Download How the Consumer Price Index Is Calculated

Chapter 26
Inflation, expectations and
credibility
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
9th Edition, McGraw-Hill Education, 2008
PowerPoint presentation by Alex Tackie and Damian Ward
©The McGraw-Hill Companies, 2008
Inflation is ...
• Inflation is a rise in the price level.
• Pure inflation is when goods and input
prices rise at the same rate.
• One of the first acts of the Labour
government in 1997 was to make the
Bank of England independent with a
mandate to achieve low inflation.
The rental contracts and the civil servant wages
are indexed to inflation in Turkey.
©The McGraw-Hill Companies, 2008
Some questions about inflation
• What are the causes of inflation?
• What are the effects and hence costs
of inflation?
• What can be done about it?
• These are the questions we seek to
answer in what follows.
©The McGraw-Hill Companies, 2008
Calculating Inflation
• We use price indices to measure
inflation.
• Consumer Price Index (CPI)
• Producer Price Index (PPI)
• Gross Domestic Product deflator
(GDP deflator)
©The McGraw-Hill Companies, 2008
Inflation in the UK, 1950-2007
30
25
% p.a.
20
15
10
5
0
2000
1990
1980
1970
1960
1950
Source: Economic Trends Annual Supplement, Labour Market Trends
©The McGraw-Hill Companies, 2008
Inflation in Turkey
2003-2011
Inflation
20
18
16
14
12
10
8
6
4
2
0
2003
Source: TEPAV
2004
2005
2006
2007
2008
2009
6
2010
2011
©The McGraw-Hill Companies, 2008
THE CONSUMER PRICE
INDEX
• The consumer price index (CPI) is a
measure of the overall cost of the
goods and services bought by a
typical consumer.
• The Bureau of Labor Statistics
reports the CPI each month.
• It is used to monitor changes in the
cost of living over time.
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THE CONSUMER PRICE
INDEX
• When the CPI rises, the typical family
has to spend more dollars to
maintain the same standard of living.
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How the Consumer Price Index Is
Calculated
• Fix the Basket: Determine what
prices are most important to the
typical consumer.
– The Bureau of Labor Statistics (BLS)
identifies a market basket of goods and
services the typical consumer buys.
– The BLS conducts monthly consumer
surveys to set the weights for the prices
of those goods and services.
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How the Consumer Price Index Is
Calculated
• Find the Prices: Find the prices of
each of the goods and services in the
basket for each point in time.
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How the Consumer Price Index Is
Calculated
• Compute the Basket’s Cost: Use
the data on prices to calculate the
cost of the basket of goods and
services at different times.
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How the Consumer Price Index Is
Calculated
• Choose a Base Year and Compute
the Index:
– Designate one year as the base year,
making it the benchmark against which
other years are compared.
– Compute the index by dividing the price
of the basket in one year by the price in
the base year and multiplying by 100.
©The McGraw-Hill Companies, 2008
How the Consumer Price Index Is
Calculated
• Compute the inflation rate: The
inflation rate is the percentage
change in the price index from the
preceding period.
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How the Consumer Price Index Is
Calculated
• The Inflation Rate
– The inflation rate is calculated as
follows:
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year 2 =
 100
CPI in Year 1
©The McGraw-Hill Companies, 2008
Table 1 Calculating the Consumer Price Index
and the Inflation Rate: An Example
©The
McGraw-Hill Companies, 2008
Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index
and the Inflation Rate: An Example
©The
McGraw-Hill Companies, 2008
Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index
and the Inflation Rate: An Example
©The
McGraw-Hill Companies, 2008
Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index
and the Inflation Rate: An Example
©The
McGraw-Hill Companies, 2008
Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index
and the Inflation Rate: An Example
©The
McGraw-Hill Companies, 2008
Copyright©2004 South-Western
CPI 851 goods and services
included in 12 main categories.
• CPI-Turkey 2012 (%)
1. Food and nonalcoholic beverages
2. Alcoholic beverages and tobacco
3. Clothing and shoes
4. Housing
5. House appliances
6. Health
7. Education
8. Communication
9. Transportation
10.Recreation and culture
11.Restaurants and Hotels
12.Other
26,22
5,21
6,87
16,44
7,45
2,29
2,18
4,6
16,73
2,98
5,63
3,4
TOTAL
Source: TÜİK
100
20
©The McGraw-Hill Companies, 2008
The GDP Deflator
• The GDP deflator is a measure of the
price level calculated as the ratio of
nominal GDP to real GDP times 100.
• It tells us the rise in nominal GDP
that is attributable to a rise in prices
rather than a rise in the quantities
produced.
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The GDP Deflator
• The GDP deflator is calculated as
follows:
Nominal GDP
GDP deflator =
 100
Real GDP
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The Causes of Inflation
• Demand-Pull Inflation: Increases
when the demand increases.
• Example: Good economic conditions
cause demand to increase.
• Cost-Push Inflation: The increase in
costs can push the prices up.
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Hyperinflation
• Hyperinflations are periods when
inflation rates are very large
• During such periods there tends to be a
‘flight from cash’, i.e. people hold as
little cash as possible
– e.g. Germany in 1922-23, Hungary 194546, Brazil in the late 1980s.
• Large government budget deficits help
to explain such periods
– persistent inflation must be accompanied by
continuing money supply growth
©The McGraw-Hill Companies, 2008
German Hyperinflation,
1922-23
(January 1922=1)
Date
Money
Supply
Prices
Real Money
Monthly
inflation(%)
Jan 1922
1
1
1.00
5
Jan 1923
16
75
0.21
189
July 1923
354
2021
0.18
386
227777
645946
0.35
2532
20201256
191891890
0.11
29720
Sept. 1923
Oct. 1923
25
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Seigniorage and Inflation
Tax
• Seigniorage: The real income that the
government gets by printing money
• Inflation Tax: The decrease in real
national debt because of the increase in
inflation.
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Inflation illusion
• People have inflation illusion when they
confuse nominal and real changes.
• Welfare depends upon real variables, not
nominal variables.
• If all nominal variables (prices and
incomes) increase at the same rate, real
income does not change.
©The McGraw-Hill Companies, 2008
The costs of inflation (1)
• Fully anticipated inflation:
• Institutions adapt to known inflation:
– nominal interest rates
– tax rates
– transfer payments
• there is no inflation illusion
• Some costs remain:
– shoe-leather
• people economise on money holdings
– menu costs
• firms need to alter price lists etc.
©The McGraw-Hill Companies, 2008
The costs of inflation (2)
• Even if inflation is fully anticipated,
the economy may not fully adapt
– interest rates may not fully reflect
inflation
– taxes may become distorted
• fiscal drag may have unintended effects on
tax liabilities
• capital and profits taxes may be distorted
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The costs of unanticipated
inflation
• Unintended redistribution of income
– from lenders to borrowers
– from private to public sector
– from old to young
• Uncertainty
– firms find planning more difficult under
inflation, which may discourage investment
• This has been seen as the most
important cost of inflation
©The McGraw-Hill Companies, 2008
Defeating inflation
• Monetary policy: Inflation will be lower if
the rate of money growth is lower.
• Fiscal Policy: If the government spends
less, then it needs to print less money to
cover its debt.
• Price policy: The government tries to
control the prices. (e.g. Limit the raise in
rental contracts).
©The McGraw-Hill Companies, 2008