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Slide Show for Lesson 5-2
Price Level Changes
Inflation is an increase in the average level of prices,
whereas deflation is a decrease in the average level
of prices.
Inflation and deflation refer to prices in general, not
prices of particular products. For example the rising
cost of gasoline is not inflation.
Figure 5-3 shows the inflation rate from 1960 to 1999.
Note the high inflation in the 1970s. The damage
done by that inflation still haunts the likes of Allen
Greenspan and the Federal Reserve. Like Buffy the
Vampire Slayer, they are determined to keep the USA
safe from this menace regardless of the cost.
Why Do We Care?
Inflation reduces the value of money. Deflation
increases the value of money. This hurts anyone
who has savings.
Inflation reduces the value of future obligations.
Deflation increases the value of future obligations.
This wipes out the value of insurance policies and
annuities.
Price level changes can create uncertainty about the
future. This tends to discourage investment.
Unanticipated inflation helps borrowers and hurts
lenders. Inflation helps those in debt but hurts the
financial institutions.
Why Do We Care? Cont.
Inflation hurts those on fixed incomes. Deflation
helps those on fixed incomes.
Many retirement programs try to overcome the
problem of fixed incomes during inflation by
arranging for indexed payments. These
payments are called COLAs.
An indexed payment is one whose dollar amount
changes with the rate of change in the price level.
Hyperinflation is usually defined as an inflation
rate in excess of 200 percent per year. This has
never happened in the USA.
Price Indices
A price index is a number whose movement
reflects movement in the average level of prices.
To calculate a price index, select the kinds and
quantities of goods to be included in the basket for
the index. For example the Consumer Price Index
should obviously contain items consumers buy.
Determine the cost of the basket in some reference
period called the base period. A base period is a
time period against which costs of the market
basket in other periods will be compared in
computing a price index.
Price Indices (cont.)
Determine the cost of the basket of goods in each
time period. Compute the price index according to
the following formula:
Price Index = (Current Cost of Basket/Base-period
Cost of Basket)x(100).
If the basket of goods cost $2,397 in 2001 and
$1,374 in the base year 1995, the the index for
2001 is (2,397/1,374) = 1.74 * 100 = 174.
Multiplying by 100 is not necessary and has no
mathematical effect. By social convention most
financial numbers are referred to without the
decimal. Who knows why?
The Consumer Price Index
The consumer price index reflects changes in the
prices for goods and services typically purchased
by consumers.
The CPI is based on a fixed basket of consumer
goods which changes about every decade.
The current CPI uses the average prices of
products in the basket during the period 1982–1984
as the base period.
CPI = (Current Cost of Basket/ 1982-1984 Cost of
Basket)(100)
The Implicit Price Deflator
The implicit price deflator is a price index that
reflects the prices of all goods and services. It is
computed from the ratio of current to real GDP.
The basket is everything produced in the current
period. Nominal GDP is the current cost of that
basket. Real GDP is the base period cost of the
same basket.
Implicit price deflator = (Nominal GDP/ Real
GDP)(100)
Computing the Inflation or Deflation Rate Inflation
rate = (Change in Index/Initial Value of the Index)(100)
For example is the CPI for 1998 was 156 and is 174 in
2001 then the inflation rate from 1998 to 2001
(174 – 156)/156*100 = 11.53%.
Computing Real Values Using Price Indices
A real value is a value measured in dollars of constant
purchasing power. A nominal value is a value
measured in dollars of current purchasing power.
To convert nominal values to real values, divide the
nominal value by a price index.
For example, what is the real cost of a gallon of gasoline.
This may seem like a nonsensical question. Gasoline costs
$1.67 a gallon, at least as of today. However, the $1.67 is
the nominal price of gasoline, not its real price.
Hidden in any discussion of this type with your friends or
relatives is a comparison with the past. Last year gasoline
cost less than it does today, so obviously it costs more this
year than last year. However, comparing past prices to
present prices only makes sense if the value or purchasing
power of money has remained the same. If the money has
changed in value, comparing prices directly will give a
distorted view of the real change in price.
In actuality, the real price of something is what you have
to give up to get it, not its money price.
For example, in 1984 gasoline cost $1.13 a gallon and in 2001 it
Costs $1.67 a gallon, so it has gone up $.54. But is gasoline more
expensive today than in 1984 in real terms, that is in terms of
affordability.
To answer this questions, lets compare gasoline costs to minimum
wage. In 1984 minimum wages was $3.35 an hour. In 2001 its
$5.71 and hour. This means in 1984 an unskilled worker worked
20.24 minutes to earn a gallon of gasoline. (1.13/3.35)*60. In
2001, an unskilled worker worked 17.55 minutes to earn a gallon
of gasoline. (1.67/5.71)*60).
So it seems gasoline is more affordable in 2001 for a minimum
wage worker. They give up almost 3 minutes less of an hour of
work to earn a gallon of gasoline. In real terms, the price of
gasoline has declined 5% for a minimum wage worker.
((3/60)*100).
Of course, generalizing about the affordability of gasoline by
comparing the price of gasoline to the price of one other
item, unskilled labor, would have its own limitations. This is
why price indexes are developed and used, and why so much
time and money goes into producing them. Check out these
web pages to get an idea of how seriously some people take
the CPI. http://stats.bls.gov/cpifaq.htm and
http://stats.bls.gov/cpihome.htm
Business decisions and personal financial decisions must be
based on real prices, rather than nominal prices, to avoid
making serious errors. This is why developing quality price
indexes is important. It’s a big area of work for the BEA and
a big area of employment for private economists. Many
industries buy proprietary price indexes from economic
consultants.
Are Price Indices Accurate Measures of Price
Level Changes?
It’s clear that it is not possible to calculate the real price of items
because it is not possible to perfectly calculate the overall change
in prices and the resulting change in the purchasing power of
money. Obviously, we do the best we can. Pages 133 and 114
detail some of the problems common in price indexes.
Because the components of the market basket are fixed,
the index does not incorporate consumer responses to
changing relative prices. Consumer ameliorate the impact
of price changes by substituting away from items going up
in price and towards items not going up in price. A price
index though has to assume the consumer does not alter
the amount purchased as a result of price change.
A fixed basket excludes new goods and services. Changing the
basket of goods obviously changes the price index, but a static
basket of goods quickly becomes nonsensical in a rapidly
changing world. How valid is a CPI that does not include cell
phones or internet charges, but these things did not exist in 1985.
Obviously, the basket must change.
Quality changes may not be completely accounted for in
computing price level changes. If the quality of a product
improves, the consumer is getting more for their money. This is
hard to include accurately in a price index.
The type of store in which consumers choose to shop can affect
the prices they pay. Price indices do not reflect changes
consumers have made in where they shop. How to include Sam’s
Club in a price index or internet shopping where reduced time and
travel costs may make an item cheaper than its nominal price.
Are Price Indices Accurate Measures of Price
Level Changes?
The Boskin Report of 1996 estimates the upward bias
in the CPI between 0.8 and 1.6 percentage points,
with 1.1 percentage points as the best estimate.
Using a measure with an upward bias to adjust
nominal values has several implications. Real wages
have been understated to the extent that the CPI has
been overstating inflation.
Since the CPI is the basis for adjusting government
payments such as Social Security and for adjusting
tax brackets, the budget balance has been affected
by the upward bias of the CPI.