9/16/14&1&Chapter 8 (21) – The Price Level and Inflation In this chapter we will look at how inflation is measured. (We saw one measure – the GDP deflator – in Chapter 6; in this chapter we will look at another frequently-used measure of inflation.) We will also talk about the problems created by inflation, and the causes of inflation. Inflation (π) ◦ Inflation ! Growth in the overall (‘average’) level of prices ! Measured as the percentage change in the price level ! Deflation occurs when overall prices are falling ! Hyperinflation is an ‘extremely high’ level of inflation ◦ Inflation itself doesn’t usually cause problems ! Uncertainty about price changes creates problems for firms and workers ! Even relatively high inflation can be managed, as long as the rate of inflation is stable. How is Inflation Measured? " Inflation is measured as the growth rate of the price level. The price level is measured by: ◦ GDP Deflator ◦ Consumer Price Index (CPI) " Consumer Price Index ◦ Based on the purchases made by a typical consumer ◦ Goal: to measure the cost of living for a typical US consumer9/16/14&2&" Bureau of Labor Statistics ◦ Determine the goods included (and their weights) ◦ Measures the prices of these goods on a monthly basis ! 8,000 goods and services in 211 product ‘categories’ in 38 geographic locations " Basic approach: ◦ Measure the prices of everything in a fixed ‘basket’ of goods (products and quantities are fixed) ◦ Compare total cost of this basket each month relative to a base period Creating a Price Index " Suppose the basket contains 10 oranges and 5 haircuts. ◦ Price of oranges is $1 in 2013 and $2 in 2014 ◦ Price of haircuts is $8 in 2013 and $10 in 2014 " Compute the price (cost) of the basket in each year " Compute the price index: " Inflation Rate = % change in price index price index = current basket pricebasket price in base year× 100Comparing Prices over Time " Most prices rise over time ◦ Travel, education, health care " Some prices fall over time ◦ Often this is because of technological advancements (for example, consumer electronics) " A price index can be used to ‘equate’ prices over time price in today's dollars = price in earlier time ×price level todayprice level in earlier timehow much the entire basket costs (1# for each year)(1)(2)(2) Cost of Basket (10 Oranges/ 5 haircuts) 2013: $1 x 10 + $8 x 5 = $10 + $40= $50 2014: $2 x 10 + $10 x 5 = $20 + $50 = $70Price index(t) Basket cost(t) / Basket cost in base) x 100Price Index in 2013 = 100.......50/50 x 100 = 100(Base 2013)*price index in the base year is 100* Price Index in 2014 (70/50) x 100 = 140New - Old / Old x 100 Inflation (140 - 100/ 100) x 100 = 40% OR Base = 2014 Price index in 2013 (50/70) x 100 = 71.42 (old) Price index in 2014= 100 (new) Inflation Rate : (100 - 71.42 / 71.42) 100 = 40.017---- Converts a price from an earlier time to todays dollars. Level= overall prices in the economy (CPI OR DEFLATOR)Price= price of goodExample : Coffee January 1980: $3.21/ lb August 2014: $5/17/ lb (Compare to what the $ buys)Which is more expensive? We want yhr prce of coffee in 1980 reported using 2014 dollars. ("Price of coffee in Canada using US dollars")CPI: 77.8 (1980) 237.85(2014)Price of coffee in 1980 (in 2004 $) = $3.21 x 237.85 / 77.8= $9.81*If you took today's dollars to 1980 it owuld take $9.81 to buy the coffee. it only takes $5.17 to buy it today. In REAL TERMS (constant dollars) the price of coffee has fallen. *Eggs June 2005: $1.21 a dozen August 2014: $1.98 a dozen Find the price of eggs in 2005 reported in 2014 dollars.PRACTICE:9/16/14&3&Accuracy of the CPI " Accuracy is important since many wages, pensions, etc. are ‘indexed’ to the CPI ◦ Contracts state that increases are based on increases in the CPI " The most common concern is that the CPI overstates true inflation (it is biased upward). Reasons for this bias: ◦ Substitution ◦ Changes in quality ◦ New products and location " Substitution ◦ Consumers don’t buy the same goods in the same quantities every month. ◦ When the price of one good rises, they typically buy less of it and more of other goods. ◦ If this is ignored, the effect of price increases is over-estimated in calculating changes in the cost of living. ◦ Since 1999 the BLS has used a formula that accounts for this shift in consumption when prices change. " Changes in Quality ◦ Prices may rise because quality is better ◦ Since 1999 BLS methodology accounts for this " New Products and Locations ◦ New electronics (flash drives, iPads) and other products are always being introduced, but the CPI was updated only after long delays. This causes upward bias because ! New product prices typically drop after a year or so ! New retail outlets (such as online stores) offer better prices than traditional stores ◦ ‘chained CPI’ updates the basket monthly -Not a big problem :)-Not a big problem :)9/16/14&4&Costs of Inflation " Inflation reduces the purchasing power of income. ◦ However, income also tends to rise during inflation " Costs of inflation include: ◦ Future Price Level Uncertainty ◦ Shoe-leather costs ◦ Money illusion ◦ Menu costs ◦ Wealth redistribution ◦ Price confusion ◦ Tax distortions " Future Price Level Uncertainty ◦ Firms often make long-term agreements that involve paying workers or paying for inputs ◦ Uncertain inflation makes long-term contracts riskier (unless they can be indexed to inflation) ! Workers: fear decreases in real wages ! Firms: fear increases in real wages and prices ◦ Firms often spend money before they are paid, and sometimes borrow to make this happen. ! Inflation affects the value of the money that must be paid back ◦ Uncertainty about inflation makes these contracts more risky and infrequent, which hurts long-run growth9/16/14&5&" Shoe-Leather Costs ◦ Extremely high inflation makes it very costly to hold money (it is a ‘tax’ on holding money) ◦ People make frequent withdraws of cash and spend it quickly ◦ These are the time, effort, and fuel costs associated with spending money quickly. " Money Illusion ◦ Inflation can lead people to interpret nominal wage or price changes as real