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Eco 6351
Economics for Managers
Chapter 10c.
The Business Cycle
Prof. Vera Adamchik
Inflation
• The biggest fear as an economy
reaches full employment is inflation.
• Inflation is an increase in the average
level of prices and services, not a
change in any specific price.
• Deflation is a decrease in the average
level of prices of goods and services.
The average price level
• The average level of prices is measured
by a price index
• The two most commonly used price
indexes are:
– The Consumer Price Index (CPI)
– The GDP Deflator
The Consumer Price Index
• The Consumer Price Index, or CPI is a
measure of the average change over
time in the prices paid by urban
consumers for a market basket of
consumer goods and services.
Information for the CPI
In order to calculate the CPI we need:
• to select a base period
• to determine the “basket” of goods and
services that a typical urban family buys
• to collect data on the prices of the items
in the “basket” in the base period and in
the following periods
Whose buying habits
does the CPI reflect?
• All Urban Consumers (CPI-U), about 87
percent of the total U.S. population
• Urban Wage Earners and Clerical
Workers (CPI-W), about 32 percent of the
total U.S. population (a subset of the CPIU's population
• Not included in the CPI are the spending
patterns of persons living in rural nonmetropolitan areas, farm families, persons in
the Armed Forces, and those in institutions,
such as prisons and mental hospitals
How is the CPI market basket
determined?
• The CPI market basket is developed from
detailed expenditure information provided by
families and individuals on what they
actually bought.
• For the current CPI, this information was
collected from the Consumer Expenditure
Survey over the three years 1993, 1994,
and 1995.
The Consumer Expenditure
Survey
• In each of these three years, more than 5,000
families provided information on their spending
habits in a series of quarterly interviews.
• Another 5,000 families in each of the 3 years
kept diaries listing everything they bought
during a 2-week period.
• Altogether, more than 30,000 individuals and
families provided expenditure information for
use in determining the importance, or weight, of
the over 200 categories in the CPI index
structure.
What goods and services
does the CPI cover?
•
•
•
•
•
•
•
•
More than 200 expenditure categories are
arranged into eight major groups:
Food and Beverages
Housing
Apparel
Transportation
Medical Care
Recreation
Education and Communication
Other Goods and Services
How are CPI prices collected
and reviewed?
• Each month, BLS data collectors (called
economic assistants) visit or call thousands
of retail stores, service establishments,
rental units, and doctors' offices, all over the
United States to obtain price information on
thousands of items used to track and
measure price change in the CPI.
• These economic assistants record the prices
of about 80,000 items each month.
How to interpret an index?
• The CPI index has a 1982-84 reference
base. That is, BLS sets the average index
level (representing the average price
level) - for the 36-month period covering
the years 1982, 1983, and 1984 - equal to
100.
• The Bureau measures changes in relation
to that figure.
• Historically, BLS has updated its reference
periods every 10 years or so.
The CPI: A simplified calculation
Year 1982-1984
Item
Basket
Price
Expenditure
Oranges
5
$0.80
$4.00
Haircuts
6
$11.00
$66.00
Bus rides
200
$0.70
$140.00
Total expenditure
$210.00
(value of basket in the 1982-84 prices)
The CPI: A simplified calculation
Year 2002
Item
Basket
Price
Expenditure
Oranges
5
$1.20
$6.00
Haircuts
6
$12.50
$75.00
Bus rides
200
$0.75
$150.00
Total expenditure
$231.00
(value of basket in the current 2002 prices)
The formula for the CPI
CPI = Value of basket in the current prices
Value of basket in the 1982-1984 prices
 100
CPI in 2002 year = ($231/$210)*100 = 110
How CPI is used
• To calculate inflation rate
• To translate from nominal to real values
( for example, in order to compare
wages over time)
The CPI and inflation
• Inflation has been defined as a
process of continuously rising
prices, or equivalently, of a
continuously falling value of money.
• Various indexes have been devised to
measure different aspects of inflation.
• The CPI measures inflation as
experienced by consumers in their dayto-day living expenses.
The inflation rate
• The inflation rate between Year 2 and
Year 1 is the percent change in the CPI.
• Inflation =
[(CPI Year 2 – CPI Year 1)/
CPI Year 1] * 100%.
The biased CPI
• The CPI is likely to overstate the inflation
rate for three reasons
– Substitution bias
– New goods bias
– Quality change bias
– Growth in discounting
• It is estimated that the CPI overstates the
inflation rate by 1.1 percentage points per
year
Quality change bias
• A 1955 television does not compare in
quality to a 2000 television.
• Today's automobiles cost more that
Henry Fords model T, but part of that
price is reflected in the higher quality.
New goods bias
• The market basket used to measure the
CPI changes.
• Products like computers did not exist in
the 1972-73 CPI market basket.
• DVD players did not exist in the 1987
CPI market basket.
Nominal versus Real Values
Real value =
Nominal value / Price Index
APPROXIMATELY:
% change in real value =
% change in nominal value –
% change in price index (inflation)
Nominal vs Real Income (Wage)
• Nominal income (wage) is the amount
of money income received in a given
time period, measured in current
dollars.
• Real income (wage) is income in
constant dollars — nominal income
adjusted for inflation.
Nominal Wages and Prices
200
190
180
170
160
150
140
130
120
110
100
1982
Nominal wages
Prices(CPI)
Real wage
1984
1986
1988
1990
1992
1994
1996
2000
Nominal vs. Real Wealth
• Inflation alters the real value of savings.
Inflation’s Impact, 2001-2011
Year
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2%
$1,000
980
961
942
924
906
888
871
853
837
820
Annual Inflation Rate
4%
6%
8%
$1,000 $1,000 $1,000
962
943
926
925
890
857
889
840
794
855
792
735
822
747
681
790
705
630
760
665
584
731
627
540
703
592
500
676
558
463
10%
$1,000
909
826
751
683
621
564
513
467
424
386
The Price Stability Goal
• Price stability is the absence of
significant changes in the average price
level.
• The Full Employment and Balanced
Growth Act of 1978 holds the rate of
inflation to less than 3%.
• Why 3 Percent?
• Congress weighs the tradeoff between
inflation and full employment.
The GDP deflator
Real GDP =
Nominal GDP/GDP deflator
The GDP deflator measures the
average level of prices of all the goods
and services that are included in GDP