Econ 1a, Foldvary

Inflation; Measuring the cost of living

The price level: an index of the total prices of a basket of goods.

Real prices are indicated by dividing the nominal price by the price level.

There are two meanings of inflation: price and monetary.

Monetary inflation is an increase in the quantity of money supplied

that is greater than the increase in the quantity of money people want to hold.

Price inflation is an on-going increase in the price level.

The rate of price inflation is the annual percentage change in the price level.

Deflation is a decrease in the price level.

Two causes of deflation: decrease in money,

and an increase in wealth greater than the increase in money.

Measures of price changes:

GDP deflator.

Commodity index for raw materials.

Producer price index for goods bought by business.

The consumer price index, CPI, measures the price level of typical goods and services bought by households.

Which agency computes the CPI?

The Bureau of Labor Statistics.

300 employees gather information goods each month.

The basket is updated every 10 years, with a few goods updated every 5 years.

The CPI includes sales taxes but not income taxes or social security taxes.

The core inflation rate is the CPI excluding food and energy prices.

Economists have created an alternate CPI,

the chain weighted price index,

that better accounts for changes in the prices and quantities of consumer goods,

in contrast to the fixed-weighted CPI.

The CPI is very important because many cost-of-living increases or adjustments (COLA)

are based on it. Including government programs such as social security.

Income tax rates get adjusted by the CPI.

There are also bonds that are indexed to inflation,

including TIPS - treasury inflation protected securities..

Steps to calculate the CPI:

1. Decide on the consumer goods in the “basket”.

Set a weight for each good in proportion to purchases.

2. Find the prices for the goods.

3. Compute the cost of the basket.

4. Choose a base year. Compute the index based on that year.

Index = sum of PQ of current year / sum of PQ of base year.

5. Compute the inflation rate: (cpi year 2 - cpi year 1)/(cpi year 1)

The largest category in the cpi housing, 41 percent of the typical household budget.

The producer price index measures the goods typically bought by firms.

When goods are cheaper, people buy more.

New CPI methods take that into account.

Some economists think they should not adjust for quality changes.

So it’s important to realize that the official CPI numbers are estimates subject to error.

The GDP deflator versus the CPI.

1. The GDP deflater is based on all of GDP, not just consumer goods.

But the CPI includes imported goods, not counted in GDP.

2. The CPI goods are fixed for 10 years, but the GDP deflator is based on goods currently produced, and changes every year.

To convert prices of one year to that of another year, multiply the price in the current dollars of the year by the price level of the other year, divided by the price level of the first year.

When prices are adjusted for inflation each year, it is called indexing.

Many wages are indexed.

The federal income tax brackets are index, but not capital gains, interest, and depreciation.

The nominal interest rate is the named, quoted rate, as paid in dollars.

The real interest rate is the nominal rate minus the inflation rate.

In economic analysis, we use the real interest rate. We keep it real.