Notes on Principles of Macroeconomics Vijaya Raj Sharma, Ph.D.

INFLATION, MEASUREMENT, AND EFFECTS INFLATION Inflation is a phenomenon of continuous rise in the general price level of goods and services. Inflation is not a rise in the prices of one or just few goods, and it is also not a just one-time rise in the prices of most commodities. During inflationary periods, prices of few goods may fall, but prices of most goods rise. Inflation can also be defined as a decline in the value or purchasing power of dollar. If the supply of dollar (money) rises faster than the supply of goods and services in the country, one would expect a decline in the value of dollar. Thus, an increase in money supply can be a reason of inflation. But, there may be other reasons too. If the demand for goods and services continuously rises faster than their supply, prices of goods and services shall rise too. This is called demand-pull inflation. On the other hand, a continuous fall in supply of goods and services or a continuous rise in cost of production pushes up the general price level. This is called cost-push inflation. CONSUMER PRICE INDEX (CPI) For measuring inflation, an aggregate representation of prices of commodities is needed. Such a general price level is represented through a price index; GDP deflator is one such price index that we briefly introduced in an earlier chapter. There are other price indices also, most notably the Consumer Price Index (CPI) and the Producer Price Index (PPI). CPI is the cost of purchasing a hypothetical market basket of consumption goods bought by a typical consumer during a given period of time (generally a month), relative to the cost of purchasing the same market basket in the base year. The U.S. Bureau of Labor Statistics publishes the CPI every month. The Bureau sends 250 surveyors to 21,000 stores around the nation to record prices of 364 consumption goods that go into the market basket. Let us demonstrate the method of computing CPI with a hypothetical example in Table 1. Table 1: Market Basket and Construction of Price Index Monthly Market 1985 1996 Cost of market basket in Cost of market basket in Basket Prices Prices 1985 1996 60 hamburgers $1.60 $3.20 $96.00 $192.00 4 T-shirts 10.00 18.00 40.00 72.00 2 jeans 24.00 24.00 48.00 48.00 1 compact disc 16.00 12.00 16.00 12.00 Total Cost of Basket $200.00 $324.00 CPI 100 162 Let 1985 be the base year. When constructing a price index, its value is normalized to 100 in the base year. Then, the value of price index in any year t can be calculated as:

(Equation 1)

PI t =

Cost of market basket in Year t x100 Cost of market basket in Base Year

According to the above equation, CPI in 1996 = (324/200)*100 = 162, which implies that the general price level increased by 62 percent during the 11-year period from 1985 to 1996. The above is a general formula for calculation of any price index. GDP deflator and PPI also are calculated similarly. The formula is the same for any price index, the only difference among different price indices is the items that go into the market basket. In CPI the market basket consists of only the consumption goods, because the objective is to measure the effect of inflation on households. In PPI, the market basket consists of producer goods, like energy, raw materials, and intermediate goods. In GDP deflator, the basket consists of all kinds of goods that go into the computation of GDP, which are consumption goods, investment goods, goods purchased by the government, and the goods internationally traded. INFLATION MEASUREMENT Inflation in any year t (t) is measured as the percentage change in price index from the previous period: (Equation 2)

t =

PI t PI t 1 x100% PI t 1

Year 1990 1991 1992

Table 2: Calculation of Inflation Rate Price Index Inflation Rate, % 100 110 {(110-100/100}*100=11% 121 {(121-110)/110}*100=10%

HYPERINFLATION Hyperinflation is a run-away or out of control inflation, a very rapid and high growth rate of prices. There is no universally accepted cut-off rate of inflation for hyperinflation. Some economists consider 50 percent or higher monthly inflation as hyperinflation, whereas some other economists consider an annual inflation rate of 200% or more as hyperinflation. PROBLEMS WITH CPI FOR MEASURING INFLATION The use of CPI for measurement of inflation has some problems in truly measuring the effect of inflation on households. They are: 1. If there has been a change in the lifestyle of consumers after the base year, such that the market basket chosen in the base year does not any more correctly represent the consumption habit of households, CPI may not reflect the true general price level and inflation measured from such CPI may not truly measure inflation. 2. CPI generally overstates inflation. When prices of market basket goods rise, consumers have been observed to substitute away from such market basket goods to other cheaper

goods, which may or may not have been included in the market basket chosen for monitoring CPI. For example, when prices of beef rise, consumers may substitute it with chicken. During the period of 1972-1980, energy prices in the USA rose by 218 percent, but the actual energy expenses of households were observed to have risen by only 140 percent. Households tend to substitute or conserve use of more expensive goods. CPI ignores this behavior of households, by sticking to the same quantity of consumption specified in the pre-determined market basket. According to some economists, CPI overestimates inflation by about 1 to 1.5 percent. This is a reason behind the often discussed proposal of lowering the cost of living adjustments of social security payments to senior citizens, which are currently adjusted for inflation as measured by CPI. Similarly, wages of government employees in some states are revised by the rate of inflation measured by CPI; such adjustment of wages is called the cost of living adjustment (COLA). 3. CPI also tends to overstate inflation because it ignores quality improvements. For example, computers purchased in 2006 at a cost of $1,600 are far superior in quality compared to computers purchased in 1985 at that cost. NOMINAL MONEY BALANCE v. REAL MONEY BALANCE We defined earlier that inflation was a decline in the value or purchasing power of money. Therefore, $2,000 amount of nominal money balance stored in your safe in Year 2000 is not expected to have the same purchasing power or real value in 2006. Money retains its nominal value, but the real value erodes with inflation. Real balance is the real value of a nominal balance, which can be calculated by using Equation 3. (Equation 3) Re al Balance or Re al Value in Year t in prices of Year b = No min al Balance or Value x If the values of price index were 100 in Year 2000 and 144 in Year 2006, the purchasing power or real balance of a nominal amount of $2,000 in Year 2006 is equal to $2,000 x (100/144), i.e., $1,388.89, evaluated in terms of prices of Year 2000. In other words, the goods that cost $1,388.89 in Year 2000 will now cost $2,000 in Year 2006. Or, you could say that if you could buy 2,000 pounds of apples with $2,000 in Year 2000, you can only buy 1,388.89 pounds with $2,000 in Year 2006. REAL INTEREST RATE v. NOMINAL INTEREST RATE Let us assume initially an inflation-free world, i.e., money loses no purchasing power in such a world. Now, suppose that you lend me $1,000 for a year. This makes you forego the opportunity of using that money for one full year. Therefore, it is reasonable for any lender to ask certain compensation from the borrower for the loss of this opportunity. Suppose you desire a real return of 4% on the sacrifice. That is, you demand me to return you, besides the principal amount of $1,000, an additional $40 for compensation. Such rate of return demanded by lenders from borrowers for compensation of loss of opportunity to use the lent money is called the real interest rate. Consider also a possibility that the borrower may default. In the event of default, the lender either loses the principal amount or will have to proceed with a collection process and even PI b PI t

litigation in a court of law to recover the principal amount. Each lender faces such risks of defaults and therefore may include a risk premium in the interest rate, on top of the desired real return. Let this premium be 1%, which would raise the above interest rate from 4 to 5%. In other words, real interest rate is the return a lender seeks for compensation of loss of opportunity of using the lent money during the period of lending, plus an appropriate risk premium. Lastly, allow the possibility of inflation. Inflation may erode the real return. Suppose you lent me $1,000 for a year at 5% interest rate. Accordingly, I returned you $1,050 at the end of the year. You got a return of $50 over and above your principal amount of $1,000. What if the prices of all goods increased by 3% during this year, i.e., what if the goods that cost $1,000 a year ago now cost $1,030? Then, your real return on lending is not $50, but $20 only after accounting for the loss of purchasing power ($50 minus $30). Lenders regularly face this possibility of inflation; therefore, they also add a premium for expected inflation on real interest rate. When the interest rate includes expected inflation rate, this is called nominal interest rate. (Equation 4) planned i = desired r + expected

where i is the nominal interest rate, r the real interest rate, and e the expected inflation rate. Lender adds the inflation premium simply to maintain the purchasing power of the lent amount. Interest rates that banks and lenders quote to potential borrowers or interest rates that are published in newspapers are nominal interest rates. If the actual inflation during the period of lending happens to be equal to the expected rate, the lender realizes the desired real interest rate. But, whenever the actual inflation rate is different from what was anticipated by lender and borrower, the actual real interest rate collected by lender or paid by borrower would be different from the desired level. To find the real interest rate actually earned or paid, one needs to subtract actual inflation rate from the nominal interest rate at which lending/borrowing happened: (Equation 5) actual r = i actual

EFFECTS OF INFLATION People engaged in the business of lending and borrowing generally spend time and other resources in predicting inflation, to form a judicious anticipation of future inflation to appropriately determine nominal interest rate. In a world of low or no inflation, scarce resources do not need to be wasted in such predictions. Therefore, controlling inflation is often an objective of macro policy makers. Suppose nominal interest rate in a transaction is fixed at 8%, expecting inflation rate of 3% and to have a real interest rate of 5%. But, if actual inflation during the period of lending/borrowing exceeds the expected rate, the actual real interest rate earned by the lender would be lower than 5%. The lender thus loses, whereas the borrower gains, whenever actual inflation is higher than expected. On the other hand, borrower loses and lender gains when actual inflation is below the anticipated rate. Thus, unanticipated inflation redistributes income between lenders and borrowers.

If unanticipated inflation tends to remain high and uncertain, lenders may hesitate from lending, which may retard investment in the economy, because investment often is carried out with borrowed funds. Instead, people start accumulate assets in the form of gold, real estate, and such other real goods to protect themselves from unanticipated inflation. HISTORICAL TREND OF INFLATION IN USA Inflation rate as measured by CPI has remained below 5.5% annually in the last 20 years, generally hovering around 2 to 3%. Except the period of 1972-1982 when inflation rate was high, sometime double digit, USA has a history of generally low inflation in the last six decades. Prior to the Second World War, inflation rate was generally %, and it is about % in the recent years.

Source: US Bureau of Labor Statistics, 2005. CORE INFLATION Inflation statistics are published every month. Besides overall inflation rate, core inflation is also reported. Core inflation is calculated by taking the CPI and excluding certain items from the index, such as energy and food products, which can have temporary large price fluctuations, because these fluctuations can diverge from the overall trend of inflation and give a false measure of inflation. Core inflation is generally considered a better indicator of underlying long-term inflation. The U.S. inflation rate in July 2006 was estimated as 0.4%, whereas the core inflation (after excluding energy and food products) was just 0.2%. The overall inflation rate was higher in July due to a sharp rise in energy prices.