©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 15: Inflation and the Price Level

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 15: Inflation and the Price Level


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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 economic data 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 cost of inflation

5. Understand the connections among inflation, nominal interest rates, and real interest rates


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Keeping up with Grandpa

It may come as a surprise to most people to know that:

Inflation can make a comparison of economic conditions at different points in time quite difficult

Inflation increases uncertainty when planning for the future (for people and policy makers) Consider costs of inflation

Egypt Morocco Turkey

Prices of Goods and Services between 1965

and 2005

40 times higher

7 times higher

800,000 times higher


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Measuring the Price Level

Consumer Price Index (CPI) is a measure of changes in prices

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

Base year changes periodically


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Calculating the CPI

2000 Spending Monthly Cost in 2000

Rent (2 bedroom apartment) $500

Sandwiches (60 at $2 each) 120

Taxi rides (10 at $6 each) 60

Monthly expenditures $680



Sandwiches (60 at $2.50 each) 150




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Calculating the CPI

CPI is the ratio of the cost of the basket of goods in current year to the cost in the base year

Cost of base-year basket of goods and services in current yearCPI =

Cost of base-year basket of goods and services in base year


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Calculating the CPI

Base year (2000) cost $680 and 2005 cost $850

CPI = (850 / 680) (100) = 1.25Cost of living in 2005 is 25% higher

than in 2000 CPI for the base year is always 1

In that year the numerator and the denominator of the CPI formula are the same

CPI for a given period is the cost of living in that period relative to what it was in the base year


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Cost of Living



Sandwiches (60 at $2 each) 120


Shirts (4 at $30) 120




Sandwiches (60 at $2.50 each) 150


Shirts (4 at $50) 200

Monthly expenditures $1,050

CPI = 1050 / 850 = 1.31


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Price Index

A price index measures the average price of a given class of good or services relative to the price of the same goods and services in a base year

The CPI is an especially well-known price index

CPI measures the change in consumer prices

Other indices Producer price index Import / export price index


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Inflation

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

Inflation in 2004(1.889 – 1.840) / 1.840

= 0.027 = 2.7%

How is inflation in the 1930s different since 2003? Inflation rates are negative Negative inflation =

Deflation

Year CPI Inflation

2003 1.840

2004 1.889 2.7%

2005 1.953 3.4%

2006 2.016 3.2%

2007 2.073 2.8%

Year CPI Inflation

1929 0.151

1930 0.167 –2.3%

1931 0.152 –9.0%

1932 0.137 –9.9%

1933 0.130 –5.1%


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Deflation Around the World

Deflation represents a situation in which the prices of most goods and services are falling over time so that inflation is negative

Japan experienced mild deflation during the past decade.

Qatar experienced a 4.86 decrease in prices between 2008 and 2009 mainly due to the global financial crisis.

Jordan experienced a 0.68 decrease in prices over the same period.


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Inflation in Egypt


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Inflation in Morocco


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Inflation in Qatar


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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 2000 and 2008

Can a family buy more with $20,000 in income in 2000 or with $22,000 in 2008? 2000 is the base year for the CPI Deflate nominal income in both years to get

real income Compare real income $20,000 in 2000 has the greater purchasing

power


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Jamal vs. Kamal: who earned more?

Compare Jamal’s salary with Kamal’s Requires a CPI series that includes 1930

CPI using 1982 as base year Kamal had higher real salary

Adjusting for inflation brings the two figures closer together but in real terms Kamal still earned more than 12 times Jamal’s salary

PlayerYear

Nominal Salary

Jamal 1930 $80,000

Kamal 2001 $10,300,000

Real Salary

$479,042$5,786,515

CPI

0.167

1.780


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Real Wages

Real wage is the purchasing power of worker's nominal wages The real wage for any given period is

calculated by dividing the nominal wage by the CPI for that period

The purchasing power in 1999 was bigger than in 2009

Year

Minimum Wage

1999 MAD10.00

2009 MAD10.64

CPI

0.915

1.103

Real Average Wage

MAD10 / 0.915 = MAD10.92

MAD10.64 / 1.103 = MAD 9.64


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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 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% in the second year of the contract and by another 2 percent in the third year

CPI is 1.00 in 1st year, 1.05 in the 2nd, and 1.10 in the 3rd

Nominal wage = real wage * CPI

Year

Real Wage

1 $12.00

2 $12.24

3 $12.48

CPI

1.00

1.05

1.10

Nominal Wage

$12.00

$12.85

$13.73


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Minimum Wage

Because the minimum wage is not indexed to inflation, its purchasing power falls as prices rise

Governments must therefore raise the nominal minimum wage periodically to keep the real value of the minimum wage from eroding Ironically, despite such government

intervention, it is common knowledge that such schemes have not contributed sufficiently to maintaining the public’s purchasing power and alleviating poverty


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CPI and Inflation

CPI and other indexes influence policy decisions and wage increases

If CPI overstates inflation by 1 to 2 percentage points a year then Unnecessary increases government spending Underestimates increase in the standard of

living

Suppose now that CPI indicates 3% inflation when cost of living actually increases 2% Real income increases 1%


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CPI and Inflation

There are two important reasons why the official inflation rate, based on the CPI, may overstate the true rate of inflation Quality adjustment bias Substitution bias


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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 not 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 Substitution Bias

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

inflationExample: base year cost of market basket

Item2000 price

2000 Spending

Coffee (50 cups)

$1.00 $50.00

Tea (50 cups) $1.00 $50.00

Cake (100 slices)

$1.00 $100.00

Total $200.00


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In 2008, coffee and scones are more expensive Buying exactly the same basket of

goods costs $300, compared to $200 in 2000

CPI = 300 / 200 = 1.50Item

2008 price2008

Spending

Coffee (50 cups)

$2.00 $100.00

Tea (50 cups) $1.00 $50.00

Cake (100 slices)

$1.50 $150.00

Total $300.00


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Actually, consumer substitutes tea for coffee Cake purchases constant

True CPI for consumer is 250 / 200 = 1.25CPI estimate of 1.50 is 20% higher than

the consumer's experience

Item2008 price

2008 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 Cost of Inflation: Not What You Think

Since the oil shocks of the 1970s, MENA countries have been plagued with relatively high inflation

When people complain about inflation, they are often concerned primarily about relative price changes Before describing the true economic costs of

inflation, let us examine this confusion people experience about inflation and its costs

Need to distinguish between the price level and the relative price

Inflation Egypt Jordan Kuwait Qatar KSA

2007 - 2008

18.3% 14.9% 10.5% 15.0% 9.8%


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Relative Prices

Price level is the overall level of prices at a particular point in time Measured by a price index such as the CPI

Relative price of a specific good is a comparison to the prices of other goods and services Calculated as a ratio Example: if the price of oil were to rise by

10 percent while the prices of other goods and services were rising on average by 3 percent, the relative price of oil would increase


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Relative Prices

Public opinion surveys suggest that many people are confused about the distinction between inflation, which is an increase in the overall price level, and an increase in a specific relative price Changes in relative prices do not necessarily

imply a significant amount of inflation Imagine, for instance, that all prices in the

economy, including wages and salaries, go up exactly 10 percent each year

The inflation rate is 10 percent, but relative prices are not changing


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Inflation and Relative Prices

Year CPI Inflation

2006 1.20

2007 1.32 10%

2008 1.40 6%

Oil Price Change

8%

8%

Relative Price

Change

-2%

2% Inflation between 2006 and 2007 is 10 percent Price of oil increased by 8%

the relative price of oil—that is, its price relative to all other goods and services—falls by about 2 percent


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The True Cost of Inflation: Noise in the Price System

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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The True Cost of Inflation: Distortions of the Tax System

Most economies in MENA operate a progressive income tax system that raises the tax burden of individuals on their higher earnings Example: the Moroccan tax code of 2008

imposed a tax rate of 42 percent on the highest income bracket

Suppose Hicham earns $30,000 The following represents a simplified look

at Hicham’s tax liability under the 2008 tax code


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Following the previous table, the tax liability increases with higher income brackets

Hicham’s total tax liability is $10,607 which represents about 35 percent of his pre-tax income of $30,000

Hicham’s after-tax income is therefore $19,393

In 2009, the Moroccan government introduced a new tax code that was designed to reduce the tax liability of people like Hicham Assume also that inflation rate in 2009 in

Morocco was 1 percent


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As the previous table shows, Hicham’s tax liability is reduced to $8,455, representing 28 percent of his pre-tax income of $30,000

Hicham’s after-tax income is, therefore, $21,545, which is 11 percent higher than his previous year’s after-tax income

Hence, the net gain to Hicham resulting from the new tax code is 10 percent (11 percent minus 1 percent inflation)


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It is important to note that the Moroccan case may be an exception for various reasons:1. The years 2008 and 2009 mark the global financial

crisis and such a change in the tax code does not necessarily signal further future adjustments

2. An inflation rate of 1 percent may be too unreasonable for Morocco where about half of the population is illiterate and is not likely to participate in detailed consumer surveys or to maintain a particular budget

3. Changes in the tax codes in countries like Morocco are generally not designed to alleviate poverty or to maintain purchasing power, but rather to fight tax evasion and to increase the country’s tax base


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The True Cost of Inflation: Shoe-Leather Costs

As all shoppers know, cash is convenient Cash can be used in almost any routine

transaction Inflation raises the cost of holding cash to

consumers and businesses If there is no inflation, cash holds its value over

time When inflation is high, cash loses value over time

More frequent, smaller withdrawals cost consumers and businesses time, travel – a real cost of inflation Banks process more transactions, increasing costs Costs of managing cash holding are called "shoe

leather" costs


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Shoe-Leather Costs: Example

Bassam’s Hardware needs $5,000 cash per day

Bassam has a choice: Go to the bank first thing on Monday morning to

withdraw $25,000—enough cash for the whole week

Go to the bank first thing every morning for $5,000 each time

The cost of going to the bank, in terms of inconvenience and lost time, at $4 per trip

Funds left in the bank earn precisely enough interest to keep their purchasing power unaffected by inflation How often will Bassam go to the bank?


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If inflation is zero, there is no cost to holding cash Bassam will go to the bank only once a week,

incurring a shoe-leather cost of $4 per week At the beginning of each day, his cash holding

will be represented by the following table: Bassam’s average cash

holding at the beginning of each day is $75,000/5 = $15,000 If inflation is 10 percent, the

cost to Bassam is $1,500 per year


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If Bassam goes to the bank every day, his average cash holding at the beginning of the day will be only $5,000 In that case, his losses from inflation will be

$500 (10 percent of $5,000) a year The benefit of changing his banking

behavior is a loss of only $500 per year to inflation (or $1,000 saved)

The cost of going to the bank every day is $4 per trip Assuming Bassam’s store is open 50 weeks a

year, going to the bank 5 days a week adds 200 trips per year (total cost of $800)

Bassam will begin going to the bank more often


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The True Cost of Inflation: Unexpected Redistribution of Wealth

Unexpected inflation redistributes wealthSuppose workers' salaries are not

indexed and inflation is higher than anticipated Salaries lose purchasing power Employers gain at the expense of workers

The effect of the inflation is not to destroy purchasing power but to redistribute it

Similarly, unexpectedly high inflation benefits borrowers at the expense of lenders Borrowers repay with dollars worth less than

anticipated


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The True Cost of Inflation: Long-Run 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 There is no official threshold above

which inflation becomes hyperinflation

Example: • Turkey: 110 percent in 1980 and 106 percent

in 1994• Nicaragua: 33,000 percent in 1988• Germany: 1932 most well known episode of

hyperinflation: inflation was 102,000,000 percent


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Hyperinflation


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Inflation and Interest Rates

Another important aspect of inflation is its close relationship to other key macroeconomic variables Economists have long realized that during

periods of high inflation, interest rates tend to be high as well

Suppose that there are two neighboring countries, Alpha and Beta In Alpha: currency is alphan

Inflation rate is zero and is expected to stay zero

In Beta: currency is betan Inflation rate is 10 percent and is expected to

remain at that level


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Bank deposits pay 2 percent annual interest in Alpha and 10 percent annual interest in Beta In which countries are bank depositors

getting a better deal?Alpha, not Beta, offers the better deal to

depositors In Alpha, someone who deposits 100

alphans in the bank will have 102 alphans representing a 2 percent increase in buying power

In Beta, the depositor who deposits 100 betans on 110 betans by the end of the year representing no increase in buying power


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Unanticipated inflation helps borrowers and hurts lenders

Real interest rate is the annual percentage increase in the purchasing power of financial assets Real interest rate = nominal interest

rate – inflationr = i -

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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Real Interest Rates in Egypt


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Egypt Real Interest Rates, 1976 - 2009


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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


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Fisher Effect

Fisher effect is the tendency for nominal interest rates to be high when inflation is high and low when inflation is low

Why do interest rates tend to be high when inflation is high? Example: Suppose inflation has recently been

high, so borrowers and lenders anticipate that it will be high in the near future

Expect lenders to raise their nominal interest rate so that their real rate of return will be unaffected

Borrowers are willing to pay higher nominal interest rates when inflation is high


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Egypt Inflation (red line) and Interest Rates (blue line), 1976 - 2009

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©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 15: Inflation and the Price Level