Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price...

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Inflation Basics Dr. D. Foster – ECO 285

Transcript of Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price...

Page 1: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Inflation Basics

Dr. D. Foster – ECO 285

Page 2: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Inflation Defined

A continuous rise in the general price level.

• Not a rise in some prices.• Not a one-time rise in prices.• What is the “general price level”?

Price level is shown by a Price Index• Hold quantities constant over time

• Use old (“base year”) quantities

• Use new quantities

• Allow some quantity change

Laspeyres; CPI

Paasche

Chained CPI & GDP deflator

Page 3: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Laspeyres & Paasche price indexes

• Paasche:

∑(P1*Q0)∑(P0*Q0)

∑(P1*Q1)∑(P0*Q1)

= 103.34$456.00$441.25

=

$447.00$440.50

= = 101.48

The CPI uses a Laspeyres index like

this, so showing inflation of 3.34%.

x 100

x 100 x 100

x 100

PI0 = 100 and PI1 = ???

• Laspeyres:

Page 4: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

The Consumer Price Index(es)• CPI-U: All urban consumers

– A fixed-weight index: consumption patterns rigid.

– Market basket is updated every two years.

– Represents about 87% of U.S. population.

– Used to adjust income tax brackets to account for inflation.

– Monthly, 60,000 prices are collected.

– Goods & services comprise 200 groups.

– Eight broad categories:

Page 5: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

The Consumer Price Index(es)• CPI-U: All urban consumers

– A fixed-weight index: consumption patterns rigid.

– Market basket is updated every two years.

– Represents about 87% of U.S. population.

– Used to adjust income tax brackets to account for inflation.

– Monthly, 60,000 prices are collected.

– Goods & services comprise 200 groups.

– Eight broad categories:

• FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)

• HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

• APPAREL (men's shirts and sweaters, women's dresses, jewelry)

• TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

• MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

• RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);

• EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

• OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Page 6: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

CPI-U from 1947, 1970 and 2000

Page 7: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

The Consumer Price Index(es)• CPI-W: Urban wage earners & clerical workers

– A fixed-weight index.

– Represents about 32% of U.S. population.

– Half of HH income from clerical, craft, service.

• Excludes salaried, part-time, self-employed …

– Records average spending on 80,000 items in 87 geographical areas around the country.

– Used to adjust Social Security payments to keep up with cost of living (COLAs).

Page 8: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

The Consumer Price Index(es)• C-CPI-U: Chained CPI, all consumers

– A variable-weight index.

– Designed to account for “substitution bias.”

• When the price of pork rises, people buy more fish.

• CPI-U only accounts for narrow substitution, e.g., if the price of Granny Smith apples rise relative to Red Delicious.

– Designed to be a better measure of the cost of living.

– Records consumer expenditures each month and allows for changing composition of the basket.

Page 9: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Chained CPI-U from 2000

Page 10: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Comparing CPI-U with C-CPI-U

Page 11: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Using Price Indexes• Converts nominal values into real values:

• Example: Your income in 2013 is $32,000 and in 2014 it is $33,100.Q - Are you “better off?”

• Convert to “real income” by looking at CPI: Say it was 172.2 in 2013 and 179.9 in 2014

Nominal Income CPI Real Income$32,000 172.2 $18,583$33,100 179.9 $18,399

Page 12: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Features of Price Indexes

• CPI2003 = 184CPI2013 = 233

Inflation = (233-184)/184 = 26.6%

Approx. annual inflation = 2.66% (10 years)

Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%

•Must choose a base year (where index = 100)•Must choose a market basket of goods and services.•Comparisons across short periods of time are more

reliable than across long periods of time.• Inflation rate is [CPI2 – CPI1]/CPI1

•Average annual rate over “N” years is given as follows:

Page 13: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Features of Price Indexes

• CPI2003 = 184CPI2013 = 233

Inflation = (233-184)/184 = 26.6%

Approx. annual inflation = 2.66% (10 years)

Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%

•Must choose a base year (where index = 100)•Must choose a market basket of goods and services.•Comparisons across short periods of time are more

reliable than across long periods of time.• Inflation rate is [CPI2 – CPI1]/CPI1

•Average annual rate over “N” years is given as follows:

Page 14: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Calculating the C-CPI-U

L: 103.34P: 101.48

Page 15: Inflation Basics Dr. D. Foster – ECO 285. Inflation Defined A continuous rise in the general price level. Not a rise in some prices. Not a one-time rise.

Inflation Basics

Dr. D. Foster – ECO 285