Module 2

Inflation
 Learning Objectives:
• Define Inflation and its types
• Calculating CPI and GDP deflator and Measure inflation rate (With
the help of MS - Excel
• Explain the difference between demand-pull and cost-push
inflation
• Explain other types of inflation and their causes
• Define Inflation and its types

Module 2: Inflation 1
 Inflation, Price Level and CPI

• The inflation rate is the percentage increase in

the price level over a specified period (quarter,
month, year; usually a year).
• The price level is the average level of prices
measured by a Consumer Price Index (CPI).
• CPI measures the typical consumer’s cost of
living.

Module 2: Inflation 2
 How the CPI Is Calculated

1. Fix the “basket.”

The Central Department of Statistics and Information (CDSI)
surveys consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices.
The CDSI collects data on the prices of all the goods and
services in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the basket.

Module 2: Inflation 3
 How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals

cost of basket in current year

100 x
cost of basket in base year

5. Compute the inflation rate.

The percentage change in the CPI from the
preceding period.

Inflation CPI this year – CPI last year

= x 100
rate CPI last year
Module 2: Inflation 4
 Example: basket: {4 pizzas, 10 Pepsi}

price of price of
year cost of basket
pizza Pepsi
2010 $10 $2.00 $10 x 4 + $2 x 10 = $60
2011 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2012 $12 $3.00 $12 x 4 + $3 x 10 = $78

Compute CPI (Inflation rate) in each year using 2010 as base year

2010: 100 x ($60/$60) = 100 115 – 100

15% = x 100
100
2011: 100 x ($69/$60) = 115
130 – 115
13% = x 100
2012: 100 x ($78/$60) = 130 115

Module 2: Inflation 5
 ACTIVE LEARNING 1
Calculate the CPI

CPI basket: price price of

{10 lbs beef, 20 lbs chicken} of beef chicken
The CPI basket cost $120 in 2010 $4 $4
2010, the base year.
2011 $5 $5
2012 $9 $6
A. Compute the CPI in 2011.

B. What was the CPI inflation rate from 2011–2012?

Module 2: Inflation 6
 ACTIVE LEARNING 1
Answers
CPI basket: price price of
{10 lbs beef, 20 lbs chicken} of beef chicken
The CPI basket cost $120 2010 $4 $4
in 2010, the base year.
2011 $5 $5
2012 $9 $6
A. Compute the CPI in 2011:
Cost of basket in 2011
= ($5 x 10) + ($5 x 20) = $150

CPI in 2011 = 100 x ($150/$120) = 125

Module 2: Inflation 7
 ACTIVE LEARNING 1
Answers

CPI basket: price price of

{10 lbs beef, 20 lbs chicken} of beef chicken
The CPI basket cost $120 2010 $4 $4
in 2010, the base year. 2011 $5 $5
2012 $9 $6
B. What was the inflation rate from 2011–2012?
Cost of CPI basket in 2012
= ($9 x 10) + ($6 x 20) = $210
CPI in 2012 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
Module 2: Inflation 8
 Major Components of KSA General Cost of
Living Index
Education and Medical care
entertainment 2%
6%
Clothing and footwear
Food and drink
8%
26%
Home furniture
11%

Other expenses and

Revonation, rent, fuel
services
and water
13%
18%
Transport and
communication
16%

Module 2: Inflation 9
Module 2: Inflation 10
 Problems with the CPI:
Substitution Bias
• Over time, some prices rise faster than others.
• Consumers substitute toward goods that become relatively
cheaper, mitigating the effects of price increases.
• The CPI misses this substitution because it uses a fixed basket of
goods.
• Thus, the CPI overstates increases in the cost of living.

Module 2: Inflation 11
 ACTIVE LEARNING 2
Substitution bias
CPI basket:
cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2010 $4 $4 $120
2010–11:
2011 $5 $5 $150
Households
bought CPI basket. 2012 $9 $6 $210

2012: Households bought {5 lbs beef, 25 lbs chicken}.

A. Compute cost of the 2012 household basket.

B. Compute % increase in cost of household basket over
2011–12, compare to CPI inflation rate.
Module 2: Inflation 12
 ACTIVE LEARNING 2
Answers
CPI basket:
cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2010 $4 $4 $120
Household
basket in 2012: 2011 $5 $5 $150
{5# beef, 2012 $9 $6 $210
25# chicken}

A. Compute cost of the 2012 household basket.

($9 x 5) + ($6 x 25) = $195

Module 2: Inflation 13
 ACTIVE LEARNING 2
Answers
CPI basket:
cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2010 $4 $4 $120
Household
basket in 2012: 2011 $5 $5 $150
{5# beef, 2012 $9 $6 $210
25# chicken}
B. Compute % increase in cost of household basket over
2011–12, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
Module 2: Inflation 14
 Problems with the CPI:
Introduction of New Goods
• The introduction of new goods increases variety, allows
consumers to find products that more closely meet their
needs.
• In effect, dollars become more valuable.
• The CPI misses this effect because it uses a fixed basket of
goods.
• Thus, the CPI overstates increases in the cost of living.

Module 2: Inflation 15
 Problems with the CPI:
Unmeasured Quality Change
• Improvements in the quality of goods in the basket increase the
value of each dollar.
• The CDSI tries to account for quality changes
but probably misses some, as quality is hard to measure.
• Thus, the CPI overstates increases in the cost of living.

Module 2: Inflation 16
 Problems with the CPI

• Each of these problems causes the CPI to overstate cost of living

increases.
• The CDSI has made technical adjustments,
but the CPI probably still overstates inflation
by about 0.5 percent per year.

Module 2: Inflation 17
 Different Measures of Inflation

• Inflation is usually measured by the “General Cost of Living

Index” in Saudi Arabia.
• But alternatives exist:
– General Wholesale Price Index – it represents a basket containing 160
items sold on primary markets (also known as PPI or Producer Price
Index)
– GDP Deflator – this measures the prices of commodities (i.e. goods and
services), which are produced domestically

Module 2: Inflation 18
 Two Measures of Inflation for US, 1950–2010
15

10
Percent per year

-5
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Module 2: Inflation CPI GDP deflator 19
 Contrasting the CPI and
GDP Deflator
Imported consumer goods:
– included in CPI
– excluded from GDP deflator
Capital goods:
 excluded from CPI
 included in GDP deflator (if
The basket:
produced domestically)
 CPI uses fixed basket
 GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.

Module 2: Inflation 20
 ACTIVE LEARNING 3
CPI vs. GDP deflator
In each scenario, determine the effects on the
CPI and the GDP deflator.

A. House of Donuts raises the price of donuts.

B. A local manufacturer raises the price of
the oil refinery equipment it manufactures.
C. Armani raises the price of the Italian jeans
it sells in Saudi Arabia.

Module 2: Inflation 21
 ACTIVE LEARNING 3
Answers

A. House of Donuts raises the price of Donuts.

The CPI and GDP deflator both rise.

B. A Saudi manufacturer raises the price of the oil refinery

equipment it manufactures.
The GDP deflator rises, the CPI does not.

C. An Italian jeans manufacturer raises the price of it’s jeans it

sells in Saudi Arabia.
The CPI rises, the GDP deflator does not.

Module 2: Inflation 22
 Hyperinflation

• Hyperinflation is generally defined as inflation exceeding 50%

per month.
• Prices rise when the government prints too much money.
• Excessive growth in the money supply always causes
hyperinflation.

Module 2: Inflation 23
 Hyperinflation in Zimbabwe
Large govt. budget deficits date Zim$ per US$
led to the creation of Aug 2007 245
large quantities of money
Apr 2008 29,401
and high inflation rates.
May 2008 207,209,688
June 2008 4,470,828,401
July 2008 26,421,447,043
Feb 2009 37,410,030
Sept 2009 355

Sign posted in public

restroom

Module 2: Inflation 24
Module 2: Inflation 25
 The Costs of Inflation

• The inflation fallacy: most people think inflation erodes real

incomes.
• But inflation is a general increase in prices of the things people
buy and the things they sell (e.g., their labor).
• In the long run, real incomes are determined by real variables,
not the inflation rate.

Module 2: Inflation 26
 U.S. Average Hourly Earnings & the CPI
250 $20
Inflation causes $18
200 the CPI and $16
nominal wages
$14
to rise together
150 over the long run. Nominal wage
$12
(right scale) $10
100 $8
$6
50 CPI $4
(left scale) $2
0 $0
1965 1970 1975 1980 1985 1990 1995 2000 2005
Module 2: Inflation 27 27
 The Costs of Inflation

• Shoeleather costs: the resources wasted when inflation

encourages people to reduce their money holdings
– Includes the time and transactions costs of more frequent bank
withdrawals
• Menu costs: the costs of changing prices
– Printing new menus, mailing new catalogs, etc.

Module 2: Inflation 28
 The Costs of Inflation

• Misallocation of resources from relative-price

variability: Firms don’t all raise prices at the
same time, so relative prices can vary…
which distorts the allocation of resources.
• Confusion & inconvenience: Inflation changes
the yardstick we use to measure transactions.
Complicates long-range planning and the
comparison of dollar amounts over time.

Module 2: Inflation 29
 The Costs of Inflation

• Tax distortions:
Inflation makes nominal income grow faster
than real income.
Taxes are based on nominal income,
and some are not adjusted for inflation.
So, inflation causes people to pay more taxes
even when their real incomes don’t increase.

Module 2: Inflation 30
 A Special Cost of Unexpected Inflation

• Arbitrary redistributions of wealth

Higher-than-expected inflation transfers purchasing
power from creditors to debtors: Debtors get to repay
their debt with dollars that aren’t worth as much.
Lower-than-expected inflation transfers purchasing
power from debtors to creditors.
High inflation is more variable and less predictable than
low inflation.
So, these arbitrary redistributions are frequent when
inflation is high.

Module 2: Inflation 31
 The Costs of Inflation

• All these costs are quite high for economies

experiencing hyperinflation.
• For economies with low inflation (< 10% per year), these
costs are probably much smaller, though their exact size
is open to debate.

Module 2: Inflation 32
 Types of Inflation

P
P AS2
AS1 AS

P2
P2
P1
P1
AD AD2
AD1
Y Y
Cost-push inflation Demand-pull inflation
Module 2: Inflation 33
 Cost-Push Inflation

• Aggregate supply is the total volume of goods and services

produced by an economy at a given price level. When there is a
decrease in the aggregate supply of goods and services
stemming from an increase in the cost of production, we have
cost-push inflation.

• Cost-push inflation basically means that prices have been

"pushed up" by increases in costs of any of the four factors of
production (labor, capital, land or entrepreneurship) when
companies are already running at full production capacity. With
higher production costs and productivity maximized,
companies cannot maintain profit margins by producing the
same amounts of goods and services. As a result, the
increased costs are passed on to consumers, causing a rise in
the general price level (inflation).

Module 2: Inflation 34
 Demand-Pull Inflation

• Demand-pull inflation occurs when there is an increase in

aggregate demand, categorized by the four sections of
the macroeconomy: households, businesses,
governments and foreign buyers.
• When these four sectors concurrently want to purchase
more output than the economy can produce, they
compete to purchase limited amounts of goods and
services. Buyers in essence "bid prices up", again,
causing inflation. This excessive demand, also referred to
as "too much money chasing too few goods", usually
occurs in an expanding economy

Module 2: Inflation 35