Inflation Lecture Note – 4

ECO – 2102

Measuring the Cost of Living: The Consumer Price Index

A dollar today doesn’t buy as much as it did twenty years ago. The cost of almost everything
has gone up. This increase in the overall level of prices is called inflation, and the percentage
change in the price level from one period to the next is called the inflation rate. Inflation is a
primary concern of economists and policymakers. Later we will examine in detail the causes
and effects of inflation. Here we discuss how economists measure changes in the cost of
living.

The Price of a Basket of Goods

The most commonly used measure of the level of prices is the consumer price index (CPI).
[Bangladesh Bureau of Statistics (BBS) measures the CPI in Bangladesh]. It begins by
collecting the prices of thousands of goods and services. Just as GDP turns the quantities of
many goods and services into a single number measuring the value of production, the CPI
turns the prices of many goods and services into a single index measuring the overall level
of prices.

The CPI is the price of a basket of goods and services relative to the price of the same
basket in some base year. For example, suppose that a typical consumer buys 5 apples and
2 oranges every month. Then the basket of goods consists of 5 apples and 2 oranges, and
the CPI is

In this CPI, 2020 is the base year. The index tells us how much it costs now to buy 5 apples
and 2 oranges relative to how much it cost to buy the same basket of fruit in 2020. Because
so much depends on the CPI, it is important to ensure that this measure of the price level is
accurate. Many economists believe that, for a number of reasons, the CPI tends to
overstate inflation.

One problem is the substitution bias. Because the CPI measures the price of a fixed basket
of goods, it does not reflect the ability of consumers to substitute towards goods whose
relative prices have fallen. Thus, when relative prices change, the true cost of living rises less
rapidly than does the CPI.

A second problem is the introduction of new goods. When a new good is introduced into
the marketplace, consumers are better off because they have more products from which to
choose. In effect, the introduction of new goods increases the real value of the dollar. Yet
this increase in the purchasing power of the dollar is not reflected in a lower CPI.

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A third problem is unmeasured changes in quality. When a firm changes the quality of a
good it sells, not all of the good’s price change reflects a change in the cost of living. For
example, if Ford increases the horsepower of a particular car model from one year to the
next, the CPI will reflect the change: the quality-adjusted price of the car will not rise as fast
as the unadjusted price. Yet many changes in quality, such as comfort or safety, are hard to
measure. If unmeasured quality improvement (rather than unmeasured quality
deterioration) is typical, then the measured CPI rises faster than it should.

Inflation Rate

The rate of inflation is the percentage change in the price level. We measure inflation using
the following formula:
𝑃𝑡−𝑃𝑡−1
Rate of inflation in year t = x 100
𝑃𝑡−1

The most widely used measure of the price level is the CPI. Thus, the formula for calculating
inflation rate using CPI is,
𝐶𝑃𝐼𝑡−𝐶𝑃𝐼𝑡−1
Rate of inflation in year t = x 100
𝐶𝑃𝐼𝑡−1

Three Strains of Inflation

Like diseases, inflations exhibit different levels of severity. It is useful to classify them into
three categories: low inflation, galloping inflation, and hyperinflation.

Low Inflation: Low inflation is characterized by prices that rise slowly and predictably. We
might define this as single-digit annual inflation rates. When prices are relatively stable,
people trust money because it retains its value from month to month and year to year. People
are willing to write long-term contracts in money terms because they are confident that the
relative prices of goods they buy and sell will not get too far out of line. Most countries have
experienced low inflation over the last decade.

Galloping Inflation: Inflation in the double-digit or triple-digit range of 20, 100, or 200
percent per year is called galloping inflation or “very high inflation.” Galloping inflation is
relatively common, particularly in countries suffering from weak governments, war, or
revolution. Many Latin American countries, such as Argentina, Chile, and Brazil, had inflation
rates of 50 to 700 percent per year in the 1970s and 1980s. Once galloping inflation becomes
entrenched, serious economic distortions arise. Generally, most contracts get indexed to a
price index or to a foreign currency like the dollar. In these conditions, money loses its value
very quickly, so people hold only the bare-minimum amount of money needed for daily

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transactions. Financial markets wither away, as capital flees abroad. People hoard goods,
buy houses, and never, ever lend money at low nominal interest rates.

Hyperinflation: While economies seem to survive under galloping inflation, a third and
deadly strain takes hold when the cancer of hyperinflation strikes. Nothing good can be said
about an economy in which prices are rising a million or even a trillion percent per year.
Hyperinflations are particularly interesting to students of inflation because they highlight its
disastrous impacts. The most thoroughly documented case of hyperinflation took place in
the Weimar Republic of Germany in the 1920s. From January 1922 to November 1923, the
price index rose from 1 to 10,000,000,000. If a person had owned 300 million marks worth of
German bonds in early 1922, this amount would not have bought a piece of candy 2 years
later. In 2008, a similar hyperinflation gripped the nation of Zimbabwe.

Seigniorage

All governments spend money. Some of this spending is to buy goods and services (such as
roads and police), and some is to provide transfer payments (for the poor and elderly, for
example). A government can finance its spending in three ways. First, it can raise revenue
through taxes, such as personal and corporate income taxes. Second, it can borrow from
the public by selling government bonds. Third, it can print money.

The revenue raised by the printing of money is called seigniorage. The term comes from
seigneur, the French word for “feudal lord.” In the Middle Ages, the lord had the exclusive
right on his manor to coin money. Today this right belongs to the central government, and it
is one source of revenue.

When the government prints money to finance expenditure, it increases the money supply.
The increase in the money supply, in turn, causes inflation. Printing money to raise revenue
is like imposing an inflation tax. In countries experiencing hyperinflation, seigniorage is often
the government’s chief source of revenue—indeed, the need to print money to finance
expenditure is a primary cause of hyperinflation.

Inflation and Interest Rates

Interest rates are among the most important macroeconomic variables. In essence, they are
the prices that link the present and the future. Here we discuss the relationship between
inflation and interest rates.

Two Interest Rates: Real and Nominal: Suppose you deposit your savings in a bank account
that pays 8 percent interest annually. Next year, you withdraw your savings and the
accumulated interest. Are you 8 percent richer than you were when you made the deposit a
year earlier?

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The answer depends on what “richer” means. Certainly, you have 8 percent more dollars
than you had before. But if prices have risen, each dollar buys less, and your purchasing
power has not risen by 8 percent. If the inflation rate was 5 percent over the year, then the
amount of goods you can buy has increased by only 3 percent. And if the inflation rate was
10 percent, then your purchasing power has fallen by 2 percent.

The interest rate that the bank pays is called the nominal interest rate, and the increase
in your purchasing power is called the real interest rate. The real interest rate is the
difference between the nominal interest rate and the rate of inflation. If i denotes the nominal
interest rate, r the real interest rate, and π the rate of inflation, then the relationship among
these three variables can be written as

r=i–π

The Fisher Effect: Rearranging terms in our equation for the real interest rate, we can show
that the nominal interest rate is the sum of the real interest rate and the inflation rate:

i = r + π.

The equation written in this way is called the Fisher equation, after economist Irving Fisher
(1867–1947). It shows that the nominal interest rate can change for two reasons: because
the real interest rate changes or because the inflation rate changes. The Fisher equation tells
us how money growth affects the nominal interest rate. According to the Fisher equation,
a 1 percent increase in the rate of inflation in turn causes a 1 percent increase in the
nominal interest rate. The one-for-one relation between the inflation rate and the
nominal interest rate is called the Fisher effect.

Anticipated vs. Unanticipated (Expected vs Unexpected) Inflation

An important distinction in the analysis of inflation is whether the price increases are
anticipated or unanticipated. Suppose that all prices are rising at 3 percent each year and
everyone expects this trend to continue. Would there be any reason to get excited about
inflation? Would it make any difference if both the actual and the expected inflation rates
were 1 or 3 or 5 percent each year? Economists generally believe that anticipated inflation
at low rates has little effect on economic efficiency or on the distribution of income and
wealth. People would simply be adapting their behavior to a changing monetary yardstick.

But the reality is that inflation is usually unanticipated. For example, the Russian people had
become accustomed to stable prices for many decades. When prices were freed from
controls of central planning in 1992, no one, not even the professional economists, guessed
that prices would rise by 400,000 percent over the next 5 years. People who naïvely put their
money into ruble savings accounts saw their net worth evaporate. Those who were more

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sophisticated manipulated the system, and some even became fabulously wealthy
“oligarchs.”

Inflation is simply an increase in the average level of prices, and a price is the rate at which
money is exchanged for a good or a service. In most modern economies, a central bank set
up by the government controls the quantity of money in the hands of the public.

The Costs of Expected Inflation

Consider first the case of expected inflation. Suppose that every month the price level rose
by 1/2 percent. What would be the social costs of such a steady and predictable 6 percent
annual inflation?

Shoeleather cost: One cost is the distorting effect of the inflation tax on the amount of
money people hold. As we have already discussed, a higher inflation rate leads to a higher
nominal interest rate, which in turn leads to lower real money balances. If people hold lower
money balances on average, they must make more frequent trips to the bank to withdraw
money—for example, they might withdraw $50 twice a week rather than $100 once a week.
The inconvenience of reducing money holding is metaphorically called the shoeleather
cost of inflation, because walking to the bank more often causes one’s shoes to wear out
more quickly.

Menu costs: A second cost of inflation arises because high inflation induces firms to change
their posted prices more often. Changing prices is sometimes costly; for example, it may
require printing and distributing a new catalog. These costs are called menu costs, because
the higher the rate of inflation, the more often restaurants have to print new menus.

Variability in relative prices: A third cost of inflation arises because firms facing menu costs
change prices infrequently; therefore, the higher the rate of inflation, the greater the
variability in relative prices.

For example, suppose a firm issues a new catalog every January. If there is no inflation, then
the firm’s prices relative to the overall price level are constant over the year. Yet if inflation is
1/2 percent per month, then from the beginning to the end of the year the firm’s relative
prices fall by 6 percent. Sales from this catalog will tend to be low early in the year (when its
prices are relatively high) and high later in the year (when its prices are relatively low). Hence,
when inflation induces variability in relative prices, it leads to microeconomic inefficiencies
in the allocation of resources.

Failure of the tax code: A fourth cost of inflation results from the tax laws. Many provisions
of the tax code do not take into account the effects of inflation. Inflation can alter individuals’
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tax liability, often in ways that lawmakers did not intend. One example of the failure of the
tax code to deal with inflation is the tax treatment of capital gains. The problem is that the
tax code measures income as the nominal rather than the real capital gain. In many cases,
inflation distorts how taxes are levied.

Inconvenience of living: A fifth cost of inflation is the inconvenience of living in a world with
a changing price level. Money is the yardstick with which we measure economic
transactions. When there is inflation, that yardstick is changing in length.

For example, a changing price level complicates personal financial planning. One important
decision that all households face is how much of their income to consume today and how
much to save for retirement. A dollar saved today and invested at a fixed nominal interest
rate will yield a fixed dollar amount in the future. Yet the real value of that dollar amount—
which will determine the retiree’s living standard—depends on the future price level.
Deciding how much to save would be much simpler if people could count on the price level
in 30 years being similar to its level today.

The Costs of Unexpected Inflation

Unexpected inflation has an effect that is more pernicious than any of the costs of steady,
anticipated inflation: it arbitrarily redistributes wealth among individuals. You can see how
this works by examining long-term loans. Most loan agreements specify a nominal interest
rate, which is based on the rate of inflation expected at the time of the agreement. If inflation
turns out differently from what was expected, the ex post real return that the debtor pays to
the creditor differs from what both parties anticipated. On the one hand, if inflation turns out
to be higher than expected, the debtor wins and the creditor loses because the debtor repays
the loan with less valuable dollars. On the other hand, if inflation turns out to be lower than
expected, the creditor wins and the debtor loses because the repayment is worth more than
the two parties anticipated.

Unanticipated inflation also hurts individuals on fixed pensions. Workers and firms often
agree on a fixed nominal pension when the worker retires (or even earlier). Because the
pension is deferred earnings, the worker is essentially providing the firm a loan: the worker
provides labor services to the firm while young but does not get fully paid until old age. Like
any creditor, the worker is hurt when inflation is higher than anticipated. Like any debtor, the
f irm is hurt when inflation is lower than anticipated.

Finally, in thinking about the costs of inflation, it is important to note a widely documented
but little understood fact: high inflation is variable inflation. That is, countries with high
average inflation also tend to have inflation rates that change greatly from year to year. The

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implication is that if a country decides to pursue a high-inflation monetary policy, it will likely
have to accept highly variable inflation as well.

One Benefit of Inflation

So far, we have discussed the many costs of inflation. These costs lead many economists to
conclude that monetary policymakers should aim for zero inflation. Yet there is another side
to the story. Some economists believe that a little bit of inflation—say, 2 or 3 percent per
year—can be a good thing.

The argument for moderate inflation starts with the observation that cuts in nominal wages
are rare: firms are reluctant to cut their workers’ nominal wages, and workers are reluctant
to accept such cuts. A 2 percent wage cut in a zero inflation world is, in real terms, the same
as a 3 percent raise with 5 percent inflation, but workers do not always see it that way. The 2
percent wage cut may seem like an insult, whereas the 3 percent raise is, after all, still a
raise. Empirical studies confirm that nominal wages rarely fall.

This finding suggests that some inflation may make labor markets work better. The supply
and demand for different kinds of labor are always changing. Sometimes an increase in
supply or decrease in demand leads to a fall in the equilibrium real wage for a group of
workers. If nominal wages can’t be cut, then the only way to cut real wages is to allow
inflation to do the job. Without inflation, the real wage will be stuck above the equilibrium
level, resulting in higher unemployment.

For this reason, some economists argue that inflation “greases the wheels” of labor
markets. Only a little inflation is needed: an inflation rate of 2 percent lets real wages fall by
2 percent per year, or about 20 percent per decade, without cuts in nominal wages. Such
automatic reductions in real wages are impossible with zero inflation.

Hyperinflation

Hyperinflation is often defined as inflation that exceeds 50 percent per month, which is just
over 1 percent per day. Compounded over many months, this rate of inflation leads to very
large increases in the price level. An inflation rate of 50 percent per month implies a more
than 100-fold increase in the price level over a year and a more than 2-million-fold increase
over three years. Here we consider the costs and causes of such extreme inflation.

The Costs of Hyperinflation

There is no doubt that hyperinflation extracts a high toll on society. The costs are qualitatively
the same as those of the costs of expected inflation. When inflation reaches extreme levels,
however, these costs are more apparent because they are so severe. Eventually, these costs
of hyperinflation become intolerable. Over time, money loses its role as a store of value, unit
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of account, and medium of exchange. Barter becomes more common. And more stable
unofficial monies—cigarettes or the U.S. dollar—start to replace the official money.

The Causes and Remedies of Hyperinflation

Why do hyperinflations start, and how do they end? This question can be answered at
different levels. The most obvious answer is that hyperinflations are due to excessive
growth in the supply of money. When the central bank prints money, the price level rises.
When it prints money rapidly enough, the result is hyperinflation. To stop the hyperinflation,
the central bank must reduce the rate of money growth. T

his answer is incomplete, however, for it leaves open the question of why central banks in
hyperinflating economies choose to print so much money. To address this deeper question,
we must turn our attention from monetary to fiscal policy. Most hyperinflations begin when
the government has inadequate tax revenue to pay for its spending. Although the
government might prefer to finance this budget deficit by issuing debt, it may find itself
unable to borrow, perhaps because lenders view the government as a bad credit risk. To
cover the deficit, the government turns to the only mechanism at its disposal—the printing
press. The result is rapid money growth and hyperinflation.

Once the hyperinflation is under way, the fiscal problems become even more severe.
Because of the delay in collecting tax payments, real tax revenue falls as inflation rises. Thus,
the government’s need to rely on seigniorage is self-reinforcing. Rapid money creation
leads to hyperinflation, which leads to a larger budget deficit, which leads to even more
rapid money creation.

The ends of hyperinflations almost always coincide with fiscal reforms. Once the magnitude
of the problem becomes apparent, the government musters the political will to reduce
government spending and increase taxes. These fiscal reforms reduce the need for
seigniorage, which allows a reduction in money growth. Hence, even if inflation is always and
everywhere a monetary phenomenon, the end of hyperinflation is often a fiscal phenomenon
as well.

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Prices in the AS-AD Framework [Causes of Inflation]

There is no single source of inflation. Like illnesses, inflations occur for many reasons. Some
inflations come from the demand side; others, from the supply side. But one key fact about
modern inflations is that they develop an internal momentum and are costly to stop once
underway.

Demand-Pull Inflation

One of the major shocks to inflation is a change in aggregate demand. In earlier chapters we
saw that changes in investment, government spending, or net exports can change aggregate
demand and propel output beyond its potential. We also saw how a nation’s central bank
can affect economic activity. Whatever the reason, demand-pull inflation occurs when
aggregate demand rises more rapidly than the economy’s productive potential, pulling
prices up to equilibrate aggregate supply and demand. In effect, demand dollars are
competing for the limited supply of commodities and bid up their prices. As unemployment
falls and workers become scarce, wages are bid up and the inflationary process accelerates.
Figure-a illustrates the process of demand-pull inflation in terms of aggregate supply and
demand. Starting from an initial equilibrium at point E, suppose there is an expansion of
spending that pushes the AD curve up and to the right. The economy’s equilibrium moves
from E0 to E1. At this higher level of demand, prices have risen from P0 to P1. Demand pull
inflation has taken place.

Cost-Push Inflation and “Stagflation”

The classical economists understood demand-pull inflation and used that theory to
explain historical price movements. But a new phenomenon has emerged over the last
half-century. We see today that inflation sometimes increases because of increases
in costs rather than because of increases in demand. This phenomenon is known as
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cost-push or supply-shock inflation. Often, it leads to an economic slowdown and to a
syndrome called “stagflation,” or stagnation with inflation.

In 1973, 1978, 1999, and again in the late 2000s severe shortages occurred in oil markets.
Oil prices rose sharply, business costs of production increased, and a sharp burst of cost
push inflation followed. These situations can be seen as an upward shift in the AS curve.
Equilibrium output falls while prices and inflation rise.

Stagflation poses a major dilemma for policymakers. They can use monetary and fiscal
policies to change aggregate demand. However, AD shifts cannot simultaneously
increase output and lower prices and inflation. An outward shift of the AD curve in
through monetary expansion would offset the decline in output but raise prices further.
Or an attempt to curb inflation by tightening monetary policy would only lower output
even further. Economists explain this situation by saying that policymakers have two
targets or goals (low inflation and low unemployment) but only one instrument (aggregate
demand).

Such a dilemma is often faced by monetary policy makers. When inflation and
unemployment are rising at the same time, what stance should the Federal Reserve or
the European Central Bank take? Should it tighten money to reduce inflation? Or focus
primarily on reducing unemployment? Or make some compromise between the two?
Economics can provide no definitive answer to this dilemma.

Inflation resulting from rising costs during periods of high unemployment and slack
resource utilization is called supply-shock inflation. It can lead to the policy dilemma of
stagflation when output declines at the same time as inflation is rising.

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