MacroEconomics

Ummad Mazhar, PhD

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Session 3: Roadmap
• Difference in price level and inflation rate

• GDP deflator as a measure of inflation

• CPI calculation

• How SBP calculates inflation?

• Economic Costs of inflation

• Winners and losers from inflation

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Price level and inflation rate
• Inflation rate is the rate of change of price level in an economy

• Inflation means persistence rise in price level

• Inflation hurts when it is unexpected

• If overall price level doubles and all the wages and incomes are also
doubled then it does not hurt anyone

• But this is not the case in actual economies

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Aggregate price level: GDP deflator
• GDP deflator is the ratio of nominal GDP to real GDP. It is a measure
of overall price level in an economy

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Notables about GDP deflator
• GDP deflator is an index and thus is unit free
• The rate of change of GDP deflator gives us rate of inflation

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 Consumer Price Index (CPI)
• The consumer price index is a measure of the overall cost of the goods
and services bought by a typical urban household
• Five steps to calculate CPI
1. Fix the basket (of goods and services relevant to a typical consumer)
2. Find the prices (usually through surveying the major markets in main
cities)
3. Compute the basket’s cost
4. Choose a base year and compute the index
5. Compute the inflation rate

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Calculating CPI: Example
1. BASKET: Rent: 40%, Food and clothing: 60%
2. PRICES:

Year Rent (in 000) Food and Clothing

(in 000)
2019 25 30
2020 26 32
2021 27 34

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• 3. Compute the cost
• Year 2019: 25000*(0.40)+30000*(0.60) = 28000
• Year 2020: 26000*(0.40)+32000*(0.60) = 29600
• Year 2021: 27000*(0.40)+34000*(0.60) = 31200

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• 4. Choose 2019 as base year as base year and compute the CPI
• CPI in 2019 = (28000/28000)*100 = 100
• CPI in 2020 = (29600/28000)*100 = 105.7
• CPI in 2021 = (31600/28000)*100 = 112.86

• 5. Calculate percentage change in CPI to have inflation rate

• Inflation in 2020 = 5.7 percent
• Inflation in 2021 = 7.12 percent

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 Inflation measures in Pakistan
Measure of Inflation Relevance Items included

CPI (national) Average Pakistani household 600

WPI Average Pak business 419

SPI Average urban household (most 51

important kitchen items)
CPI (urban) Average urban household 356

CPI (rural) Average rural household 244

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SBP’s Calculations
• All the three measures CPI, WPI, and SPI are based on Laspeyres index
formula :

• Where I is the price index, w represents weight of commodity j in the

overall basket, P is price, t is time period and 0 is base time period.
• Base year for all the indices is 2015-16

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 GDP deflator vs CPI
GDP Deflator CPI
Cover all goods and services Focus only on items relevant to
produced specific groups

Does not consider imports Consider imports as well if they are

relevant to consumers

No need to fix basket; flexible basket Fixed basket, causes bias in CPI

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Weakness of CPI based inflation numbers
• Substitution bias: It does not take into account the possibility of
substitution in the face of changing prices

• New goods: Basket remains fixed (until it is revised). It ignores the

welfare effect of new goods enjoyed by consumers

• Quality change: Improvement in quality of various goods is not taken

into account

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Economic costs of inflation
• Shoe leather costs
• Cost of making transactions to avoid the erosion of purchasing
power

• Menu costs
• Cost of adjusting prices

• Unit of account costs

• Cost of uncertainty in making long term decisions and calculations
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Winners and losers from inflations
• Scenario: A person has invested in government bonds that
promises a rate of interest of 10 percent. After one year a
person earns a return of Rs. 10 on his Rs. 100
• What if the rate of inflation during the same period is 8
percent? Then the real return the investor has is just 2
percent
• Point: Inflation erodes real returns
• Real Return = Nominal Return – Inflation

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• Unexpected inflation benefits debtors
• They are paying back less valuable dollars

• Unexpected deflation benefits creditors

• They are receiving back more valuable dollars

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See you next time

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