Diploma in Management Studies

Macroeconomics ECO003

Lecture 2
Inflation and the Price Level

Ref:
Tan Khay Boon, Macroeconomics,
SIM Global Education, 2016
Session 2

1
Learning Objectives
1. Define inflation, consumer price index and
distinguish between demand pull and cost push
inflation
2. Compute CPI and calculate inflation rate using
CPI
3. Adjust for inflation using indexing method
4. Analyse the limitation of CPI in measuring
inflation
5. Distinguish between real and nominal quantity in
the presence of inflation
6. Analyse the cost of inflation

5-2
Inflation

• Inflation is a sustained increase in the

average level of prices
• Average prices of all goods and services in
the economy is described as “price level”
• Inflation rate is the percentage increase in
price level
• Hyperinflation is very high levels of inflation
>50%

5-3
Inflation

• Measured on monthly or annual basis

• Inflation reduces purchasing power
when nominal income is kept constant
• Reduces standard of living
• Opposite of inflation is deflation: A
sustained decrease in average prices

4
Types of Inflation

• Demand pull inflation arises from higher

demand for goods and services
• Demand from households, firms,
government or foreign economy can bid
up price of goods and services

(GDP = C+I+G+NX)

5
Types of Inflation

• Consumer demand is affected by

– Disposable income

– Optimism about future economy or income

• Firm demand is affected by

– Interest rates

– Optimism about future economy and profit

6
Types of Inflation
• Government expenditure is affected by
– Policies based on key macroeconomic objectives:
growth, unemployment, inflation and balance of payment
– Expansionary policy involves higher government
spending or lower taxes
• Net exports is affected by
– Income in foreign economy
– Inflation levels in foreign economy

7
Types of Inflation
• Cost push inflation arises from a shortage of
resources which lead to higher prices
– Higher wages
– Higher rental
– Higher prices of raw materials and capital goods
– Natural disasters that destroy resources
• Cost push inflation results in higher price and
lower output
– Stagflation: Inflation and recession

8
Demand pull vs Cost push Inflation
• Demand pull inflation considered “better” as
it involves higher price and higher output
– Higher real GDP partially offset higher prices

• Cost push inflation involves higher price

and lower output
– Residents of the economy are worse off both
ways

9
Price Index

• A price index measures the average

price of a given quantity of goods and
services relative to the price of the
same goods and services in a base
year
• Price index over time is used to
measure inflation

5-10
Price Index - CPI
• Consumer price index (CPI) is the average
price of goods and services purchased by
households for consumption
• Core inflation is CPI without energy and food
• Common indicator of cost of living
• Used by workers to bargain for wage
increases

11
Price index - PPI

• Producer price index (PPI) is the average

prices of resources purchased by producers
in production

• Higher PPI means higher cost of production

– Passed on to consumer in terms of higher retail
prices

12
Price Index

• Export-import price index measures

average prices of imported and
exported goods and services

• Monitored by firms that trade with other

countries

13
Price Index – GDP Deflator

• GDP deflator measures average prices

of goods and services used in GDP
computation

• Higher GDP deflator mean higher

output prices

14
Price Index and Inflation
• Price index overtime used to measure inflation
• Different price indices give rise to different
inflation rate
• Use the appropriate price index
– CPI: Cost of living
– GDP Deflator: Competitiveness of economy
– PPI: Firms production plan
– Export-Import index: International traders

15
Measuring the Price Level
• The Consumer Price Index (CPI) is a measure of
the cost of living during a particular period
• The CPI measures
– cost of a standard basket of goods and services in a
given year
– relative to the cost of the same basket of goods and
services in the base year

• Base year is assigned in the year where prices are

relatively stable
– Base year changes periodically

5-16
Calculating the CPI

Item Quantity Price in Price in Price in

2014 2015 2016
Fish 20 $3 $3.10 $3.30
Rice 30 $2.50 $2.30 $2.40
Bread 15 $1.20 $1.50 $1.60
Bus Fare 20 $2 $2.20 $2.40
Medical Care 5 $20 $22 $25

5-17
Calculating the CPI
• CPI is the ratio of the cost of the basket of goods in the current year to the
cost in the base year
– Base year (2014) cost $293
– 2015 cost $307.5
– 2016 cost $335

• CPI2015 = ($307.5 / $293) = 1.0495

• CPI2016 = ($335 / $293) = 1.1433
• Cost of living in 2015 is 4.95% higher than 2014 and cost of living in 2016 is
14% higher than 2014
– CPI for the base year is always 1
– CPI for a given period is the cost of living in that period relative to what it was in the base
year

5-18
Cost of Living
CPI = 1050 / 800 = 1.31
2010 Spending Monthly Cost in 2010
Rent (2 bedroom apartment) $500
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $6 each) 60
Sweaters (4 at $30) 120
Monthly expenditures $800
2015 Spending Monthly Cost in 2015
Rent (2 bedroom apartment) $630
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $7 each) 70
Sweaters (4 at $50) 200
Monthly expenditures $1,050

5-19
Inflation
• The rate of inflation is the annual percentage change in the price
level
• Inflation rate at time t:
Year CPI
– It = CPIt – CPIt-1 X100%
2009 1.00
CPIt-1 (Base Year)
• Inflation from 2011 and 2012 2010 1.03
2011 1.08
(1.12-1.08) / 1.08 X100%
2012 1.12
= 3.7%
2013 1.10
• Inflation from 2012 to 2013: 2014 1.15
(1.10-1.12) / 1.12 X100%
= -1.79%
(Deflation) 5-20
Limitations of CPI as an Indicator
of Inflation Rate

21
CPI Quality Adjustment Bias
• One important bias in the CPI is its measurement
of price changes but not quality changes
– PC with 20% more memory has 20% higher price
• Not the same PC as the one with less memory
– If no adjustment is made for quality, PC's contribution
to the CPI will be 20%
• Adjusting for quality is difficult
– Large numbers of goods
– Subjective differences
• Incorporating new goods is difficult
– No base year price for this year's new goods
5-22
CPI Substitution Bias
• CPI uses a fixed basket of goods and services
– When the price of a good increases, consumers buy
less and substitute other goods
– Failure to account for substitution overstates inflation
• Example: 2014 is the base year

Item 2014 2014 2015 2015

Price ($) Qty Price ($) Qty
Rice 2.00 50 2.10 60
Noodle 3.00 30 3.50 20
Bus Fare 1.00 30 1.10 40
Train Fare 1.20 20 1.60 10

5-23
CPI Substitution Bias
• 2014 (base year) spending= $244
• 2015 spending = $256
• 2015 spending (based on 2014 quantity) = $275
• CPI in 2015 = 275/244 = 1.127
– Inflation rate is 12.7%
• CPI in 2015 (based on actual spending) = 256/244
= 1.049
– Actual inflation rate is 4.9%
• Substitution to cheaper goods led to CPI
overstating inflation
5-24
CPI bias
• CPI tends to overstate inflation rate
• Employers who compensate workers based on CPI
face “extra” rise in cost of production
– Workers benefit from higher standard of living
• Government may pay extra pension to retirees if
social security is pegged to CPI changes
– Stress on government budget
– Result in a cut in spending or a rise in taxes

25
Adjusting for Inflation
• A nominal quantity is measured in terms of its
current dollar value
• A real quantity is measured in physical terms
– Quantity of goods and services
• To compare values over time, use real
quantities
• Deflating a nominal quantity converts it to a
real quantity
– Divide a nominal quantity by its price index to
express the quantity in real terms

5-26
Family Income in 2010 and 2015
• Can a family buy more with $30,000 in income in
2010 or with $40,000 in 2015?
– 2010 is the base year for the CPI
– Deflate nominal income in both years to get real
income
– Compare real income
– $30,000 in 2010 has the greater purchasing power
Year Nominal Income CPI Real Income
2010 $30,000 1.00 $30,000/1.00 = $30,000
2015 $40,000 1.50 $40,000/1.5 = $26,666.67

5-27
Real Wages
• Nominal wage is the wage paid in dollar
value
– Nominal wages increases overtime but due to
inflation, the worker may not be better off
• Real wage is the wage paid to the worker
measured in terms of purchasing power
– The real wage for any given period is
calculated by dividing the nominal wage by the
CPI for that period

Year Average Wage CPI Real Average Wage

1980 $1000 per month 0.5 $1000 / 0.5 = $2000
2016 $3000 per month 2.5 $3000 / 2.5 = $1200

5-28
Production Workers’ Wages, 1970 - 2013

5-29
Indexing
• Indexing is used to prevent a fall in standard of
living/purchasing power due to inflation
• Indexing increases a nominal quantity each period
by the percentage increase in a specified price
index
• Indexing automatically adjusts certain values, such
as pensions, by the amount of inflation
– If prices increase 5% in a given year, the pensioners
receive 5% more
• No action by Parliament required
– Indexing is sometimes included in labor contracts
5-30
Adjusting for Inflation
• Consider an indexed 3-year labor contract
– First year wage is $1000 per month
• Real wages rise by 5% per year for next 2 years
– Relevant price index is 1.00 in first year, 1.04 in
the second, and 1.08 in the third
• Nominal wage is real wage times the price
index
Year Real Wage Price Index Nominal Wage
1 $1000 1.00 $1000
2 $1050 1.04 $1092
3 $1102.5 1.08 $1190.7
5-31
Inflation and Interest Rates
• Unanticipated inflation helps borrowers and hurts
lenders
• The real interest rate is the annual percentage
increase in the purchasing power of financial
assets
– Real interest rate = nominal interest rate – inflation
r=i-
• The nominal interest rate is the annual
percentage increase in the dollar value of financial
assets
– Nominal interest rates are the most commonly stated
rates 5-32
Inflation and Interest Rates

• Lender wishes to earn a real interest rate of

3% p.a. and predicts that inflation rate will be
5%
• Lender will demand nominal interest of
(3+5)% = 8%
• However if inflation rate is 10%, the real
interest he gets:
r = i -  = 8 – 10 = -2%

33
Inflation and Interest Rates
• Nominal interest rates and Year
Interest Inflation
inflation vary Rate (%) Rate (%)
– Nominal interest rate 3.2% - 1975 8.0% 9.1
11.4% 1980 11.4 13.5
– Inflation rate range 1.6% - 1985 10.6 3.6
13.5% 1990 8.6 5.4
1995 6.6 2.8
• Real interest rate is (i - ) 2000 6.0 3.4
– real interest rate highest in
2005 4.3 3.4
1985, 7%
2010 3.2 1.6
– Real interest rate lowest in
1980, -2.1%

5-34
Inflation and Interest Rates
• Unexpected inflation benefits borrowers and hurts
lenders
– For a given nominal interest rate, the higher the
inflation rate, the lower the real interest rate
• Unexpected inflation may not hurt lenders if they
can index the nominal interest rates
– Inflation-protected bonds pay a real rate of interest
plus the inflation rate
• The Fisher effect is the tendency for nominal
interest rates to be high when inflation is high and
low when inflation is low
5-35
Costs of Inflation

• Low and stable inflation not so “harmful”

to economy
– Mainly menu and shoe leather costs
• High and volatile inflation imposes
severe costs to economy
– Limit/destroy function of money
– Higher costs

36
Menu Cost

• Cost incurred by sellers who have to

review price list due to inflation
• Time, effort and costs to reprint menus,
relabel price tags, change sign boards,
update computer systems etc

37
Shoe Leather Cost
• Cost incurred by buyers who need to replace their cash
due to inflation
• Time and effort to make more trips to ATM machines or
banks
• Average consumer goes once a month to withdraw
$1000. With inflation, $1000 can now last only 1 week
– Go to bank 4 times
– Time and transportation costs
– Incur higher transaction costs at bank

38
Noisy Prices
• Prices transmit information about
– The cost of production and
– The value buyers place on buying an additional
unit
• Inflation creates static in the communication
– Buyers and sellers can't easily tell whether
• The relative price of this good is increasing OR
• Inflation is increasing the price of this good and all others
– Deciding these issues requires market participants
gather information – at a cost
– Response to changing prices is tentative and slow
• Market allocation is inefficient
5-39
Distortions Caused by Taxes

• Bracket creep of income taxes

– Bracket creep occurs when a household is
moved into a higher tax bracket due to
increases in nominal but not real income
– Higher tax brackets have a higher tax rate
• Progressive tax rates
– Disincentive to work
Distortions Caused by Taxes
• Capital depreciation allowance
encourages purchase of capital goods
– Allows firms to deduct a share of the
purchase price as a business expense
– Machine cost is $1,000 and its useful life is 10
years
• Capital depreciation allowance of $100 per year
• $100 in year 1 is worth more than $100 in year 10
because of inflation
• In times of high inflation, investment in
plant and equipment decreases
Distortions Caused by Taxes

• Inflation distorts tax system which in

turn distorts the incentives for people to
work, save, and invest
– Lower savings and investment means
lower economic growth: a real cost of
inflation
Unexpected Redistribution of Wealth
• Unexpected inflation redistributes wealth
• Suppose workers' salaries are not indexed
and inflation is higher than anticipated
– Salaries lose purchasing power
– Employers gain at the expense of workers
• Similarly, unexpectedly high inflation benefits
borrowers at the expense of lenders
– Borrowers repay with dollars worth less than
anticipated
• Unexpected inflation confuses incentives to
save and lend
5-43
Interference with Long-Term Planning
• Some decisions have a long time horizon
– Erratic inflation makes planning risky
• Retirement planning requires an estimated
cost for your desired life-style
– Save too little and you live less well in the future
– Save too much and you live less well now
• Given the costs of inflation, most economists
agree that low and stable inflation promotes a
healthy economy
5-44
Hyperinflation
• Hyperinflation is an extremely high rate of inflation
– In 1923, German employers paid workers twice a day
– Magnifies the costs of inflation
– Minimize your cash holding
• A study of market economies, 1960 – 1996 showed 45
episodes of high inflation (100+%) in 25 countries
– Real GDP/person fell by an average of 1.6% per year
– Real consumption/ person fell by an average of 1.3% per year
– Real investment per person fell by an average of 3.3% per
year

5-45
SUMMARY
• Inflation is a sustained increase in
general price level
• Inflation arises due to excessive demand
(demand pull inflation) and rising costs of
production (cost push inflation)
• A price index is used to measure inflation
rate

46
SUMMARY
• Common measure of inflation is the consumer price
index (CPI).
• The CPI measures the cost of purchasing a fixed
basket of goods and services in any period relative
to the cost of the same basket of goods and services
in the base year
• The inflation rate is the annual percentage rate of
change in the price level as measured by a price
index such as the CPI
SUMMARY
• The inflation rate based on the CPI may
overstate the true inflation rate for 2 reasons.
• First, it may not adequately reflect improvements in
the quality of goods and services.
• Second, the method of calculating the CPI ignores
the fact that consumers can substitute cheaper
goods and services for more expensive ones
SUMMARY
• A nominal quantity is a quantity that is measured
in terms of its current dollar value.
• Dividing a nominal quantity by a price index
expresses that quantity in real purchasing power.
• This process is called deflating the nominal
quantity.
• If nominal quantities from 2 different years are
deflated by a common price index, the purchasing
power of the 2 quantities can be compared
SUMMARY
• The real interest rate is the annual
percentage increase in the purchasing
power of a financial asset. It is equal to the
nominal interest rate minus the inflation rate
• When inflation is unexpectedly high, the real
interest rate is lower than anticipated, which
hurts lenders but benefit borrowers
SUMMARY
• Inflation imposes a number of true costs on
the economy, including
– menu costs to adjust price lists
– “shoe leather” costs, which are the real resources
that are wasted as people try to economise on
cash holdings
– “noise” in the price system
– distortion of the tax system
– unexpected redistributions of wealth
– interference with long term planning
SUMMARY

• Because of these costs, most economists

agree that sustained economic growth is
more likely if inflation is low and stable
• Hyperinflation, a situation in which the
inflation rate is extremely high, greatly
magnifies the costs of inflation and is
highly disruptive to the economy
Question 1
If a borrower and lender agree to an interest
rate on a loan when inflation is expected to be
10% and inflation turns out to be 7% over the
life of the loan, then the borrower _____ and
the lender ______.
(A) gains; gains
(B) loses; gains
(C) gains; loses
(D) loses; loses
(E) is not affected; gains
53
Answer to Question 1

54
Question 2
To correct a nominal quantity for changes in
the price level, one should:

(A) add a price index to it.

(B) subtract a price index from it.
(C) divide it by a price index.
(D) multiple it by a price index.
(E) increase it by a percentage equal to the rate of
inflation for that year.

55
Answer to Question 2

56
Question 3
If the CPI equaled 1 in 1995 and 1.1 in 2000 and a
typical household's income equaled $35,000 in
1995 and $38,500 in 2000, then between 1995
and 2000, real household income:

A)increased.
B)may have increased or decreased.
C)decreased.
D)cannot be determined.
E) was constant.
57
Answer to Question 3

58
Question 4
The CPI in year one equaled 1.45. The CPI
in year two equaled 1.51. The rate of
inflation between years one and two was
_____ percent.

(A) 4.0
(B) 4.1
(C) 4.5
(D) 5.1
(E) 6.0
59
Answer to Question 4

60
Question 5
Suppose that the price of apples rises sharply
compared to the price of oranges. People buy more
oranges and fewer apples than they did in the CPI
base year. In this situation the CPI will tend to
_____ inflation as a result of _____ bias.

(A) overstate; substitution

(B) overstate; quality adjustment
(C) understate; substitution
(D) understate; quality adjustment
(E) accurately measure; substitution
61
Answer to Question 5

62
Question 6
Refer to the table below which shows some information on the
expenditure pattern of a typical household in an economy over the
years 2006 and 2007:

Take 2006 as the base year and compute the CPI in 2006 and
2007. Use the CPI to calculate the inflation rate between 2006 and
2007 in the economy.

2006 2007

Price Quantity Price Quantity

Food $2 100 $2.20 95

Clothing $5 50 $5.50 60

Transport $0.80 25 $1 22
63
Answer to Question 6

64
Question 7
Jim lends his cousin $100 for one year at 9%
nominal interest

A.What is the interest to be paid at the end of the year?

B.If expected inflation is 5%, what is the real interest rate
on loan?
C.Identify the gainer(s) and the loser(s) if inflation rate
turned out to be 11%?
D.What is the implication of a negative real interest rate?

65
Answer to Question 7

66