What is inflation and what are its causes and consequences are among

the most important topics in macroeconomics.

In the next lecture, we will introduce the monetary system
and the causes of inflation explicitly in our analysis;
in this unit, we will start by understanding how inflation is measured
with the Consumer Price Index.
To understand the definition and the measurement of inflation it is useful
to start by recalling what is the growth rate of a variable.
The growth rate of any variable is the percentage change of that
variable in a given period. To calculate a growth rate we
use the change of the variable between a period t and period t plus one
in the numerator and the initial value in period t in the
denominator. For instance, the growth rate of GDP between
2015 and 2016 is given by the GDP
in 2016 minus the GDP in 2015
divided all by the GDP in 2015.
In the previous lecture we have implicitly seen
this concept by stating that the evolution of the growth rate
of the GDP deflator is a measure of the changes in prices of
domestically produced goods. The definition of growth rates
and its formula are important because the inflation rate is the
increase in the overall level of prices in the economy
and it is measured as the growth rate of a price index.
This price index can be the GDP deflator we have defined the
previous unit or the Consumer Price Index, that is our next topic.
The Consumer Price Index measures the overall cost of a
basket of goods bought by a typical family.
Its main purpose is to evaluate how the change in prices affect
the cost of leaving of that family. The first step to calculate
the Consumer Price Index, the CPI, is the definition of a "representative" basket.
This is based on surveys of families that provide information
on their consumption of goods and services.
With this information, the quantity of each good consumed by
a typical family are defined. These surveys are collected every
several years and therefore the basket remains the same for
quite long periods. In Spain, the relative importance of the different
kind of goods in the basket of the CPI
(Índice de precios al consumo in Spanish) have been recently updated
with a survey from 2016. This survey revealed
that the group of goods of food and beverages account for twenty
percent of the total expenditure of a typical family.
Other important groups are transportation, with thirteen percent,
and spending and hotels, cafés and restaurants, which is
the twelve percent of the total expenditure.
The second step is collecting information, in a representative
sample of shops, on prices of each of the goods in the basket.
The information on prices is collected
usually every month. Once we have prices and quantities,
the cost of the basket can be calculated by multiplying the quantity
of each good by its price. The fourth step is computing the index.
For doing so, we need to define a base year and then dividing
the cost of the basket in any year for the cost of the basket
in the base year. The fifth and last step is to calculate the
inflation rate by computing the growth rate of the CPI in the
way described at the beginning of this lecture.
Let's see an example to make this process more concrete.
The first step would be to define the basket of goods.
Let's assume that after the consumers' surveys we confirm that families
consume a very simple basket. Only five sandwiches and ten lemonades.
The second step would be to collect the prices of these two goods
in a representative sample of shops. Assuming yearly data,
let's say that in 2014, the average price of sandwiches
is twenty dollars and the average price of lemonade is
five dollars. In 2015, the respective prices
are twenty five and five point five and in 2016
there are thirty and six. The third step is to compute
the cost of the basket for each year: one hundred and fifty
in 2014, one eighty in 2015
and two hundred and ten in 2016.
The fourth step is to compute the Consumer Price Index.
Remember that the Consumer Price Index is the value of the basket in
each year divided by the value of the basket in the base year.
If the base year is 2014, the CPI
in 2014 will be equal to
a hundred and in 2015, one hundred and twenty,
and finally, in 2016, one hundred and forty.
The last step, the calculation of the inflation rates, is based
on our definition of inflation and our definition of growth rates.
We will measure inflation as the growth rate of the CPI,
that is, twenty percent between 2014
and 2015 and sixteen point seven percent between
2015 and 2016.
Obviously, in reality the computations are more
complex because we have many more goods,
but otherwise the procedure is the same. It is just computing
how the cost of the basket of goods changes along time.