Chapter 6

Measuring the Price Level and

Inflation

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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 changes periodically

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 Calculating the CPI
Item Monthly Cost in 2015
Rent (2-bedroom apartment) $750
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $7 each) 70
Monthly expenditures $940

Item Monthly Cost in 2020

Rent (2-bedroom apartment) $945
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $8 each) 80
Monthly expenditures $1,175

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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 $940
– 2020 cost $1,175
CPI = (1,175 / 940) = 1.25
• Cost of living in 2020 is 25% higher than in 2015
– 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
– BEA uses CPI as a percentage – the ratio times 100

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 Price Index
• A price index measures the average price
of a given quantity 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
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 Inflation
• The rate of inflation is the Year CPI Inflation
annual percentage change 2015 2.37
in the price level 2016 2.40 1.3%
2017 2.45 2.1%
• Inflation in 2016
2018 2.51 2.4%
(2.40 – 2.37) / 2.37 2019 2.56 2.0%
= 0.0126 = 1.3%
Year00 CPI Inflation
• The Great Depression
1929 0.171
– Period of falling output
and prices 1930 0.167 –2.3%
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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Inflation Rate in the US

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Inflation Rate in Turkey

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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

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 Family Income in 2015 and 2020
• Can a family buy more with $40,000 in income in
2015 or with $44,000 in 2020?
– 2015 is the base year for the CPI
– Deflate nominal income in both years to get real
income
– Compare real income
– $40,000 in 2015 has the greater purchasing power

Year Nominal Income CPI Real Income

2015 $40,000 1.00 $40,000/1.00 = $40,000
2020 $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
• U.S. production worker wages
– Real wages stayed roughly the same between 1970 and
2019 despite the fact that the nominal wage in 2019 was
almost 7 times the nominal wage in 1970
Year Average Wage CPI Real Average Wage
1970 $3.40 0.388 $3.40 / 0.388 = $8.76
2019 $23.51 2.56 $23.51 / 2.56 = $9.18
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Production Workers’ Wages,
1970 - 2022

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Indexing as a way to protect real
magnitudes
• 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 is sometimes included in labor
contracts

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 Example for indexing
• An indexed labor contract
– First year wage is $12 per hour
• Real wages rise by 2% per year for the next 2 years
– Suppose the 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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 Minimum Wage
• The government sets 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
• Minimum wage can increase but the
real wage can still decrease
simultaneously
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Minimum Wage in Turkey

https://www.reuters.com/world/middle-east/turkey-raises-monthly-minimum-wage-by-49-2024-2023-12-27/.

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Real minimum wages in Turkey

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https://betam.bahcesehir.edu.tr/wp-
 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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• Imagine the early days of the pandemic
with cloth masks vs. the second half of
the pandemic with K-95 masks.
• How do we measure the quality
improvement when we did not have the
K-95 masks earlier?

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 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 2015 price 2015 Spending
Coffee (50 cups) $1.00 $50.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.00 $100.00
Total $200.00
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 CPI Substitution Bias
• In 2020, coffee and scones are more
expensive
– Buying exactly the same basket of goods
costs $300, compared to $200 in 2015
– CPI = 300 / 200 = 1.50
Item 2020 price 2020 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 25% higher than the
consumer's experience
Item 2020 price 2020 Spending
Coffee (0 cups) $2.00 $0.00
Tea (100 cups) $1.00 $100.00
Scones (100) $1.50 $150.00
Total $250.00
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 Relative Price Increase vs.
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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US data release (Feb 12, 2025)

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

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 Costs of Inflation
• What are the costs of inflation on the
society?
– Noisy prices
– Cost of holding cash
– Redistribution of wealth
– Harder long term planning

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Noisy Prices

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Noisy Prices

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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

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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

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• Simply Google «enflasyondan
korunmak» and you’ll see all the
articles/advise on the topic that offer
ways to protect
• Households
• Businesses
• Investors
against «shoe leather costs»

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 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
– Less Investment

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 Interference with Long-Term
Planning
• 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

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 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

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 Inflation and Interest Rates
• Unanticipated inflation helps borrowers and
hurts lenders
• 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
• 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–

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 Inflation and Interest Rates
• Nominal interest rates Year
Interest Inflation
Rate (%) Rate (%)
and inflation vary
1970 6.5% 5.7%
• Nominal interest rate
range is 0.05% to 11.5% 1975 5.8 9.1
• Inflation rate range is 1980 11.5 13.5
0.12% to 13.5% 1985 7.5 3.6
– Real interest rate is nominal 1990 7.5 5.4
interest rate minus inflation 1995 5.5 2.8
• Real interest rate was 2000 5.8 3.4
highest in 1985, 3.9%
2005 3.2 3.4
• Real interest rate was
lowest in 1975, – 3.3% 2010 0.1 1.6
2015 0.05 0.12
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U.S. Real Interest Rates,
1970 - 2022

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Real Interest Rates in Turkey

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 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
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 The Fisher Effect
• The Fisher effect is the tendency for
nominal interest rates to be high when
inflation is high and low when inflation
is low
• Intuitively, it means that lenders ask for
a higher nominal interest rate when
inflation rate increases

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U.S. Inflation and Interest Rates,
1970 - 2022

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Turkish Inflation Rate and
Nominal Interest Rates

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 End of Chapter Questions
You can solve most of the end of chapter
questions except question 4

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 Question 1

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 Question 5

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 For each year, calculate the real income
as Nominal Income/CPI
If the CPI is multiplied by 100, do the
necessary adjustment
For example:
Real Income (1985)=23,618/1.076
=21,949

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 Question 8

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