar value of an asset
Nominal interest rates are the most commonly stated rates

35. Inflation and Interest Rates
Nominal interest rates and inflation vary
Nominal interest rate range is 3.2% to 11.4%
Inflation rate range is 1.6% to 13.5%
Real interest rate is nominal interest rate minus inflation
Real interest rate was highest in 1985, 7.0%
Real interest rate was lowest in 1980, – 2.1%
Year
Interest Rate (%)
Inflation Rate (%)
1975
8.0%
9.1
1980
11.4
13.5
1985
10.6
3.6
1990
8.6
5.4
1995
6.6
2.8
2000
6.0
3.4
2005
4.3
2010
3.2
1.6
2012
1.8
2.1

36. U.S. Real Interest Rates, 1960 - 2012

37. Inflation and Interest Rates
Unexpected inflation benefits borrowers and hurts lenders
For a given nominal interest rate, the higher the inflation rate, the lower the real interest rate
Expected inflation may not hurt lenders if they can adjust the nominal interest rates
Inflation-protected bonds pay a real rate of interest plus the inflation rate
The Fisher effect is the tendency for nominal interest rates to be high when inflation is high and low when inflation is low

38. US Inflation and Interest Rates, 1960 - 2012

39. Inflation and Price Levels
Hyperinflation
Price Level
CPI
CPI Biases
Real and Nominal Values
Indexing
Costs of Inflation
Real and Nominal Interest Rates