Chapter 18

Measuring the Price Level and Inflation

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 Learning Objectives
1. Explain how the consumer price index (CPI) is
constructed and use it to calculate the inflation
rate.
2. Show how the CPI is used to adjust dollar
amounts to eliminate the effects of inflation.
3. Discuss the two most important biases in the CPI.
4. Distinguish between inflation and relative price
changes to find the true costs of inflation.
5. Summarize the connections among inflation,
nominal interest rates, and real interest rates.

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 Measuring the Price Level
• The Consumer Price Index (CPI) is a
measure of the cost of living during a
particular period
• The CPI measures
– The cost of a standard basket of goods and
services in a given year
– relative to the cost of the same basket of goods
and services in the base year
• 2010 is the base year for the CPI
– Base year changes periodically

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 Calculating the CPI
2010 Spending Monthly Cost in 2010
Rent (2 bedroom apartment) $750
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $6 each) 70
Monthly expenditures $940

2015 Spending Monthly Cost in 2015

Rent (2 bedroom apartment) $945
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $7 each) 80
Monthly expenditures $1,175

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 Calculating the CPI
• CPI is the ratio of the cost of the basket of goods in
the current year to the cost in the base year
– Base year cost $940
– 2015 cost $1,175
CPI = (1175 / 940) (100) = 1.25
• Cost of living in 2015 is 25% higher than in 2010
– CPI for the base year is always 1
– CPI for a given period is the cost of living in that period
relative to what it was in the base year
– BEA uses CPI as a percentage – the ratio times 100

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 Cost of Living
CPI = 1375 / 1060 = 1.30
2010 Spending Monthly Cost in 2010
Rent (2 bedroom apartment) $750
Hamburgers (60 at $2 each) 120
Movie tickets (10 at $6 each) 70
Sweaters (4 at $30) 120
Monthly expenditures $1,060

2015 Spending Monthly Cost in 2015

Rent (2 bedroom apartment) $945
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $7 each) 80
Sweaters (4 at $50) 200
Monthly expenditures $1,375
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 Price Index
• A price index measures the average price of
a given quality of goods and services relative
to the price of the same goods and services
in a base year
• CPI measures the change in consumer prices
• Other indices
– Core inflation is CPI without energy and food
– Producer price index
– Import / export price index

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 Inflation
• The rate of inflation is the Year CPI Inflation

annual percentage change 2012 2.30

in the price level 2013 2.33 1.3%

2014 2.37 1.7%
• Inflation in 2013
2015 2.37 0.0%
(2.33 – 2.30) / 2.30 2016 2.40 1.3%
= 0.0139 = 1.3%
Year00 CPI Inflation
• The Great Depression
1929 0.171
– Period of falling output
1930 0.167 –2.3%
and prices
1931 0.152 –9.0%
– When inflation rates are
1932 0.137 –9.9%
negative there is deflation
1933 0.130 –5.1%

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 Adjusting for Inflation
• A nominal quantity is measured in terms of
its current dollar value
• A real quantity is measured in physical terms
– Quantities of goods and services
• To compare values over time, use real
quantities
– Deflating a nominal quantity converts it to a real
quantity
• Divide a nominal quantity by its price index to express
the quantity in real terms

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 Family Income in 2010 and 2015
• Can a family buy more with $40,000 in income in
2010 or with $44,000 in 2015?
– 2010 is the base year for the CPI
– Deflate nominal income in both years to get real
income
– Compare real income
– $40,000 in 2010 has the greater purchasing power

Year Nominal Income CPI Real Income

2010 $40,000 1.00 $40,000/1.00 = $40,000
2015 $44,000 1.25 $44,000/1.25 = $35,200

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 Baseball Stars
• Compare Babe Ruth's salary with Clayton Kershaw‘s
– Requires a CPI series that includes 1930
• CPI using 1982 – 1984 as base year
– Kershaw had higher real salary
• Does not convey information about relative incomes
– 1930 was Great Depression
– Multi-million dollar salaries common for sports stars in
2017

Player Year Nominal Salary CPI Real Salary

Babe Ruth 1930 $80,000 0.167 $479,042
Clayton 2.45 $13,795,918
2017 $33,800,000
Kershaw
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 Real Wages
• The real wage is the wage paid to the worker
measured in terms of purchasing power
– The real wage for any given period is calculated by dividing the
nominal wage by the CPI for that period
• US production worker wages
– CPI uses 1982 – 1984 as base year
– Real wages stayed roughly the same between 1970 and 2016
despite the fact that the nominal wage in 2016 was more than
6 times the nominal wage in 1970
Year Average Wage CPI Real Average Wage
1970 $3.40 0.39 $3.40 / 0.39 = $8.72
2016 $21.56 2.40 $21.56 / 2.40 = $8.98

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Production Workers’ Wages, 1970 -
2016

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 Indexing
• Indexing increases a nominal quantity each period
by the percentage increase in a specified price index
– Indexing prevents the purchasing power of the nominal
quantity from being eroded by inflation
• Indexing automatically adjusts certain values, such
as Social Security payments, by the amount of
inflation
– If prices increase 3% in a given year, the Social Security
recipients receive 3% more
• No action by Congress required
– Indexing is sometimes included in labor contracts

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 Adjusting for Inflation
• An indexed labor contract
– First year wage is $12 per hour
• Real wages rise by 2% per year for next 2 years
– Relevant price index is 1.00 in first year, 1.05 in the
second, and 1.10 in the third
• Nominal wage is real wage times the price index

Year Real Wage Price Index Nominal Wage

1 $12.00 1.00 $12.00
2 $12.24 1.05 $12.85
3 $12.48 1.10 $13.73
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 Minimum Wage
• Congress sets the national minimum wage
in nominal terms
– Publicized debate results in periodic increases
• Indexing would be simpler and less controversial
• Politicians appear to benefit from the debate
• Minimum wage increased 15 times
between 1970 and 2008
– Real minimum wage has decreased by about
one-third in that period

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 CPI and Inflation
• CPI and other indexes influence policy
decisions and wage increases
• Inflation may be overstated
– Unnecessarily increases government spending
– Underestimates increase in the standard of living
• Suppose CPI indicates 3% inflation when cost of living
actually increases 2%
– Real income increases 1%

• The Bureau of Labor Statistics makes great

efforts to improve CPI calculations

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 CPI Quality Adjustment Bias
• One important bias in the CPI is its measurement
of price changes but not quality changes
– PC with 20% more memory has 20% higher price
• Not the same PC as the one with less memory
– If no adjustment is made for quality, PC's contribution to
the CPI will be 20%
• Adjusting for quality is difficult
– Large numbers of goods
– Subjective differences
• Incorporating new goods is difficult
– No base year price for this year's new goods

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 CPI Biases
• CPI uses a fixed basket of goods and services
– When the price of a good increases, consumers buy
less and substitute other goods
– Failing to account for substitution overstates inflation
• Example: base year cost of market basket
Item 2010 price 2010 Spending
Coffee (50 cups) $1.00 $50.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.00 $100.00
Total $200.00

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 CPI Substitution Bias
• In 2015, coffee and scones are more expensive
– Buying exactly the same basket of goods costs
$300, compared to $200 in 2005
– CPI = 300 / 200 = 1.50

Item 2015 price 2015 Spending

Coffee (50 cups) $2.00 $100.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.50 $150.00
Total $300.00

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 CPI Substitution Bias
• Actually, consumer substitutes tea for coffee
– Scone purchases constant
• True CPI for consumer is 250 / 200 = 1.25
• CPI estimate of 1.50 is 20% higher than the
consumer's experience
Item 2015 price 2015 Spending
Coffee (00 cups) $2.00 $0.00
Tea (100 cups) $1.00 $100.00
Scones (100) $1.50 $150.00
Total $250.00

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 The Costs of Inflation
• The price level is a measure of the overall level
of prices at a particular point in time
– Measured by a price index such as the CPI
• The relative price of a specific good is a
comparison of its price to the prices of other
goods and services
– Calculated as a ratio
• Suppose we have a one-time doubling of the gas
price
– Overall price level and inflation increase by a small amount
– The increase in the relative price of gasoline is large

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 Relative Prices
• Relative prices can change markedly
without corresponding changes in
inflation
• Summer prices
Higher Lower
• Beach hotels • Fresh fruit and
• Cruises vegetables
• Gas prices • Heating oil

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 Inflation and Relative Prices

Year CPI Inflation Relative Price Oil Price

of Oil Change
2015 1.20
2016 1.32 10% -2% 8%
2017 1.40 6% 2% 8%

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 Noisy Prices
• Prices transmit information about
– The cost of production and
– The value buyers place on buying an additional unit
• Inflation creates static in the communication
– Buyers and sellers can't easily tell whether
• The relative price of this good is increasing OR
• Inflation is increasing the price of this good and all others
– Deciding these issues requires market participants
gather information – at a cost
– Response to changing prices is tentative and slow

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 Indexing Avoids Distortions
• Income taxes have been indexed to avoid
bracket creep
– Bracket creep occurs when a household is moved
into a higher tax bracket due to increases in nominal
but not real income
• Higher tax brackets have a higher tax rate
• Indexing income taxes matches tax rates to the
real income level
– Suppose the tax rate on $50,000 is 25% in 2000
– CPI is 1 for 2000, 1.25 for 2005
– Nominal income of $62,500 is taxed 25% in 2005

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 Distortions Caused by Taxes
• Not all taxes are indexed
• Capital depreciation allowance encourages
purchase of capital goods
– Allows firms to deduct a share of the purchase price
as a business expense
– Machine cost is $1,000 and its useful life is 10 years
• Capital depreciation allowance of $100 per year
• $100 in year 1 is worth more than $100 in year 10 because
of inflation
• In times of high inflation, investment in plant and
equipment decreases
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 Distortions Caused by Taxes
• US tax system is complex
– Taxes are collected at the federal, state,
and city levels
– Conflicting incentives
• Taxes that are not indexed distort the
tax incentives for people to work, save,
and invest
– Lower savings and investment means lower
economic growth – a real cost of inflation
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 Inflation Increases the Cost
of Cash
• If there is no inflation, cash holds its value over time
– Some cash will be held for convenience
• When inflation is high, cash loses value over time
• Manage cash balances to limit losses
– More frequent, smaller withdrawals cost consumers and
businesses time, travel – a real cost of inflation
– Banks process more transactions, increasing costs –
another real cost of inflation
– Costs of managing cash holding are called "shoe
leather" costs, referring to the cost of frequent trips to
the bank

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 Unexpected Redistribution of Wealth

• Unexpected inflation redistributes wealth

• Suppose workers' salaries are not indexed and
inflation is higher than anticipated
– Salaries lose purchasing power
– Employers gain at the expense of workers
• Similarly, unexpectedly high inflation benefits
borrowers at the expense of lenders
– Borrowers repay with dollars worth less than
anticipated
• Unexpected inflation confuses incentives
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 Interference with Long-Term
Planning
• Some decisions have a long time horizon
– Erratic inflation makes planning risky
• Retirement planning requires an estimated
cost for your desired life-style
– Save too little and you live less well in the future
– Save too much and you live less well now
• Given the costs of inflation, most economists
agree that low and stable inflation promotes
a healthy economy

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 Hyperinflation
• Hyperinflation is an extremely high rate of inflation
– In 1923, German employers paid workers twice a day
– Magnifies the costs of inflation
– Minimize your cash holding
• A study of market economies, 1960 – 1996 showed
45 episodes of high inflation (100 +%) in 25 countries
– Real GDP/person fell by an average of 1.6% per year
– Real consumption/ person fell by an average of 1.3%
per year
– Real investment per person fell by an average of 3.3%
per year

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 Inflation and Interest Rates
• Unanticipated inflation helps borrowers and hurts
lenders
• The real interest rate is the annual percentage
increase in the purchasing power of financial assets
– Real interest rate = nominal interest rate – inflation
r=i-
• The nominal interest rate is the annual
percentage increase in the dollar value of an asset
– Nominal interest rates are the most commonly stated
rates

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 Inflation and Interest Rates
• Nominal interest rates Interest Inflation
Year
Rate (%) Rate (%)
and inflation vary
1970 6.5% 5.7%
• Nominal interest rate
1975 5.8 9.1
range is .05% to 11.5%
• Inflation rate range is . 1980 11.5 13.5
12% to 13.5% 1985 7.5 3.6
– Real interest rate is nominal 1990 7.5 5.4
interest rate minus inflation 1995 5.5 2.8
• Real interest rate was 2000 5.8 3.4
highest in 1985, 3.9% 2005 3.2 3.4
• Real interest rate was 2010 0.1 1.6
lowest in 1975, – 3.3% 2015 0.05 0.12

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U.S. Real Interest Rates,
1970 - 2016

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 Inflation and Interest Rates
• Unexpected inflation benefits borrowers and hurts
lenders
– For a given nominal interest rate, the higher the
inflation rate, the lower the real interest rate
• Expected inflation may not hurt lenders if they can
adjust the nominal interest rates
– Inflation-protected bonds pay a real rate of interest plus
the inflation rate
• The Fisher effect is the tendency for nominal
interest rates to be high when inflation is high and
low when inflation is low

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U.S. Inflation and Interest Rates,
1970 - 2016

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 Inflation and Price Levels

Inflation Price Level

• Hyperinflation •CPI Real and Nominal
Values
• CPI Biases

Indexing Costs of Inflation Real and Nominal

Interest Rates

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