Inflation

ECON 3A. MACROECONOMICS

Inflation

 Increase in the overall level of prices

 Undesirability of inflation
 People with fixed incomes
 Benefits of pensioners
 Creditors
 Depreciation of purchasing power
 Inflation gainers
 People with flexible incomes
 Speculators
buy goods at cheaper prices and sell them
at higher price
 Debtors
Causes of Inflation

 Demand-pull inflation
 Rising demand, rising prices
Quantity theory of money
Elections
Causes of Inflation

 Cost-push inflation
 Rising costs, rising prices
 Example: 1970s Oil Crisis
Oil prices
Rising wages
Monopolies – mark-up pricing
Currency devaluation (or depreciation)
Trade-off between Inflation and
Unemployment
Measures of Price Increases

1. Consumer Price Index

2. Retail Price Index
3. Wholesale Price Index
4. Stock Price Index
The Consumer Price Index

 Consumer price index (CPI)

 Measure of the overall level of prices

 Measure of the overall cost of goods and
services
Bought by a typical consumer
Calculating CPI

1. Fix the basket

 Which prices are most important to the typical
consumer
 Different weight
2. Find the prices
 At each point in time
3. Compute the basket’s cost
 Same basket of goods
 Isolate the effects of price changes
Typical Basket of Goods and Services
Other goods This figure shows
Apparel (4%) and services
Recreation (3%) how the typical
(6%) consumer divides
Medical care his spending
(7%) among various
Education Housing (42%) categories of
and
communicatio
goods and
n (6%) services. The
Bureau of Labor
Statistics calls each
Food and
beverages percentage the
(15%) “relative
importance” of the
Transportation
(17%) category.
Calculating CPI

4. Choose a base year and compute the

CPI
 Base year = benchmark
 Price of basket of goods and services in current
year
 Divided by price of basket in base year
Inflation
 Timesin100year 2
CPI in year 2 – CPI in year 1
5. Compute the inflation rate
= X 100
CPI in year 1
Calculating the CPI and the
Inflation Rate
1. Survey consumers to determine fixed
basket of goods.

Basket = 4 hotdogs, 2 hamburgers

Calculating the CPI and the
Inflation Rate
2. Find the price of each good in each
year
Year Price of hotdogs Price of Hamburgers
2010 $1 $2
2011 2 3
2012 3 4
Calculating the CPI and the
Inflation Rate
3. Compute the cost of the basket of
goods in each year.
Year Cost of basket
2010 ($1 per hotdog X 4 hot dogs) + ($2 per
hamburger X 2 hamburgers) = $8 per basket
2011 ($2 per hotdog X 4 hot dogs) + ($3 per
hamburger X 2 hamburgers) = $14 per basket
2012 ($3 per hotdog X 4 hot dogs) + ($ 4 per
hamburger X 2 hamburgers) = $20 per basket
Calculating the CPI and the
Inflation Rate
4. Choose one year as a base year (2010)
and compute the consumer price index

Year CPI
2010 ($8 / $8) X 100 = 100
2011 ($14 / $8) X 100 = 175
2012 ($20 / $8) X 100 = 250
Calculating the CPI and the
Inflation Rate
5. Use the consumer price index to
compute the inflation rate from previous
year.
Year Inflation Rate
2010-2011 {(175 - 100) / 100} X 100 = 75%

2011-2012 {(250 - 175) / 175} X 100 = 43%

The Consumer Price Index

 Inflation rate

 Percentage change in the price index

From the preceding period
The Consumer Price Index

 Problems in measuring the cost of living

1. Substitution bias
 Prices do not change proportionately
 Consumers substitute toward goods that
have become relatively less expensive
The Consumer Price Index

2. Introduction of new goods

 More variety of goods

3. Unmeasured quality change

 Changes in quality