1. Price Level Changes Slide Show for Lesson 5-2

2. Inflation is an increase in the average level of prices, whereas deflation is a decrease in the average level of prices. Inflation and deflation refer to prices in general, not prices of particular products. For example the rising cost of gasoline is not inflation. Figure 5-3 shows the inflation rate from 1960 to 1999. Note the high inflation in the 1970s. The damage done by that inflation still haunts the likes of Allen Greenspan and the Federal Reserve. Like Buffy the Vampire Slayer, they are determined to keep the USA safe from this menace regardless of the cost.

3. Why Do We Care? Inflation reduces the value of money. Deflation increases the value of money. This hurts anyone who has savings. Inflation reduces the value of future obligations. Deflation increases the value of future obligations. This wipes out the value of insurance policies and annuities. Price level changes can create uncertainty about the future. This tends to discourage investment. Unanticipated inflation helps borrowers and hurts lenders. Inflation helps those in debt but hurts the financial institutions.

4. Inflation hurts those on fixed incomes. Deflation helps those on fixed incomes. Many retirement programs try to overcome the problem of fixed incomes during inflation by arranging for indexed payments. These payments are called COLAs. An indexed payment is one whose dollar amount changes with the rate of change in the price level. Hyperinflation is usually defined as an inflation rate in excess of 200 percent per year. This has never happened in the USA. Why Do We Care? Cont.

5. Price Indices A price index is a number whose movement reflects movement in the average level of prices. To calculate a price index, select the kinds and quantities of goods to be included in the basket for the index. For example the Consumer Price Index should obviously contain items consumers buy. Determine the cost of the basket in some reference period called the base period. A base period is a time period against which costs of the market basket in other periods will be compared in computing a price index.

6. Price Indices (cont.) Determine the cost of the basket of goods in each time period. Compute the price index according to the following formula: Price Index = (Current Cost of Basket/Base-period Cost of Basket)x(100). If the basket of goods cost $2,397 in 2001 and $1,374 in the base year 1995, the the index for 2001 is (2,397/1,374) = 1.74 * 100 = 174. Multiplying by 100 is not necessary and has no mathematical effect. By social convention most financial numbers are referred to without the decimal. Who knows why?

7. The Consumer Price Index The consumer price index reflects changes in the prices for goods and services typically purchased by consumers. The CPI is based on a fixed basket of consumer goods which changes about every decade. The current CPI uses the average prices of products in the basket during the period 1982–1984 as the base period. CPI = (Current Cost of Basket/ 1982-1984 Cost of Basket)(100)

8. The Implicit Price Deflator The implicit price deflator is a price index that reflects the prices of all goods and services. It is computed from the ratio of current to real GDP. The basket is everything produced in the current period. Nominal GDP is the current cost of that basket. Real GDP is the base period cost of the same basket. Implicit price deflator = (Nominal GDP/ Real GDP)(100)

9. Computing the Inflation or Deflation Rate Inflation rate = (Change in Index/Initial Value of the Index)(100) For example is the CPI for 1998 was 156 and is 174 in 2001 then the inflation rate from 1998 to 2001 (174 – 156)/156*100 = 11.53%. Computing Real Values Using Price Indices A real value is a value measured in dollars of constant purchasing power. A nominal value is a value measured in dollars of current purchasing power. To convert nominal values to real values, divide the nominal value by a price index.

10. For example, what is the real cost of a gallon of gasoline. This may seem like a nonsensical question. Gasoline costs $1.67 a gallon, at least as of today. However, the $1.67 is the nominal price of gasoline, not its real price. Hidden in any discussion of this type with your friends or relatives is a comparison with the past. Last year gasoline cost less than it does today, so obviously it costs more this year than last year. However, comparing past prices to present prices only makes sense if the value or purchasing power of money has remained the same. If the money has changed in value, comparing prices directly will give a distorted view of the real change in price. In actuality, the real price of something is what you have to give up to get it, not its money price.

11. For example, in 1984 gasoline cost $1.13 a gallon and in 2001 it Costs $1.67 a gallon, so it has gone up $.54. But is gasoline more expensive today than in 1984 in real terms, that is in terms of affordability. To answer this questions, lets compare gasoline costs to minimum wage. In 1984 minimum wages was $3.35 an hour. In 2001 its $5.71 and hour. This means in 1984 an unskilled worker worked 20.24 minutes to earn a gallon of gasoline. (1.13/3.35)*60. In 2001, an unskilled worker worked 17.55 minutes to earn a gallon of gasoline. (1.67/5.71)*60). So it seems gasoline is more affordable in 2001 for a minimum wage worker. They give up almost 3 minutes less of an hour of work to earn a gallon of gasoline. In real terms, the price of gasoline has declined 5% for a minimum wage worker. ((3/60)*100).

12. Of course, generalizing about the affordability of gasoline by comparing the price of gasoline to the price of one other item, unskilled labor, would have its own limitations. This is why price indexes are developed and used, and why so much time and money goes into producing them. Check out these web pages to get an idea of how seriously some people take the CPI. http://stats.bls.gov/cpifaq.htm and http://stats.bls.gov/cpihome.htmhttp://stats.bls.gov/cpifaq.htm http://stats.bls.gov/cpihome.htm Business decisions and personal financial decisions must be based on real prices, rather than nominal prices, to avoid making serious errors. This is why developing quality price indexes is important. It’s a big area of work for the BEA and a big area of employment for private economists. Many industries buy proprietary price indexes from economic consultants.

13. Are Price Indices Accurate Measures of Price Level Changes? It’s clear that it is not possible to calculate the real price of items because it is not possible to perfectly calculate the overall change in prices and the resulting change in the purchasing power of money. Obviously, we do the best we can. Pages 133 and 114 detail some of the problems common in price indexes. Because the components of the market basket are fixed, the index does not incorporate consumer responses to changing relative prices. Consumer ameliorate the impact of price changes by substituting away from items going up in price and towards items not going up in price. A price index though has to assume the consumer does not alter the amount purchased as a result of price change.

14. A fixed basket excludes new goods and services. Changing the basket of goods obviously changes the price index, but a static basket of goods quickly becomes nonsensical in a rapidly changing world. How valid is a CPI that does not include cell phones or internet charges, but these things did not exist in 1985. Obviously, the basket must change. Quality changes may not be completely accounted for in computing price level changes. If the quality of a product improves, the consumer is getting more for their money. This is hard to include accurately in a price index. The type of store in which consumers choose to shop can affect the prices they pay. Price indices do not reflect changes consumers have made in where they shop. How to include Sam’s Club in a price index or internet shopping where reduced time and travel costs may make an item cheaper than its nominal price.

15. Are Price Indices Accurate Measures of Price Level Changes? The Boskin Report of 1996 estimates the upward bias in the CPI between 0.8 and 1.6 percentage points, with 1.1 percentage points as the best estimate. Using a measure with an upward bias to adjust nominal values has several implications. Real wages have been understated to the extent that the CPI has been overstating inflation. Since the CPI is the basis for adjusting government payments such as Social Security and for adjusting tax brackets, the budget balance has been affected by the upward bias of the CPI.