Macroeconomic Theory
Inflation
Attendance
Agenda
1
Tracking Inflation
2
How to Measure Changes in the Cost of Living
3
Inflation Debates
4
Review and to Do
Tracking Inflation
Definitions
Inflation is a sustained rise in the general level of prices.
The inflation rate is the rate at which the price level increases.
Deflation is a sustained decline in the price level (negative inflation rate).
Disinflation is a decline in the rate of inflation
Warning
- Not all prices rise by the same amount.
- The inflation rate is the annual percentage increase in the average price level.
One familiar measure
Recall that The GDP deflator in year t (Pt) is the ratio of nominal GDP to real GDP in year t:
Pt=NominalGDPtRealGDPt=$YtYt
It is called an index number (1 in 2012), which has no economic interpretation.
The rate of change has a clear interpretation: the rate of inflation.
πt=Pt−Pt−1Pt−1
CPI
The Consumer Price Index (CPI) is a measure of the cost of living.
The CPI is published monthly by the Bureau of Labor Statistics (BLS), which collects price data for 211 items in 38 cities.
The CPI gives the cost in dollars of a specific list of goods and services over time.
Steps to constructing CPI
Find out what people typically buy.
Collect prices from the stores where people do their shopping.
Tally up the price of the basket of goods and services.
Calculate the inflation rate.
Example
| Goods | Price in 2018 | Price in 2019 |
|---|---|---|
| 300 cups of coffee | $2.50 | $2.75 |
| 10 textnooks | $150 | $175 |
| 50 pizzas | $8 | $9 |
cost of basket in 2019: $3,025
cost of basket in 2018: $2,650
setting base year to 2018 for index:
p2018=26502650∗100=100
$p_{2019} = *100= 114.15
Inflation = 114.15−100100 = 14.15%
Biases
Substitution bias
an inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise considerably.
Quality/new goods bias
inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not account for improvements in the quality of existing goods or the invention of new goods.
Adjustments
To allow for some substitution between goods, the Bureau of Labor Statistics uses alternative mathematical methods for calculating the CPI.
Updates the basket of goods behind the CPI more frequently, so that it can include new and improved goods more rapidly.
The substitution bias and quality/new goods bias has been somewhat reduced.
The rise in the CPI most likely overstates the true rise in inflation by only about 0.5% per year.
Poking around
Inflation Adjustment
Today's Dollars=Another time's dollars×Price index todayPrice Index another time
Real and Nominal Interest Rates
The stated interest rate without a correction for the effects of inflation is a nominal interest rate.
The interest rate in terms of changes in your purchasing power is a real interest rate.
Real rate = Nominal rate – Inflation rate
Core inflation
Core inflation index - takes the CPI and excludes volatile economic variables, like energy and food prices. Economists can have a better sense of the underlying trends in prices that affect the cost of living. A preferred gauge from which to make important government policy changes.
Other indicators
Producer Price Index (PPI) - a measure of inflation based on prices paid for supplies and inputs by producers of goods and services. Different industries, commodities, and stages of processing.
International Price Index - a measure of inflation based on the prices of merchandise that are exported or imported.
Employment Cost Index - a measure of inflation based on wages paid in the labor market.
Pure Inflation
Pure inflation is proportional increase in all prices and wages.
This type of inflation causes only a minor inconvenience as relative prices are unaffected.
Real wage (wage measured by goods rather than dollars) would be unaffected.
There is no such thing as pure inflation.
Inflation and distribution
Inflation affects income distribution when not all prices and wages rise proportionally.
Inflation leads to distortions due to uncertainty, some prices that are fixed by law or by regulation, and its interaction with taxation (bracket creep in taxes).
Most economists believe the “best” rate of inflation to be a low and stable rate of inflation between 1 and 4%.
Inflation and distribution
Inflation hurts creditors
Inflation helps debtors
Inflation Debates
Current Fed Targets
Fed targets at 2%
Specifically tracks core PCE
Inflation stabilized
Inflation stabilized without large job losses
Is this “immaculate disinflation”?
