INFLATION AND PRICE INDEXES

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 Inflation and Price Indexes
• Inflation is the persistent rise in the general
level of prices in the economy.
• Overtime changes in the overall price level can
be computed as the percentage change in the
prices index.
• Commonly used price indexes are the
Consumer Price Index, Producer Price Index,
and GDP Price Deflator

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 Consumer Price Index
• The weighted average of prices of a given
basket or bundle of goods and services
purchased by a common or ordinary
household during a given period of time.

Total expenditure for the bundle in the current

period
Current Period CPI = x 100
Total expenditure for the bundle in the base year

Current CPI – CPI last year

Current-period = x 100
inflation rate CPI last year

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 EXAMPLE basket: {4 pizzas, 10 lattes}
price of price of
year cost of basket
pizza latte
2007 Php10 Php2.00 Php10 x 4 + Php2 x 10 = Php60
2008 Php11 Php2.50 Php11 x 4 + Php2.5 x 10 = Php69
2009 Php12 Php3.00 Php12 x 4 + Php3 x 10 = Php78
using 2007 base year:
Compute CPI in each year Inflation rate:
2007: 100 x (Php60/Php60) = 100 115 – 100
15% = x 100
100
2008: 100 x (Php69/Php60) = 115
130 – 115
13% = x 100
2009: 100 x (Php78/Php60) = 130 115

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ACTIVE LEARNING
Calculate the CPI
price price of
CPI basket: of beef chicken
{10 kls beef, 2004 Php4 Php4
20 kls chicken}
2005 Php5 Php5
The total expenditure for the
bundle in 2004 is Php120 2006 Php9 Php6
in 2004, the base year.
A. Compute the CPI in 2005.

B. What was the CPI inflation rate from 2005-2006?

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ACTIVE LEARNING
Answers
price price of
CPI basket: of beef chicken
{10 kls beef, 2004 Php4 Php4
20 kls chicken}
2005 Php5 Php5
The CPI basket cost $120
in 2004, the base year. 2006 Php9 Php6

A. Compute the CPI in 2005:

Cost of CPI basket in 2005
= (Php5 x 10) + (Php5 x 20) = Php150

CPI in 2005 = 100 x (Php150/Php120) = 125

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ACTIVE LEARNING \
Answers
price price of
CPI basket: of beef chicken
{10 kls beef, 2004 Php4 Php4
20 kls chicken}
2005 Php5 Php5
The basket cost $120
in 2004, the base year. 2006 Php9 Php6

B. What was the inflation rate from 2005-2006?

Cost of CPI basket in 2006
= (Php9 x 10) + (Php6 x 20) = Php210
CPI in 2006 = 100 x (Php210/Php120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
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ACTIVE LEARNING
Substitution bias
CPI basket:
cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2004 Php4 Php4 Php120
2004-5:
2005 Php5 Php5 Php150
Households
bought CPI basket. 2006 Php9 Php6 Php210

2006: Households bought {5 lbs beef, 25 lbs chicken}.

A. Compute cost of the 2006 household basket.

B. Compute % increase in cost of household basket over
2005-6, compare to CPI inflation rate.
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ACTIVE LEARNING
Answers
CPI basket: cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2004 Php4 Php4 Php120
Household
basket in 2006: 2005 Php5 Php5 Php150
{5# beef, 2006 Php9 Php6 Php195
25# chicken}

A. Compute cost of the 2006 household basket.

(Php9 x 5) + (Php6 x 25) = Php195

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ACTIVE LEARNING
Answers
CPI basket: cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2004 Php4 Php4 Php120
Household
basket in 2006: 2005 Php5 Php5 Php150
{5# beef, 2006 Php9 Php6 Php210
25# chicken}
B. Compute % increase in cost of household basket over
2005-6, compare to CPI inflation rate.
Rate of increase: (Php195 – Php150)/Php150 = 30%
CPI inflation rate from previous problem = 40%
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 Problems with the CPI:
Substitution Bias
• Over time, some prices rise faster than others.
• Consumers substitute toward goods that
become relatively cheaper.
• The CPI misses this substitution because it uses
a fixed basket of goods.
• Thus, the CPI overstates increases in the cost
of living.

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 Problems with the CPI:
Introduction of New Goods
• The introduction of new goods increases
variety, allows consumers to find products
that more closely meet their needs.
• In effect, peso become more valuable.
• The CPI misses this effect because it uses a
fixed basket of goods.
• Thus, the CPI overstates increases in the cost
of living.

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 Problems with the CPI:
Unmeasured Quality Change
• Improvements in the quality of goods in the
basket increase the value of each peso.
• The PSA tries to account for quality changes
but probably misses some, as quality is hard to
measure.
• Thus, the CPI overstates increases in the cost
of living.

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 The GDP Deflator

• The GDP deflator is a measure of the overall

level of prices.
• Definition:

nominal GDP
GDP deflator = 100 x
real GDP

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 The GDP Deflator
 One way to measure the economy’s inflation rate is
to compute the percentage increase in the GDP
deflator from one year to the next.
GDP Price Deflator this year – GDP Price
Current-period Deflator last year
= X 100
inflation rate
GDP Price Deflator last year

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EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2005 Php6000 Php6000 100.0
14.6%
2006 Php8250 Php7200 114.6
2007 Php10,800 Php8400 128.6
12.2%

Compute the GDP deflator in each year:

2005: 100 x (6000/6000) = 100.0

2006: 100 x (8250/7200) = 114.6

2007: 100 x (10,800/8400) = 128.6

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 Producer Price Index
• Weighted average of prices of goods and
services. Prices used are those charged by the
producers when output come out of the factory
(first stage of the distribution process).
Total expenditure for the bundle in the current
period
Current Period PPI = x 100
Total expenditure for the bundle in the base year

Current PPI– PPI last year

Current-period x 100
inflation rate PPI last year

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