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Chapter 52: Low and stable inflation (2.3)
Key concepts
 Inflation, disinflation and deflation
 Measuring inflation using the consumer price index (CPI)
 Core – underlying – rate of inflation
 Weaknesses of inflation figures
o Consumption and quality bias
o Inflation is an average (ind HHs will each have a diff i level, use expats in
Jakarta as a good ex)
 Producer price index
 Consequences of inflation
HL extensions
 A weighted price incex
 Calculating the price index (weighted data)
The meaning of
inflation, disinflation
and deflation
Consequences of
inflation
HL extension
•
Distinguish between inflation, disinflation and deflation
•
Explain that inflation and deflation are typically measured by calculating a
consumer price index (CPI), which measures the change in prices of a
basket of goods and services consumed by the average household
•
Explain that different income earners may experience a different rate of
inflation when their pattern of consumption is not accurately reflected by
the CPI
•
Explain that inflation figures may not accurately reflect changes in
consumption patterns and the quality of the products purchased
•
Explain that economists measure a core/underlying rate of inflation to
eliminate the effect of sudden swings in the prices of food and oil, for
example
•
Explain that a producer price index measuring changes in the prices of
factors of production may be useful in predicting future inflation
Discuss the possible consequences of a high inflation rate, including greater
uncertainty, redistributive effects, the erosion of purchasing power,
less saving and the damage to export competitiveness
Construct a weighted price index using a set of data provided
Calculate the inflation rate from a set of data
“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars
when you had hair.” (Sam Ewing, author)

Inflation, disinflation and deflation
Definition; Inflation
Inflation is defined as a consistent increase in the general (i.e. average) price level, measured
by the consumer price index (CPI) or GDP deflator.

Creeping inflation would be ‘moderate’ and involve a change in prices of a few percent per year.
Most OECD countries showed inflation rates of this magnitude during 2003 – between 1% and
6%.1

Hyperinflation is a situation where inflation hits triple-digits, for example when inflation in
Brazil peaked at over 2500% during the early 1990s.2
Definition; Deflation
When the average price level, determined by the CPI or the GDP deflator, falls consistently
during a time period, there is deflation, or negative inflation.
Definition; Disinflation
When there is a fall in the rate of inflation, say from 5% to 4%, one speaks of disinflation.

Measuring inflation using the consumer price index (CPI)
Pbasket in tn
Where tn is the year being looked at andt0 is the
CPI at t 0 = -----------------------------  100
Pbasket in t0
base year values, i.e. the original price of the basket.
The CPI is amassed by having a representative basket of consumer goods over time to show overall price
changes in a country. Every country’s ‘basket’ will have different goods in varying quantities, but the basic
methodology is the same. The base year is 1995 in figure 52.2, rendering a CPI value of 100. Summing the
total cost of the basket at consecutive points in time shows that the price level has increased to 101.6 during
the first year, or a 1.6% increase. Over the entire six year period the price level went from 100 to 119, a
19% increase in the price of the basket, e.g. the average price level has gone up by almost a fifth.

Core – underlying – rate of inflation
Economists often find it useful to exclude goods which are notoriously volatile, such as energy/oil and
food/agricultural goods, in which case one refers to core inflation. When the overall consumer price index
is adjusted by removing goods which are highly volatile over time it is easier to follow the trend of inflation
over longer time periods. Core inflation is a reasonable indicator of future inflation rates.

Weaknesses of inflation figures
Like all measurements we use in economics, weaknesses arise. Four major weaknesses rear their ugly
heads from within the values we compile for inflation.
o Inflation is an average
1OECD
2IMF
in figures, 2003 edition, see www.oecd.org
working paper, WP/01/50, High inflation and Real Wages, by Benedikt Braumann, 2001
Perhaps the most important limitation of using the CPI to measure inflation is that the index values are
averages. Different households will not be equally affected by inflation caused by large price increases in
certain goods. For example, households on lower incomes will spend proportionately more on food than
high income households, so an increase in foodstuffs will affect low income households more. Another
weakness dealing with averages is that not all goods will show the same rate of price increase. Taken
together, one could say that every household – indeed, every person – in the economy will have an
individual rate of inflation.
o Consumption and quality bias
Products improve over time – some of them quite considerably. The first hand-held computer I purchased
in 1998 cost $US500, had a black and white screen and 2 megabytes of memory. My next one, in 2003,
cost $US400, has 65,000 colours and close to 150 megabytes of memory – plus a number of features not
even dreamt of when I bought the first one. The Samsung Galaxy S I bought in December 2010…forget it;
the information will be obsolete (= out of date) by the time this leaves the printer. Anyhow, this on-going
process of continuous improvement and innovation often grossly overestimates inflation since the enhanced
value of better products is not taken into account in the CPI.
o Substitution bias
The CPI does not adequately take into account that consumers will substitute expensive goods with lowerpriced alternatives over time. The time lag between when increasingly substituted goods are also taken out
or replaced in the CPI basket will overestimate inflation.
o Weight and content bias
Another way in which the CPI overestimates inflation due to time lags arises when good become obsolete.
The CPI basket needs to represent household spending and since consumption patterns change over time
the contents in the basket need to change. If there is a lag in adjusting the basket to consumption patterns
then the basket will incorrectly measure and weight items in the basket thereby skewing inflation
measurements. In the other direction, if the goods and weights are changed often then the CPI might be
comparing increasingly different baskets of goods over time, which would weaken the value of lengthy
inflation series.

Producer price index
Definition: “Producer price index – PPI”
The producer price index – PPI – is an index measuring the change in the price of factor
inputs, intermediary products and final goods seen from the vantage point of producers (not
consumers). It is comprised of the selling prices of goods used in thousands of industries in
an economy. It is assumed to be an indicator of how future inflation will move.
The PPI has a base year and is put into year-on-year increases, just like the CPI. However, do not confuse
‘final output prices’ with consumer prices! The PPI measures what sellers are getting rather than what end
consumers are paying. In effect, the PPI vs the CPI shows the ability of retailers to increase prices (the
profit margin) over that of what wholesalers received for the goods. Also, retailers will be subject to a
variety of further price determinants such as sales taxes, government subsidies and distribution costs.

Consequences of inflation
Inflation decreases the ability of money to function as in ‘money units per unit of output’. Modern
economies are highly dependent on a functioning monetary system. Inflation has the effect of eroding the
value of money, which can inflict serious damage on an economy if inflation is high enough. Yet too low
an inflation level runs the risk of turning into deflation – which most economists consider a far worse a
problem. Finding the ‘Goldilocks rate’3 of inflation is an almost magical feat.
(Type 4 Smaller heading) Redistribution effects of inflation
Vulnerable groups such as pensioners, households dependent on social security benefits, stand to lose a
great deal when inflation rates are high since they are often on fixed incomes. Even if these incomes are
indexed to inflation rates, there will be time lags which will have adverse effects on purchasing power. In
addition to this, workers in weak positions will not be able to bid up wages as much as workers in strong
bargaining positions. (See “In real life…”story further on.)
Two other groups which stand to lose real income due to inflation are lenders and savers. Inflation has the
tendency to decrease the distance between inflation and interest – the real interest rate – which will lower
real returns for lenders. Similarly, savers will see how the real value increase in their savings will go down
as it is eaten away by inflation and therefore diminishes future real purchasing power. On the other hand,
borrowers will gain at the expense of savers and lenders, since inflation will also serve to erode the real
debt of the original loan. Basically, income has been redistributed from lenders and savers to borrowers. 4
Finally, the financially strong will suffer far less than the weak. The wealthy will have access to more and
better information and thus the ability to cope with inflation by finding assets which are relatively secure in
value-retention, such as land and other fixed assets.
(Type 4 Smaller heading) Negative effects on growth
Inflation causes an increase in interest rates and will therefore have a negative effect on investment and
output, both of which will adversely affect employment rates. Neo-classical and monetarist economists
are quick to point to this particular effect of inflation.
(Type 4 Smaller heading) Behavioural distortions in the economy
Inflation (and increasing rates of inflation) affects the ‘view’ of firms seeking to maximise returns on
investment since the ratio between future profitability and the cost of loans is distorted when price levels
increase. (Keynes, in keeping with his philosophical preference to be ‘vaguely right rather than precisely
wrong’, referred to firms’ expectations as the ‘animal spirits’ of firms’ investment plans.) Inflation also
affects factor prices differently from final output prices, which adds further variables and thus
complications to investment plans. Anything which causes insecurity and lack of predictability in firms’
futures will serve to make them more cautious.
In addition to investment, consumption plans are often affected by inflation. Households have an incentive
to increase consumption of durable goods if future inflation is expected to rise, which can actually create
higher inflation rates. This is a macro force which to a certain extent can actually countermand falling
investment in firms.
(Type 4 Smaller heading) “Shoe leather” and “menu” costs
Stable prices give the economy an element of transparency, in that firms and households can – within
margins – safely foresee changes in prices and interest rates and plan accordingly. High inflation rates
decrease the certainty in knowing correct (or at least “fair”) market prices for factors and goods, leading
firms and households to spend more time searching for the best prices on the market. The time spent
analysing the market yields opportunity costs in productivity; this is a ‘shoe leather cost’, i.e. the cost of
walking around comparing prices.
Higher inflation also means that businesses will have to continuously change their prices in order to keep
up to date on the price level. Catalogues, price lists, price labels, vending machines etc will all have to be
3I.e.
4I
not too hot and not too cold. You know, the porridge…
know a good many people who bought houses in the early 1970s and are overjoyed at what high inflation
rates did to their real debt over the next 20 years.
adjusted continuously in order to avoid losses in real terms. These ‘menu costs’ for firms can be quite
considerable when inflation hits double digits.
(Type 4 Smaller heading) Possible breakdown of the monetary economy
All the examples of how inflation damages the economy are in fact illustrations of how the functions of
money wear down. In an economy with hyperinflation it is possible for the entire monetary system to
collapse. For example, in Bolivia during 1985, the rate of inflation (at an annualised rate) soared to
11,750%!5 Now, ask yourself this; “Would I want to hold on to money when it will be worth 0.84% of its
present value in one year’s time?”6 No, you will want to get rid of your Bolivianos as quickly as possible
since every day you spend with cash in your pocket means an opportunity cost in terms of what it will buy
you. The solution is to get something tangible for your cash such as consumer durables – or another
currency. Since everyone else is thinking the same thing, inflation will be driven even further by increasing
demand for goods but decreasing demand for holding on to the domestic currency. This self-reinforcing
feedback loop results is a breakdown in the system since money becomes virtually worthless. People will
spend enormous amounts of time tracking down the “best” prices and ultimately simply resort to bartering.
This process is incredibly time-consuming and allocatively wasteful since barter involves high search
costs for all parties in finding someone with co-wants; if you have piglets and need tomatoes then you have
to find someone who not only has tomatoes but also wants a few piglets. This shows the importance of the
transactions function of money. The breakdown of the functions of money will cause massive disruptions
to the government sector, since households and firms will have an incentive to put off tax-paying for as
long as possible. This can cause severe cash flow problems for governments needing money with which to
keep public services going.
(Type 4 Smaller heading) Exchange rates, trade and inflation
Finally, inflation is strongly linked to the external value of the currency, i.e. the value of the domestic
currency in terms of other currencies, which is the exchange rate. When domestic inflation is higher than
in countries with which trade is done, there is a tendency for the value of the domestic currency to fall. The
reason is that a higher domestic price level will make domestic goods less competitive internationally. As
foreign demand for domestic goods falls, the derived demand for the domestic currency (which foreigners
need to buy goods) will also fall – as will the price of the domestic currency, which is non other than the
exchange rate.
HL extensions
 A weighted price incex
Figure 52.4 shows a weighted basket of consumer goods for Ireland. Note that the same basic methodology
is applied when constructing a broader measure of inflation such as the GDP deflator.
Figure 52.4 Weighted price index for Ireland
5Abel
& Bernake, pages 459 – 461
purchasing power of one Boliviano after one year of inflation at 11,750% is calculated as
1/[inflation/100]+1. At 50% inflation your Boliviano would be worth 1/[50/100]+1 = 0.666…, or 66.6% of
the original value. At an inflation rate of 17,750 one Boliviano will be worth 1/[11,750/100]+1 = 0.0084, or
0.84%.
6The
Base year (t0)
% of income
spent on
good
(1)
Weight
(2)
∆Price
Affect on
CPI
(1) x (2)
20 pints of Guinness:
€30
20 pints of Guinness:
€32
20%
0.2
6.70%
1.34%
10 kg of mutton: €35
10 kg of mutton: €36
30%
0.3
2.90%
0.87%
10 cans of crab pâté: €40
10 cans of crab pâté: €45
10%
0.1
12.50%
1.25%
100 kg potatoes: €20
100 kg potatoes: €21
40%
0.4
5%
2.00%
Total cost of basket =
€125
Total cost of basket in
next time period = €134
100%
1
CPIt0 = €
125
---------  100
125
CPIt0 = 100

Un-weighted CPI (t1)
134  100
CPIt1 = €
---------125
Total:
5.46%
Weighted CPI shows an increase in the price level from
100 to 105.46.
CPIt1 = 107.2
CPIt1(weighted) = 105.5
Calculating the price index (weighted data)
In the example above, the inflation rate of 5.5% in the weighted index is more accurate than a rate of 7.2%
as the case is in the un-weighted price index. Using weights to show which goods are more important as
proportion of total spending more correctly illustrates the impact on households.
Summary and revision
1. Inflation is a general and consistent rise in the average price level as measured by
the CPI or the GDP deflator.
2. Deflation is a general and consistent fall in average prices as measured by the CPI
or the GDP deflator.
3. Deflation can be benign (caused by an increase in AS whereby the price level falls
but GDP increases) or malign (a decrease in AD causes both deflation and negative
growth).
4. The consumer price index (CPI) is an index which shows the price of a basket of
goods at the base period (year) and over consecutive periods (years). The difference
in the CPI is inflation.
5. Core inflation is the CPI with highly volatile goods removed – these are usually
oil/energy and food/agricultural goods. When the most volatile goods are removed,
the index has a better predictive value for future inflation.
6. Weaknesses of measurements of inflation include
a. The CPI and GDP deflator are both based on average price changes.
b. Consumption and quality bias – the goods compared over time are often far
superior to the ‘same’ ones in the basket 10 years ago.
c. Substitution bias – lower priced goods often replace higher priced goods
over time as a natural process.
d. Weight and content bias – the CPI doesn’t change at the same rate
consumers’ habits to and the lag makes inflation figures unreliable.
7. The producer price index (PPI) is a measurement of the change of prices in inputs
used by firms. Raw materials, goods in process and finished wholesale goods are
price indexed and computed. It is posited – though highly uncertain in many cases
– that the PPI will precede the CPI and thus act as good lead indicator of future
inflationary movements.
8. The consequences of inflation are:
a. Redistribution effects – households on fixed incomes will lose more than
those who can bid up their wages. Lenders (creditors, e.g. banks) will lose
at the expense of borrowers (debtors, e.g. households) since inflation eats
away at real debt and the real value of money repaid to banks. The
financially strong will lose more than the lower income groups.
b. Negative influence on growth – higher inflation makes both households
and firms reluctant to spend/invest due to the insecurity of future prices.
c. Shoe leather costs – the increased time and resources spent on finding the
lowest prices.
d. Menu costs – firms will need to change prices frequently to keep up with
inflation.
e. Possible breakdown of monetary economy – hyperinflation can lead to
widespread abandonment of money and the emergence of a barter
economy.
Summary and revision
9. External balance effects:
a. Higher inflation (= internal value of money) means that the price of exports
rises (ceteris paribus) and the price of imports falls. This leads to decreased
exports and increased imports – a negative effect on the trade balance.
b. Following the above, a decrease in exports will mean lower demand for the
Home currency which means a depreciation of the home currency.
HL extension
10. A weighted price index sets values for goods indicating the relative importance of
the good based on how households spend their money. For example, electricity will
have a heavier weight than paperclips and using these weights to compute a CPI
which better represents the effect on households.