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Chapter 5
Econ104 Parks
Inflation
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Measuring Inflation
• To measure inflation, we must first construct a
price index.
• A price index is a device for measuring price
level changes by tracking the price of a
designated bundle of goods and services
through time with respect to a base year.
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Step to Construct a Price Index
1. Select a base year. The price index for the base year
is set equal to 100.
2. Select a bundle of goods and services for which
prices will be monitored over time.
3. Compute the cost of the bundle in the base year.
4. Compute the cost of the bundle in the year you wish
to compare to the base year (year i).
5. Apply the following formula:
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Example of a “Movie” Price Index
Base year is 1996. Bundle consists of two bags of
popcorn, one movie ticket, and one soft drink.
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prices
1996
1997
1998
price inflation
4
4.5
5
quantaties
2
expenditures
1996
8
1997
9
1998
10
7
7.5
7.5
2
2
2
1
1
1.125
1.25
Total
7
7.5
7.5
2
2
2
relative importance
1996
0.4706
0.4118
1997
0.4865
0.4054
1998
0.5128
0.3846
0.1176
0.1081
0.1026
1.0714
1.0714
1.0000
1.0000
CPI
17
1.0000
18.5
1.0882
19.5
1.1471
1
1
1
relative importance times price inflation
0.5294
0.4412
0.1176
1.0882
0.5882
0.4412
0.1176
1.1471
http://econ124.wustl.edu/sp09/calc-relimport.xls
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Weights – Relative Importance
• http://econ124.wustl.edu/sp09/calcrelimport.xls
• http://econ124.wustl.edu/sp09/cpi-relimportance.xls
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Using a Price Index to Measure Inflation
• Once we create a price index, we can use that
index to calculate the inflation rate.
• The inflation rate is the percentage change in
the price index from one year to the next, or
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Inflation at the Movies
• Inflation in 1997 is (108.8 - 100)/100 x 100 = 8.8%
• Inflation in 1998 = (114.7 - 108.8)/108.8 x 100 = 5.4%
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Movie Price Index Recalculated Using
Consumption Patterns from 1998
• Base year is 1996. Bundle consists of one bag of
popcorn, one movie ticket, and two soft drinks.
• Inflation rates are now 6.7% and 3.1%.
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A Problem with the Fixed-Weight
Price Index
• Substitution bias occurs in a fixed-weight
price index because consumers substitute
away from those goods and services rising
the most quickly, and purchase more of the
relatively lower-cost items.
– A fixed-weight price index tends to overstate
the true cost of living.
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The Geometric Mean Price Index
• A geometric mean price index re-weights
quantities in the price index each year for
certain categories of the CPI. Therefore,
changes in consumption patterns due to
relative price changes are picked up quickly
and the substitution bias is reduced.
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The Geometric Mean Price Index
• The geometric mean of two numbers is the square
root of their product.
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Common Price Indices
• The CPI, PPI, and GDP Deflator are the
three most common price indices in the U.S.
economy.
– Consumer Price Index (CPI) is composed of
the bundle of goods and services that the typical
urban household consumes.
– Producer Price Index (PPI) consists of a bundle
of goods traded at the wholesale level.
– (Implicit) GDP deflator consists of the bundle
of all newly produced final goods and services.
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Deflating Nominals to Reals
• Another important function of a price index
is to compare prices across time.
– A nominal value is not corrected for the effects
of inflation.
– A real value is the value of a good or service
that is corrected for the effects of inflation.
– Deflating is the process of deriving the real
value of some nominal value by dividing by an
appropriate price index.
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An Example
• Suppose that gasoline cost $1.45 in November
2002 but just $0.74 in November 1978. In
which year was gasoline cheaper in real terms?
– The CPI in Nov. 1978 was 67.5.
– The CPI in Nov. 2002 was 181.5.
– Real price of gasoline in 1978 was:
• $0.74/67.5 x 100 = $1.10
– Real price of gasoline in 2002 was:
• $1.45/181.5 x 100 = $0.80.
• Gas was much less expensive in 2002.
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Economic data available at
ECONOMAGIC.COM
• http://economagic.com
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Inflation
• Inflation is a sustained increase in the price
level.
• The price level is the weighted average of all
prices in the economy (as measured by a given
price index).
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U.S. Inflation Rates
Inflation Rate
14
12
10
8
6
4
2
20
05
20
00
19
95
19
90
19
85
19
80
19
75
19
70
0
• Inflation increased a bit in 2004 and 2005 due to higher energy
prices.
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U.S. CPI NSA AND SA
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U.S. SA AND NSA Inflation Rates
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U.S. Inflation Rates
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Why Is Inflation Costly?
Inflation and Compensation
(%change)
14
Inflation
12
10
Compensation
8
6
4
2
2005
2000
1995
1990
1985
1980
1975
1970
1965
1960
0
• When prices rise, wages don’t always keep up.
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Other Costs of Inflation
• If inflation is anticipated, the costs include:
– Shoe-leather costs
– Menu costs
– Tax costs
• If inflation in unanticipated, the costs
include:
– The arbitrary redistribution of income
– Inflation uncertainty
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Hyperinflation
• Hyperinflation is inflation that proceeds at
exceptionally high rates.
• Some historical examples:
– Germany Oct. 1923: 29,586%.
– Nicaragua in 1988: 33,602%
– Brazil 1990: 2,360%.
• The root cause is usually excessive money
creation by the government to pay off debt.
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