2.

4 Price
Indices and
Inflation
Inflation

• Inflation is defined as a rise in

the overall price level and fall in
the purchasing value of money.
In practical terms, the price of
everything goes up.
• It occurs naturally over time,
But can escalate due to
numerous reasons
• Anticipated inflation v.
unanticipated inflation
Types of Inflation

• Demand Pull Inflation – when inflation is caused by

rising demand
• Too many consumers chasing too few goods
(demand rising too fast)
• Excessive spending out of fear of future inflation
• Too few unemployed and wages inflate due to
competition
• Cost Push Inflation – when inflation is caused by lower
supply
• Natural disasters cut supply
• Political actions, like boycotts or tariffs, cut the
supply (OPEC ‘73, ‘79)
• Natural reduction of resources with no new
discoveries
Hyperinflation – very high and accelerating inflation,
typically caused by overprinting currency (usually so the
gov’t can pay for its spending w/o having to tax)
Helped or hurt?

• Unexpected inflation can cause people to lose or gain wealth. For the following
scenarios indicate whether or not the parties involved will be helped or hurt by
unexpected inflation.
1. Banks extend fixed-rate (meaning the rate doesn’t adjust for inflation) loans.
Would the bank benefit or be hurt by unexpected inflation?
2. A farmer buys machinery with a fixed-rate loan. Would the farmer…?
3. Your savings are in a savings account with a fixed interest rate. Would you.?
4. A retired couple lives entirely on income from a fixed-rate pension the woman
receives from her former employer. Would the couple…?
Nominal v. Real

• When we look at most numerical economic value (average income, GDP,

etc.)in the world there are two values you can see: nominal and real
• Nominal refers to values made using that year’s prices
• Real refers to values made by using a base year’s prices, to try and
accurately gage the impact inflation had on that nominal value ; Real
adjusts for inflation
 Income

• Money someone earns in the form of wages or

salary

Nominal
GDP

• value of an economy’s output in current dollars

values Interest Rate

• the percentage increase in money you pay the

lender for the use of the money you borrowed.
• For instance, imagine that you borrowed $100 from
your bank one year ago at 8% interest on your loan.
 Income
• Purchasing power of a given wage or salary

GDP
Real values • The value of an economy’s output in
inflation (adjusted dollar)

Interest Rate
• the rate of interest an investor, saver or
lender receives (or expects to receive) after
allowing for inflation.
Why this
matters
Consumer Price
Index (CPI)
• The CPI is a measure that
examines the weighted
average of prices of a
basket of consumer goods
and services, such as
transportation, food and
medical care.
• It’s a very simple way of
tracking inflation year-to-
year.
  1987 2019/20 Rate of Inflation % 2051/52
Change
CPI 113 251  1.22 122% 557
Median Income $ 22,500 $ 62,000 1.756 175.6% $170,872

Min. Wage $ 3.35 $ 7.25 1.164 116.4% $15.69

Average Fast food $ 0.77 $ 1.77 1.298 129.8% $4.07
Burger
Nike Air Jordans $ 65 $ 180 1.769 176.9% $498.42
Gasoline per gallon $ 1.20 $ 2.66  1.217 121.7% $5.89

Gasoline (in Cali) $ 1.20 $ 4.00 2.333 233% $13.32

TV $ 500 $ 915 .83 83% $1674.45
Movie Ticket $ 2.50 $ 9.15 2.66 266% $13.32
New Car $ 6,000 $ 32,500 4.417 441.7% $176,052
New Home (in TX) $90,000 $270,000 2 200% $810,000
Yr. of Public College $ 5,800 $ 24,000 3.138 313.8% $99,312
Yr. of Private College $13,000 $ 60,000 3.615 361.5% $276,900
Some Issues with CPI

• Does the CPI reflect the rapid changes in technology, technology costs, and
residents’ demands for that technology? (We all want new phones…)
• The BLS uses the CPI-W to determine COLAs. This method shows a slightly
lower annual inflation rate than shown by the CPI-U.
• The Fed uses a separate measure for measures of inflation. It is known as
the “Core Personal Consumption” rate. It also a lower rate than the CPI-U.
• Different Fed Districts use regional measures that involve “trimmed” and
“moving average” systems. These are adjusted to reflect regional
purchasing patterns.
How is the CPI created?

• 1. The long way to measure inflation: Take the national expenditure

number and compare it over time. Example: The US family of 4 spent
$48,398 as a national, annual average for the year 2006.
• In 2007, the same basket of goods cost the family $48,898.
• So, using the measure of inflation:
• Year later minus Year earlier/Year earlier = rate of change.
• The rate of change x 100 = inflation rate.
• 48,898 – 48,398/48,398 = 500/48,398 = .01 (.01 x 100 = 1% inflation)
The Index Method

• First, compare 2006 with itself. You get a ratio of 100.

• This is the Index Year.
• 2007 is given as a CPI of 101 (trust the math). Now you can do the math
without a calculator.
• 101-100/100 = 1/100 = .01…
• Basically, the index method is a simplified way of figuring out inflation
• https://www.youtube.com/watch?v=XxkDhGlMqko
 Year Price CPI
Calculating CPI Market
Basket
• CPI = (Price of market basket /
Price of market basket in base 1999 $40
year) * 100
2000 $50
• The CPI of your base year will 2001 $55
always be 100
2002 $60
• Assuming 2000 in the base
year, complete the table: 2005 $100
Year Market CPI with Base CPI with Base CPI with Base
Basket Year 2009 Year 2010 Year 2011

2009 $20 100

2010 $40 100

2011 $50 100

Calculating Inflation Rate

• 1. Assume the CPI for Year 1 is 100 and the CPI for year 2 is 125, what is the
inflation rate (to find inflation rate use the rate of change formula)?

• 2. Assume the CPI for Year 2 is 125 and the CPI for year 2 is 150, what is the
inflation rate between these two years?

• 3. Assume the CPI for Year 1 is 80 and the CPI for year 2 is 100, what is the
inflation rate?
Year Market Basket Base Year Base Year Base Year
2009 2010 2011

2009 $40

2010 125

2011 200
Shortcoming
associated with
the CPI