Download Inflation and the Consumer Price Index Review for AP

Inflation and the Consumer Price Index Review for AP Macroeconomics 1
Inflation and the Consumer Price Index Review for AP Economics
Main Topics: Consumer Price Index, Inflation, Is Inflation Bad, Measurement Issues
My "Latte Price Index" illustrates that a price index can be constructed to measure changes in the price
of anything. Another price index, the GDP price deflator, measures the increase in the price level of
items that compose GDP. But not all goods that fall into GDP are goods that the everyday household
shops for. If United Airlines buys a 767 from Boeing, it falls in GDP, but the price of a new 767 doesn't
exactly fall within what we might call consumer spending. We need a statistic that focuses on consumer
prices.
The Consumer Price Index (CPI)
To measure the average price level of items that consumers actually buy, use the Consumer Price Index
(CPI). The Bureau of Labor Statistics (BLS) selects a base year and a market basket is compiled of
approximately 400 consumer goods and services bought in that year. A monthly survey is conducted in
50 urban areas around the country, and based on the results of this survey, the average prices of the
items in the base year market basket is factored into the CPI. Confused yet? Let's do a simple example of
a price index for a typical consumer using Table 12.5.
Price Index Current Year = 100 * (Spending Current Year)/(Spending Base Year)
2001 Price Index = 100 * (531)/(486) = 109.26
Inflation
In the above example, the price index increased from 100 in the base year to 109.26 in 2001. In other
words, the average price level increased by 9.26 percent.
On a much larger scale, the official CPI is constructed and used to measure the increase in the average
price level of consumer goods. The annual rate of inflation on goods consumed by the typical consumer
is the percentage change in the CPI from one year to the next.
"So What Is the Difference Between the CPI and the GDP Deflator?"
This can be confusing. The difference between these two price indices lies in the content of the market
basket of goods. The CPI is based upon a market basket of goods that are bought by consumers, even
those goods that are produced abroad. The GDP deflator includes all items that make up domestic
production. Because GDP includes more than just consumer goods, the index is a broader measure of
inflation, while the CPI is a measure of inflation of only consumer goods.
Inflation and the Consumer Price Index Review for AP Macroeconomics 2
Nominal and Real Income
As a consumer, I am also a worker and an income earner. Rising consumer prices hurt my ability to
purchase the items that make me happy. In other words, rising prices can cause a decrease in my
purchasing power. Ideally, I would like to see my income rise at a faster rate than the price of consumer
goods. One way to see if this is happening is to deflate nominal income by the CPI to calculate my real
income. Real income is calculated in the same way that real GDP is calculated.

Real Income This Year = 8(Nominal Income This Year)/CPI (in hundredths)
Example:
In 2002 Kelsey's nominal income is $40,000 and it increases to $41,000 in 2003. Curious about her
purchasing power, she looks up the CPI in 2002 and finds that at the end of 2002 it was 181.6 and at the
end of 2003 it was 185. This is compared to the base year value of 100 in 1984.
Real Income 2002 = $40,000/1.816 = $22,026
Real Income 2003 = $41,000/1.850 = $22,162
After accounting for inflation, real income increased by $136. Her nominal income increased at a rate
slightly faster than the rate of inflation, and so her purchasing power has slightly increased.
Example:
What if Kelsey's wages were frozen and she did not receive that raise in 2003?
Real Income 2003 = $40,000/1.85 = $21,622,
or a $404 decrease in purchasing power
Is Inflation Bad?
The previous example illustrates that inflation erodes the purchasing power of consumers if nominal
wages do not keep up with prices. In general, inflation impacts different groups in different ways. It can
actually help some individuals! The main thing to keep in mind with inflation is that it is the unexpected
or sudden inflation that creates winners and losers. If the inflation is predictable and expected, most
groups can plan for it and adjust behavior and prices accordingly.
Inflation and the Consumer Price Index Review for AP Macroeconomics 3
Expected Inflation
If my employer and I agree that the general price level is going to increase by 3 percent next year, then
my salary can be adjusted by at least 3 percent so that my purchasing power does not fall. This cost of
living adjustment doesn't hurt my employer so long as the prices of the firm's output and any other
inputs also increase by 3 percent. Many unions and government employees have cost of living raises
written into employment contracts to recognize predictable inflation over time.
Banks and other lenders acknowledge inflation by factoring expected inflation into interest rates. If they
do not, savers and lenders can be hurt by rising prices. For this reason, the bank adds an inflation factor
on the real rate of interest to create a nominal rate of interest that savers receive and borrowers pay.
Nominal Interest Rate = Real Interest Rate + Expected Inflation
Savings Example 1:
When I see the bank offering an interest rate of 1 percent for a savings account and I put $100 in the
bank, I expect to have $101 worth of purchasing power a year from now. But if prices increase by 2
percent, my original deposit is only worth $98. So even when I receive my $1 of interest, I have lost
purchasing power.
If you have a savings account, the real rate is the rate the bank pays you to borrow your money for a
year. You must be compensated for this because you do not have $100 to spend if you put it into the
bank. Look at my savings example again with an inflation expectation of 2 percent and a real interest
rate of 1 percent.
Savings Example 2:
 January 1: The purchasing power of my $100 is $100 and the bank offers me a 3 percent
nominal interest rate on a savings account.
 Throughout the year, inflation is indeed 2 percent.
 December 31: My bank balance says $103, but $2 of purchasing power has been lost to inflation,
leaving me with $1 as payment from the bank for having my money for one year.
Borrowing Example:
If you are looking for a loan of $100, the real interest is the rate the bank will charge you for borrowing
the bank's money for a year. After all, if the bank lends the money to you, it will not have those funds
for some other profitable opportunity. Again, let's assume that the expected inflation is 2 percent but
the real rate of interest is 3 percent.
 January 1: The purchasing power of the bank's $100 is $100 and the bank lends it to me with a 5
percent nominal interest rate.
 Throughout the year, inflation is indeed 2 percent.
Inflation and the Consumer Price Index Review for AP Macroeconomics 4

December 31: I pay the bank back $105, but $2 of the bank's purchasing power has been lost to
inflation, leaving it with $3 as payment from me for having its money for one year.
Unexpected Inflation
When price levels are unpredictable or increase by a much larger or much smaller amount than
predicted, some sectors of the economy gain and others lose. Though not a comprehensive list, some of
the groups that win and lose from unexpected inflation include the following.
 Employees and Employers. If the real income of workers is falling because of rapid inflation, it is
possible that firms are benefiting at the expense of the workers. In a simple case, you work at a
grocery store and the price of groceries unexpectedly rises by 10 percent a year, but your
nominal wages rise by 8 percent. Your employer is clearly benefiting by selling goods at higher
and higher prices but paying you wages that are rising more slowly.
 Fixed Income Recipients. A retiree receiving a pension can expect to see it slowly eroded by
rising prices. Likewise a landlord who is locked into a long-term lease receives payments that
slowly decline in purchasing power. If the minimum wage is not adjusted for inflation then
minimum wage workers see a decline in their purchasing power.
 Savers and Borrowers. If I put my money in the bank and leave it for a year when inflation is
higher than expected, and then withdraw it, the purchasing power is greatly diminished. On the
other hand, if I borrow from the bank at the beginning of that year and pay it back after higher
than expected inflation, I am giving back dollars that are not worth as much as they used to be.
This benefits me and hurts the bank.