Diploma in Management Studies

Macroeconomics ECO003

Lecture 2
Inflation and the Price Level

Ref: Frank and Bernanke, Chapter 5

Learning Outcomes

1. Explain how the consumer price index (CPI) is

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

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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 is a fixed year, say 2010
– Base year changes periodically

Calculating the CPI

2010 Spending Monthly Cost in 2010

Rent (2 bedroom apartment) $500
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $6 each) 60
Monthly expenditures $680

2015 Spending Monthly Cost in 2015

Rent (2 bedroom apartment) $630
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $7 each) 70
Monthly expenditures $850

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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
– 2015 cost $850
CPI = (850 / 680) (100) = 1.25
• Cost of living in 2015 is 25% higher than in 2010
– 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
• CPI is sometimes multiplied by 100 to get rid of decimal
point
– CPI = 125
– Base-year CPI = 100

Cost of Living
CPI = 1050 / 800 = 1.31
2010 Spending Monthly Cost in 2010
Rent (2 bedroom apartment) $500
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $6 each) 60
Sweaters (4 at $30) 120
Monthly expenditures $800
2015 Spending Monthly Cost in 2015
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

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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

Inflation

• The rate of inflation is the Year CPI Inflation

2006 2.02
annual percentage change
2007 2.07 2.5%
in the price level
2008 2.15 3.9%
• Inflation in 2007 2009 2.15 0%
(2.07 – 2.02) / 2.02 2010 2.18 1.4%

= 0.0247 = 2.5% Year CPI Inflation

• The Great Depression 1929 0.171
– Period of falling output 1930 0.167 –2.3%
and prices 1931 0.152 –9.0%
– When inflation rates are 1932 0.137 –9.9%
negative there is deflation 1933 0.130 –5.1%

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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

Family Income in 2010 and

2015
• Can a family buy more with $40,000 in income in
2010 or with $44,000 in 2015?
– 2010 is the base year for the CPI
– Deflate nominal income in both years to get real
income
– Compare real income
– $40,000 in 2010 has the greater purchasing power

Year Nominal Income CPI Real Income

2010 $40,000 1.00 $40,000/1.00 = $40,000
2015 $44,000 1.25 $44,000/1.25 = $35,200

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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 CPI Real Average Wage
1970 $3.40 0.39 $3.40 / 0.39 = $8.72
2010 $19.00 2.18 $19.00 / 2.18 = $8.72

Production Workers’ Wages, 1960

- 2010

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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

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 Price Index Nominal Wage

1 $12.00 1.00 $12.00
2 $12.24 1.05 $12.85
3 $12.48 1.10 $13.73

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CPI and Inflation

• CPI and other indexes influence policy

decisions and wage increases
• 1996 report said CPI overstates 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

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

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CPI Substitution 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 2010 price 2010 Spending
Coffee (50 cups) $1.00 $50.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.00 $100.00
Total $200.00

CPI Substitution Bias

• In 2015, coffee and scones are more expensive

– Buying exactly the same basket of goods costs
$300, compared to $200 in 2005
– CPI = 300 / 200 = 1.50

Item 2015 price 2015 Spending

Coffee (50 cups) $2.00 $100.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.50 $150.00
Total $300.00

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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 2015 price 2015 Spending

Coffee (00 cups) $2.00 $0.00
Tea (100 cups) $1.00 $100.00
Scones (100) $1.50 $150.00
Total $250.00

Relative Prices and 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

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Relative Prices and Inflation

• Relative prices can change markedly

without corresponding changes in inflation
• Remedies for the two problems are
different
– To counteract changes in relative prices,
government would need to implement policies
that affect the supply and demand for specific
goods
– To counteract inflation, government would
need to resort to changes in macroeconomic
policies such as monetary or fiscal policies

True Costs of Inflation

• “Noise” in the price system

• Distortions of the tax system
• “Shoe-leather” costs
• Unexpected redistributions of wealth
• Interference with long-term planning

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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

Distortions Caused by Taxes

• Bracket creep of income taxes

– 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
• Progressive tax rates
– Disincentive to work

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 Distortions Caused by Taxes
• 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

Distortions Caused by Taxes

• Inflation distorts tax system which in

turn distorts the incentives for people to
work, save, and invest
– Lower savings and investment means
lower economic growth – a real cost of
inflation

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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

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

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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

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

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 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

Inflation and Interest Rates

• Nominal interest rates

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

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U.S. Real Interest Rates,
1960 - 2010

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

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US Inflation and Interest Rates,
1960 - 2010

Exercise 2.1
Refer to the table below which shows some information on the
expenditure pattern of a typical household in an economy over the
years 2006 and 2007:

Take 2006 as the base year and compute the CPI in 2006 and
2007. Use the CPI to calculate the inflation rate between 2006 and
2007 in the economy.

2006 2007

Price Quantity Price Quantity

Food $2 100 $2.20 95

Clothing $5 50 $5.50 60

Transport $0.80 25 $1 22
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 Exercise 2.2
If a borrower and lender agree to an interest
rate on a loan when inflation is expected to be
10% and inflation turns out to be 7% over the
life of the loan, then the borrower _____ and
the lender ______.
(A) gains; gains
(B) loses; gains
(C)gains; loses
(D)loses; loses
(E) is not affected; gains
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Exercise 2.3
To correct a nominal quantity for changes in
the price level, one should:
(A) add a price index to it.
(B) subtract a price index from it.
(C) divide it by a price index.
(D) multiple it by a price index.
(E) increase it by a percentage equal to the
rate of inflation for that year.

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Exercise 2.4
If the CPI equaled 1 in 1995 and 1.1 in 2000 and a
typical household's income equaled $35,000 in
1995 and $38,500 in 2000, then between 1995
and 2000, real household income:
A) increased.
B) may have increased or decreased.
C) decreased.
D) cannot be determined.
E) was constant.

39

Exercise 2.5
The CPI in year one equaled 1.45. The CPI
in year two equaled 1.51. The rate of
inflation between years one and two was
_____ percent.
(A) 4.0
(B) 4.1
(C) 4.5
(D) 5.1
(E) 6.0
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Exercise 2.6
Suppose that the price of apples rises sharply
compared to the price of oranges. People buy
more oranges and fewer apples than they did in
the CPI base year. In this situation the CPI will
tend to _____ inflation as a result of _____ bias.
(A) overstate; substitution
(B) overstate; quality adjustment
(C) understate; substitution
(D) understate; quality adjustment
(E) accurately measure; substitution
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