Chapter 5 The Cost of Living and Inflation

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Chapter 5The Cost of Living and Inflation
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Measuring Inflation

• GDP deflator measures the average price of all
  goods produced within a country
• The GDP deflator measures the price of all goods
  that make up GDP.
• Consumption goods, investment goods, government
  goods, and export goods
• Excludes imports
• Notice that many of these goods are not in a
  consumer's shopping basket.
• The CPI is the average level of prices of goods
  typically bought by households.
• Inflation is the percentage change in the general
  price level, usually the CPI.

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CPI Inflation Bias

• Inflation based on the CPI is biased upward
• The CPI overestimates the actual impact of
  inflation on consumers.
• Fixed shopping basket problem
• When prices are rising, the shopping basket is
  held fixed by the statisticians.
• Consumers, however, substitute for cheaper goods
  to dampen the effects of inflation as they
  experience it.
• Improvements in quality are difficult to
  incorporate.
• Overestimates inflation by 0.5 to 1

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The American Experience with Inflation (a)

• Historically the United States has had relatively
  stable prices, or low inflation.
• Except in wartime and during the period 1973 to
  1981 following oil price shocks
• Hyperinflation inflation of over 100 per month!
• Deflation a period of falling prices negative
  inflation rate
• In the United States the last deflation was
  during the Great Depression.
• Disinflation a period of falling inflation
• Example inflation falling from 5 to 3. Prices
  are still rising but at a slower rate.
• Disinflation is often the result of government
  policy to reduce inflation.

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Consumer Price Index
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U.S. Inflation
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German Hyperinflation
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The Costs of Inflation

• May be difficult to determine
• Wages are often partially or perfectly indexed to
  inflation.
• Example COLAs (cost of living adjustments) are
  included in many labor contracts and Social
  Security
• Who suffers from inflation?
• Lenders, who are paid back in dollars that have
  lower purchasing power
• Taxpayers, since the tax code is only partially
  indexed
• Holders of currency, since inflation is a tax on
  holding currency

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Social Costs of Inflation

• Shoe-leather costs
• The costs of managing cash balances and otherwise
  avoiding the inflation tax
• Added variability in relative prices
• Not all prices rise by the same percentage during
  inflation.
• This may make it may be difficult to determine
  whether the price of a good is increasing due to
  higher demand for that good or due to a rise in
  the general price level.
• Increased uncertainty
• Makes planning more difficult

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The Costs of Deflation

• Hurts borrowers
• Failure to repay loans may lead to widespread
  bankruptcies and a banking and financial crisis.
• Deflation puts a lower bound on the real interest
  rate.
• Nominal interest rate real interest rate
  inflation
• Nominal interest rate ? 0 so
• Real interest rate inflation ? 0,
• Which means real interest rate ? - inflation.
• Example if inflation is -5 (a deflation) then
  the real interest rate ? 5
• This may discourage borrowing by businesses and
  consumers which would lead to lower investment
  and consumer spending.

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Measuring Prices and Inflation

• Economists ask what would it cost consumers to
  buy the same bundle of goods this year as last
  year? This measure is called a price index.
• Base year the year in which the bundle is
  determined currently 1993 95
• Base year index always equals 100.
• CPI price index representing the expenditure on
  goods purchased by the typical urban family of
  four in period 1993 95
• Weights each good enters the CPI shopping
  basket with a weight that reflects the
  importance of that good in the average
  households spending
• Example cars receive weight of 4.6 out of 100
• Mens footwear receives a weight of 0.241.

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Measuring the CPI and CPI Inflation

• For just three goods the Consumer Price Index in
  2005 would be calculated in the following way
• Inflation change in price index
• Inflation in 2005 100(CPI2005 CPIbase
  year)/(CPIbase year)