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Introduction to Macroeconomics
Chapter 5.
Measuring Changes in Prices
Chapter 5. Measuring Changes in Prices
1. Inflation and deflation
2. Costs of inflation
3. Measuring inflation with price indexes
4. Causes of inflation
Introduction to Macroeconomics
1. Inflation and Deflation
Definitions
Inflation
= Increase in average level of prices
Deflation
= Decrease in average level of prices
Introduction to Macroeconomics
1. Inflation and Deflation
Hyperinflation
Hyperinflation
= a very high rate of inflation
over 50% per month
over 200% per year
Generally caused by governments printing
money to finance large fiscal deficits caused
by wars, revolutions, the establishment of
new states, or exorbitant social programs.
Introduction to Macroeconomics
2. Costs of Inflation
• Purchasing power
• Menu costs
• Expected versus unexpected
inflation
Introduction to Macroeconomics
2. Costs of Inflation
Purchasing Power
Purchasing Power
= the quantity of goods and services
that can be purchased with a given
amount of money; the value of
money.
Introduction to Macroeconomics
2. Costs of Inflation
Menu Costs
Menu Costs
= opportunity costs of resources
required (e.g., cash costs) to change
prices.
Introduction to Macroeconomics
2. Costs of Inflation
Unanticipated Inflation
• Arbitrary redistribution of income between borrowers and lenders,
between employers and labor
• Uncertainty - more difficult to enter
into contracts
• Uncertainty - change in relative
versus change in average prices
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
•
•
•
•
•
•
Price indexes
GDP deflator
Consumer price index (CPI)
GDP deflator - CPI differences
Problems with price indexes
Chain-weighted index
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
Price Indexes
Price Index - a measure of the change
in the average level of prices
• GDP Deflator
• Consumer Price Index
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
GDP Deflator
• Nominal GDP
– Value of output measured at actual prices
(current dollar output)
– Does not correct for inflation
• Real GDP
– Value of output based on prices of some base
period (“constant” dollar output)
– eliminates effect of inflation
• GDP Deflator = Nominal GDP x 100
Real GDP
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
GDP Deflator: Sample Problem 1
Average Prices
Quantity Sold
1992
1994 % Change 1992
$ 12
$ 14
17 %
4
5
Housing
9
10
11 %
3
3
Fun
4
5
25 %
3
4
Machines
20
20
0%
2
2
Food
Introduction to Macroeconomics
1994
3. Measuring Inflation with Price Indexes
Nominal and Real GDP
Nominal GDP
= Current year Quantities
x Current year Prices
Real GDP
= Current year Quantities
x Base year Prices
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
GDP Deflator: Sample Problem 1
Nominal GDP Real GDP
1992
(base year)
1994
Introduction to Macroeconomics
127
127
160
143
3. Measuring Inflation with Price Indexes
GDP Deflator: Sample Problem 1
GDP Deflator = Nominal GDP • 100
Real GDP
1992 GDP Deflator = 127• 100 = 100.0
127
1994 GDP Deflator = 160 • 100 = 111.9
143
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
GDP Deflator: Sample Problem 1
Change in GDP Deflator (Inflation) from
1992 to 1994:
= (1994 Deflator - 1992 Deflator) • 100
1992 Deflator
= (111.9 - 100.0) • 100 = 11.9%
100.0
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
GDP deflator - CPI differences
Year:
CPI
0
(base year)
Σ P0 Q0
Σ P0 Q0
1
Σ P1 Q0
Σ P0 Q0
2
Σ P2 Q0
Σ P0 Q0
GDP
Deflator
Σ P0 Q0
Σ P0 Q0
Σ P1 Q1
Σ P0 Q1
Σ P1 Q2
Σ P0 Q2
where, for products “a” and “b”:
Σ P0 Q0 = (p0a x q0a) + (p0b x qob)
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
GDP deflator - CPI differences
• GDP Deflator
– All final goods and services included
– Quantities variable
– Imports excluded
• Consumer Price Index
– Only goods and services purchased by
households included
– Quantities fixed (the market basket)
– Imports (of consumer goods) included
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
Problems With Price Indexes
• Substitution bias - changes in relative
prices
– between goods (butter vs margarine)
– between stores (small mom and pop
versus large discount stores)
• Quality changes and new products
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
CPI versus GDP Deflator
20%
Consumer Price Index
Annual Change, percent
15%
10%
5%
0%
-5%
GDP Deflator
-10%
-15%
1930
1940
1950
1960
1970
1980
1990
2000
Source: CPI - Bureau of Labor Statistics (www.bls.gov)
GDP Deflator – Bureau of Economic Analysis (www.bea.doc.gov)
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator: Sample Problem 2
• Assumptions:
– Income does not change
– Only 2 products: food and toys
– Each household spends ½ of their income
on food and ½ on toys
– Price of food has been constant
– Price of toys increasing by 10% per year
– Year 1 is base year for real GDP and CPI
• Implication:
– The cost of living has been increasing 5%
per year
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator: Sample Problem 2
Year:
Food
1
3
4
Q
100
100
100
100
P
$100
$100
$100
$100
$10,000
$10,000
$10,000
$10,000
Q
100
90.91
82.64
75.13
P
$100
$110
$121
$133.1
$10,000
$10,000
$10,000
$10,000
Total
Toys
2
Total
As the price of toys becomes more expensive relative
to the price of food, households buy fewer toys.
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator: Sample Problem 2
where,
Pn = price in year n (i.e., 1, 2, 3, or 4)
Qn = quantity in year n
Pb = price in base year (year 1)
Qb = quantity in base year (year 1)
Σ Pn Qn = sum of prices x quantities
ΣP2Q2 = ($100 x 100) + ($110 x 90.91) = $20,000
ΣPbQ2 = ($100 x 100) + ($100 x 90.91) = $19,091
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
CPI vs GDP Deflator: Sample Problem 2
Year:
1
2
3
4
= ΣPn Qn
$20,000
$20,000
$20,000
$20,000
Real GDP = ΣPb Qn
$20,000
$19,091
$18,264
$17,513
100.00
104.76
109.50
114.20
4.8 %
4.5 %
4.3 %
105.00
110.50
116.55
5.0 %
5.2 %
5.5 %
Nominal
GDP
GDP
Deflator
= Nominal
Real
Inflation
CPI
= ΣPn Qb
ΣPb Qb
Inflation
Introduction to Macroeconomics
100.00
3. Measuring Inflation with Price Indexes
Chain Weighted Index
• Problem: the measures of real GDP, GDP
deflator, Consumer Price Index, and
inflation become less and less accurate as
you move further away from the base year.
• Solution: always use the previous year as
the base year. Individual year deflators are
“chained” (multiplied) together to produce
the GDP deflator.
Introduction to Macroeconomics
3. Measuring Inflation with Price Indexes
Chain Weighted Index: Sample Problem 2
Year:
Nominal
GDP
= ΣPn Qn
Deflated
GDP
= ΣPn-1 Qn
Deflator
= Nominal
Real
GDP
Deflator
= Deflatorn-1
x Deflatorn
1
2
3
4
$20,000
$20,000
$20,000
$20,000
$19,091
$19,091
$19,091
104.76
104.76
104.76
104.76
109.75
114.97
4.8 %
4.8 %
4.8 %
$19,091
$18,224
$17,396
100
Inflation
Real GDP
Introduction to Macroeconomics
$20,000
4. Causes of Inflation
• Money supply
• Demand-pull and cost-push inflation
• Expectations
Introduction to Macroeconomics
4. Causes of Inflation
Money Supply
Introduction to Macroeconomics
4. Causes of Inflation
Demand-Pull and Cost-Push Inflation
• Demand-Pull Inflation - caused by an
increase in aggregate demand for
goods and services.
• Cost-Push Inflation - caused by an
increase in the costs of production of
goods and services.
Introduction to Macroeconomics
4. Causes of Inflation
Expectations
Introduction to Macroeconomics