CPI, INFLATION

Course Title: MACROECONOMICS

Course Code: ECO2114

Course Conductor: Shamsuddin Sarker

Lecturer,
Department of Economics, SEU.
E-mail: [email protected] Mob: 01763071299
 GDP Deflator

The inflation rate is the percentage increase

in the overall level of prices.
One measure of the price level
is the GDP deflator, defined as

Nominal GDP
GDP deflator = 100  Real GDP

CHAPTER 2 The Data of Macroeconomics

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 Inflation by GDP Deflator

GDP Inflation
Nom. GDP Real GDP
deflator rate
2006 $46,200 $46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000

Use your previous answers to

compute the GDP deflator in each
year.
Use GDP deflator to compute the inflation
rate from
CHAPTER 2
2006 to 2007, and from 2007 to
The Data of Macroeconomics
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 Answers to practice problem, part
2
Nominal GDP Inflation
Real GDP
GDP deflator rate
2006 $46,200 $46,200 100.0 n.a.

2007 51,400 50,000 102.8 2.8%

2008 58,300 52,000 112.1 9.1%

CHAPTER 2 The Data of Macroeconomics

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Consumer Price index:
The most commonly used measure of the level of prices is the consumer price index(CPI).
It begins by collecting the prices of thousands of goods and services. Just as the GDP
turns the quantities of many goods and services into a single number measuring the
value of production, the CPI turns the prices of many goods and services into a single
index measuring the overall level of prices.
How should economists aggregate the many prices in the company into a single
index that reliably measures the price level? They could simply compute an average of all
prices. Yet this approach would treat all goods and services equally. Because people buy
more chicken than caviar, the price of chicken should have a greater weight in the CPI
than the price of caviar. The Bureau of Labor Statistics weights different items by
computing the price of a basket of goods and services purchased by a typical consumer.
The CPI is the price of this basket of goods and services relative to the price of the same
basket in some base year.
For example, suppose that the typical consumer buys 5 apples and 2 oranges, and the
CPI is:

CPI= (5X Current Price of Apples) + (2X Current Price of Oranges)

(5X 2006 Price of Apples) + (2X 2006 Price of Oranges)
 Consumer Price Index (CPI)
A measure of the overall level of prices
Published by the Bureau of Labor
Statistics (BLS)
Uses:
tracks changes in the typical
household’s cost of living
adjusts many contracts for inflation
(“COLAs”)
allows comparisons of dollar amounts
over time
CHAPTER 2 The Data of Macroeconomics
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 How the BLS constructs the CPI

1. Survey consumers to determine composition

of the typical consumer’s “basket” of goods.
2. Every month, collect data on prices of all items
in the basket; compute cost of basket
3. CPI in any month equals

Cost of basket in that month

100 
Cost of basket in base period
 Exercise: Compute the CPI

Basket contains 20 pizzas and 10 compact discs.

prices: For each year, compute

pizza CDs the cost of the basket
2002 $10 $15 the CPI (use 2002 as
2003 $11 $15 the base year)
2004 $12 $16  the inflation rate
from
2005 $13 $15 the preceding year

CHAPTER 2 The Data of Macroeconomics

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 Inflation and CPI :
Cost of Inflation
CPI rate
basket
2002 $350 100.0 n.a.
2003 370 105.7 5.7%
2004 400 114.3 8.1%
2005 410 117.1 2.5%

CHAPTER 2 The Data of Macroeconomics

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 The composition of the CPI’s
“basket”
Food and bev. 6.2%
17.4% 5.6%
Housing
3.0%
Apparel 3.1%
3.8%
Transportation 3.5%

Medical care

Recreation

Education 15.1%

Communication

Other goods 42.4%

and
services
CHAPTER 2 The Data of Macroeconomics
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 Limitations
the CPI may overstate inflation
The CPI uses fixed weights,
 Substitution
so it cannot reflect consumers’ ability to substitute
bias:
toward goods whose relative prices have fallen.

The introduction of
 Introduction of new
new goods makes consumers better off and, in effect,
goods:
increases the real value of the dollar. But it does
not
reduce the CPI, because the CPI uses fixed weights.

 Unmeasured changes in quality:

Quality improvements increase the value of the dollar,
but are often
CHAPTER 2
not fully measured.
The Data of Macroeconomics
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 In this CPI, 2006 is the base year. The index tells us how much it costs now to buy 5 apples
and 2 oranges relative to how much it cost to buy the same basket of fruit in 2006.
The consumer price index is the most closely watched index of prices, but it is not the
only such index. Another is the producer price index, which measures the price of a typical
basket of goods bought by firms rather than consumers.
INFLATION:
In economics, inflation is a sustained increase in the general price level of goods and
services in an economy over a period of time resulting in a loss of value of currency. When
the price level rises, each unit of currency buys fewer goods and services. Consequently,
inflation reflects a reduction in the purchasing power per unit of money – a loss of real
value in the medium of exchange and unit of account within the economy. A chief measure
of price inflation is the inflation rate, the annualized percentage change in a general price
index, usually the consumer price index, over time. The opposite of inflation is deflation.
HYPERINFLATION:
Although as consumers we may hate rising prices, many economists believe that a
moderate degree of inflation is healthy for a nation’s economy. Typically, central banks aim
to maintain inflation around 2 to 3%. Increases in inflation significantly beyond this range
can lead to fears of possible hyperinflation, a devastating scenario in which inflation rises
rapidly out of control.
There have been several notable instances of hyperinflation throughout history. The most
famous example is Germany during the early 1920s, in which inflation reached 30,000% per
month. Zimbabwe offers an even more extreme example. According to research by Steve H.
Hanke and Alex K. F. Kwok, monthly price increases in Zimbabwe reached an estimated
79,600,000,000% in November 2008.
TYPES OF INFLATION:
Keynesian Economics identifies two types of inflation:

1. Cost-push inflation:
Cost-push inflation results from general increases in the costs of the factors of
production. These factors—which include capital, land, labor and entrepreneurship—
are the necessary inputs required to produce goods and services. When the cost of
these factors rise, producers wishing to retain their profit margins must increase the
price of their goods and services. When these production costs rise on an economy-
wide level, it can lead to increased consumer prices throughout the whole economy,
as producers systematically pass on their increased costs to consumers. Consumer
prices, in effect, are thus pushed up by production costs.

2. Demand-pull inflation:
Demand-pull inflation results from an excess of aggregate demand relative to
aggregate supply. For example, consider a popular product where demand for the
product outstrips supply. The price of the product would increase. The theory in
demand-pull inflation is that if aggregate demand exceeds aggregate supply, prices
will increase economy wide.
Causes of Inflation:

Demand-pull inflation occurs when aggregate demand for goods and services in an
economy rises more rapidly than an economy’s productive capacity. One potential
shock to aggregate demand might come from a central bank that rapidly increases the
supply of money. See Chart 1 for an illustration of what will likely happen as a result
of this shock. The increase in money in the economy will increase demand for goods
and services from D0 to D1. In the short run, businesses cannot significantly increase
production and supply (S) remains constant. The economy’s equilibrium moves from
point A to point B and prices will tend to rise, resulting in inflation.
Cost-push inflation, on the other hand, occurs when prices of production process inputs
increase. Rapid wage increases or rising raw material prices are common causes of this
type of inflation. The sharp rise in the price of imported oil during the 1970s provides a
typical example of cost-push inflation (illustrated in Chart 2). Rising energy prices caused
the cost of producing and transporting goods to rise. Higher production costs led to a
decrease in aggregate supply (from S0 to S1) and an increase in the overall price level
because the equilibrium point moved from point Z to point Y.
 Monetary Inflation:
Monetary inflation is a form of demand-pull inflation. In this case, excess demand is
created by an excessive growth of the money supply. A group of economists,
appropriately called monetarists, believe that the only cause of inflation is the money
supply increasing faster than output. They argue that if the money supply increases,
people will spend more and this will lead to an increase in prices.

Consequences of Inflation:
1. Erodes Purchasing Power:
This first effect of inflation is really just a different way of stating what it is. Inflation is a
decrease in the purchasing power of currency due to a rise in prices across the economy.
Inflation requires prices to rise across a "basket" of goods and services, such as the one
that comprises the most common measure of price changes, the consumer price index
(CPI). When the prices of goods that are non-discretionary and impossible to substitute –
food and oil – rise, they can affect inflation all by themselves. For this reason, economists
often strip out food and fuel to look at "core" inflation, a less volatile measure of price
changes.
2. Encourages Spending and Investing:
A predictable response to declining purchasing power is to buy now, rather than later.
Cash will only lose value, so it is better to get your shopping out of the way and stock up
on things that probably won't lose value.
For consumers, that means filling up gas tanks, stuffing the freezer, buying shoes in the
next size up for the kids, and so on. For businesses, it means making capital
investments that, under different circumstances, might be put off until later. Many
investors buy gold and other precious metals when inflation takes hold, but these assets'
volatility can cancel out the benefits of their insulation from price rises, especially in the
short term.
3. Causes More Inflation:
Unfortunately, the urge to spend and invest in the face of inflation tends to boost
inflation in turn, creating a potentially catastrophic feedback loop. As people and
businesses spend more quickly in an effort to reduce the time they hold their
depreciating currency, the economy finds itself awash in cash no one particularly wants.
In other words, the supply of money outstrips the demand, and the price of money – the
purchasing power of currency – falls at an ever-faster rate.
4. Raises the Cost of Borrowing:
As these examples of hyperinflation show, states have a powerful incentive to keep price
rises in check. For the past century in the U.S. the approach has been to manage inflation
using monetary policy. To do so, central banks rely on the relationship between inflation
and interest rates. If interest rates are low, companies and individuals can borrow
cheaply to start a business, earn a degree, hire new workers, or buy a shiny new boat. In
other words, low rates encourage spending and investing, which generally stoke inflation
in turn.
5. Lowers the Cost of Borrowing:
When there is no central bank, or when central bankers are beholden to elected
politicians, inflation will generally lower borrowing costs.
Say you borrow $1,000 at a 5% annual rate of interest. If inflation is 10%, the real value of
your debt is decreasing faster than the combined interest and principle you're paying off.
When levels of household debt are high, politicians find it electorally profitable to print
money, stoking inflation and whisking away voters' debts. If the government itself is
heavily indebted, politicians have an even more obvious incentive to print money and use
it to pay down debt.
6. Reduces Unemployment:
There is some evidence that inflation can push down unemployment. Wages tend to
be sticky, meaning that they change slowly in response to economic shifts.
7. Increases Growth:
Unless there is an attentive central bank on hand to push up interest rates, inflation
discourages saving, since the purchasing power of deposits erodes over time. That
prospect gives consumers and businesses an incentive to spend or invest. At least in the
short term, the boost to spending and investment leads to economic growth. By the same
token, inflation's negative correlation with unemployment implies a tendency to put more
people to work, spurring growth.
8. Reduces Employment and Growth:
Wistful talk about inflation's benefits is likely to sound strange to those who remember
the economic woes of the 1970s. In today's context of low growth, high unemployment
(in Europe) and menacing deflation, there are reasons think a healthy rise in prices – 2%
or even 3% per year – would do more good than harm. When, however, growth is slow,
unemployment is high and inflation is in the double digits.

9. Weakens (or Strengthens) the Currency:

High inflation is usually associated with a slumping exchange rate, though it is usually a
case of the weaker currency leading to inflation, not the other way around. Economies
that import significant amounts of goods and services – which, for now, is just about every
economy – must pay more for these imports in local-currency terms when their
currencies fall against those of their trading partners.

Control of inflation:
One popular method of controlling inflation is through contractionary monetary policy.
The goal of a contractionary policy is to reduce the money supply within an economy by
decreasing bond prices and increasing interest rates. 
There are three main ways to carry out a contractionary policy. 
1)Increase interest rates:
The first is to increase interest rates through the Federal Reserve. The Federal Reserve
rate is the rate at which banks borrow money from the government, but, in order to
make money, they must lend it at higher rates. So, when the Federal Reserve increases
its interest rate, banks have no choice but to increase their rates as well. When banks
increase their rates, less people want to borrow money because it costs more to do so if
that money accrues interest. So, spending drops, prices drop and inflation slows.
2) Increase reserve requirements:
The second method is to increase reserve requirements on the amount of money banks
are legally required to keep on hand to cover withdraws. The more money banks are
required to hold back, the less they have to lend to consumers. If they have less to lend,
consumers will borrow less, which will decrease spending.
3) Reduce the money supply:
The third method is to directly or indirectly reduce the money supply by enacting policies
that encourage reduction of the money supply. Two examples of this include calling in
debts that are owed to the government and increasing the interest paid on bonds so that
more investors will buy them. The latter policy raises the exchange rate of the currency
due to higher demand and, in turn, increases imports and decreases exports. Both of
these policies will reduce the amount of money in circulation because the money will be
going from banks, companies and investors pockets and into the government’s pocket
where they can control what happens to it.
PHILLIPS CURVE:
The Phillips curve is a single-equation empirical model, named after William Phillips,
describing a historical inverse relationship between rates of unemployment and
corresponding rates of inflation that result within an economy. Stated simply, decreased
unemployment, (i.e., increased levels of employment) in an economy will correlate with
higher rates of inflation.
While there is a short run tradeoff between unemployment and inflation, it has not been
observed in the long run. In 1968, Milton Friedman asserted that the Phillips curve was only
applicable in the short-run and that in the long-run, inflationary policies will not decrease
unemployment
The Phillips curve in its modern form states that the inflation rate depends on three
forces:
•Expected inflation
•The deviation of unemployment from the natural rate, called cyclical unemployment
•Supply shocks
The three forces are expressed in the following equation:
Inflation= Expected Inflation- (β X Cyclical Unemployment) + Supply Shock