Chapter 9

quantities in that period * prices in that period

Value of market basket in any period equals

False

Deflation means that the overall price level is increasing at a decreasing rate true or false

deflation

negative inflation; most prices in the economy are falling

An adjustable-rate mortgage (ARM)

is a kind of loan used to purchase a home in which the interest rate varies with the rate of inflation.

Producer Price Index (PPI)

is based on prices paid for supplies and inputs by producers of goods and services.

Inflation and unintended redistributions for wage earners****

Inflation can cause unintended redistributions for wage earners. Wages do typically creep up with inflation over time eventually. Average hourly wage in the U.S. economy increased from $3.23 in 1970 to $19.55 in 2014, which is an increase by a factor of almost six. Over that time period, the Consumer Price Index increased by an almost identical amount. However, increases in wages may lag behind inflation for a year or two, since wage adjustments are often somewhat sticky and occur only once or twice a year. Moreover, the extent to which wages keep up with inflation creates insecurity for workers and may involve painful, prolonged conflicts between employers and employees. If the minimum wage is adjusted for inflation only infrequently, minimum wage workers are losing purchasing power from their nominal wages.

Blurred Price Signals *****

Prices are the messengers/signals in a market economy, conveying information about conditions of demand and supply. Inflation blurs those price messages. Inflation means that price signals are perceived more vaguely. In Israel, when inflation accelerated to an annual rate of 500% in 1985, some stores stopped posting prices directly on items, since they would have had to put new labels on the items or shelves every few days to reflect inflation. When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals. High and variable inflation means that the incentives in the economy to adjust in response to changes in prices are weaker. Markets will adjust toward their equilibrium prices and quantities more erratically and slowly, and many individual markets will experience a greater chance of surpluses and shortages.

A person who salary has increased is able to purchase fewer goods and services

Which of the following provides the best evidence that inflation has occurred

International Price Index

based on the prices of merchandise that is exported or imported

quality/new goods bias

inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living because it does not take into account imporovements in the quality of existing goods or the invention of new goods

cost-of-living adjustments (COLAs)

which guaranteed that their wages would keep up with inflation.

True

A negative rate of inflation implies that deflation has taken place true or false

True

Deflation means that the overall price level is decreasing true or false

Figure 9.4 Countries with Relatively Low Inflation Rates, 1960-2014

This chart shows the annual percentage change in consumer prices compared with the previous year's consumer prices in the United States, the United Kingdom, Japan, and Germany. Many industrialized countries, not just the United States, had relatively high inflation rates in the 1970s. For example, in 1975, Japan's inflation rate was over 8% and the inflation rate for the United Kingdom was almost 25%. In the 1980s, inflation rates came down in the United States and in Europe and have largely stayed down.

, substitution bias

an inflation rate calculated using a fixed basket of goods over time tends to overstate thte true rise in the cost of living because it does not take into account that the person can substitute away from goods whose prices rise by a lot

Inflation

is a general and ongoing rise in the level of prices in an entire economy.

Employment Cost Index

measures wage inflation in the labor market.

stagflation

, if recession (stagnation) is combined with inflation, we will face one of the most difficult to deal situations in the economy called

stagflation

However, if recession (stagnation) is combined with inflation, we will face one of the most difficult to deal situations in the economy called stagflation. During stagflation, regular government expansionary policy that aims to combat recession worsen the inflation, and regular government contractionary policy that aims to combat inflation worsen the recession. A supply side policy (policies to improve long run supply) could be used to combat stagflation.

Table 9.1 Price Comparisons, 1970 and 2014

In 2014, $1 had about the same purchasing power in overall terms of goods and services as 18 cents did in 1972, because of the inflation that has occurred over that time period.

value of market basket in current year / value of market basket in base year) * 100

Price index in current year =

(Level in new year - Level in previous year) / Level in previous year *100

Percentage change=

An increase in the overall price level

What is inflation

take the CPI and subtract the base year (100) then divide the cpi by 100 and finally to get the percentage multiply it by 100

how to calculate the inflation rate

core inflation index

is typically calculated by taking the CPI and excluding volatile economic variables such as food and eneergy prices to better measure the underlying and persistent trend in long term prices

nominal interest rate - inflation

real interest rate =

Overestimate Substitution bias

Inflation is often measured by evaluating changes in the cost of a fixed basket of goods and services this method (overestimated, underestimates) inflation because it does not account for changes in spending patterns that result from relative price changes This problem is known as

Indexing in Government Programs

Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person's income rises above certain levels, the tax rate on the marginal income earned rises as well; this is what is meant by the expression "move into a higher tax bracket." Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. This "bracket creep," as it was called, was eliminated by law in 1981. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation.

Might Indexing Reduce Concern over Inflation?

Some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. But as partial inflation indexing spreads, the political opposition to inflation may diminish. After all, older people whose Social Security benefits are protected against inflation, or banks that have loaned their money with adjustable-rate loans, no longer have as much reason to care whether inflation heats up. In a world where some people are indexed against inflation and some are not, financially savvy businesses and investors may seek out ways to be protected against inflation, while the financially unsophisticated and small businesses may suffer from it most.

Figure 9.6 U.S. Minimum Wage and Inflation

After adjusting for inflation, the federal minimum wage dropped more than 30 percent from 1967 to 2010, even though the nominal figure climbed from $1.40 to $7.25 per hour. Increases in the minimum wage in between 2008 and 2010 kept the decline from being worse—as it would have been if the wage had remained the same as it did from 1997 through 2007. (Sources: http://www.dol.gov/whd/minwage/chart.htm; http://data.bls.gov/cgi-bin/surveymost?cu)

Benefits of Inflation*****

Although the economic effects of inflation are primarily negative, two countervailing points are worth noting. First, the impact of inflation will differ considerably according to whether it is creeping up slowly at 0% to 2% per year, galloping along at 10% to 20% per year, or racing to the point of hyperinflation at, say, 40% per month. While hyperinflation can rip an economy and a society apart, an annual inflation rate of 2% or 3%, inflation is better than deflation which occurs with severe recessions. Second, a moderate inflation may help the economy by making wages in labor markets more flexible. Wages tend to be sticky in their downward movements and that unemployment can result. A little inflation could nibble away at real wages, and thus help real wages to decline if necessary. Not all economists agree with this argument.

Inflation in China and russia

Countries with controlled economies in the 1970s, like the Soviet Union and China, historically had very low rates of measured inflation—because prices were forbidden to rise by law, except for the cases where the government deemed a price increase to be due to quality improvements. However, these countries also had perpetual shortages of goods, since forbidding prices to rise acts like a price ceiling and creates a situation where quantity demanded often exceeds quantity supplied. As Russia and China made a transition toward more market-oriented economies, they also experienced outbursts of inflation, although the statistics for these economies should be regarded as somewhat shakier. Inflation in China averaged about 10% per year for much of the 1980s and early 1990s, although it has dropped off since then. Russia experienced hyperinflation—an outburst of high inflation—of 2,500% per year in the early 1990s, although by 2006 Russia's consumer price inflation had dipped below 10% per year,

What's the best measure of inflation

If concerned with the most accurate measure of inflation, use the GDP deflator as it picks up the prices of goods and services produced. However, it is not a good measure of cost of living as it includes prices of many products not purchased by households (for example, aircraft, fire engines, factory buildings, office complexes, and bulldozers). If one wants the most accurate measure of inflation as it impacts households, use the CPI, as it only picks up prices of products purchased by households. That is why the CPI is sometimes referred to as the cost-of-living index. As the Bureau of Labor Statistics states on its website: "The 'best' measure of inflation for a given application depends on the intended use of the data."

adjustable-rate mortgage (ARM)

Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate charged on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a kind of loan used to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower.

Deflation

Negative inflation which represents a period of decrease in overall prices is called deflation. There are also two periods of deflation in the early decades of the twentieth century: one following the deep recession of 1920-21 and the other during the Great Depression of the 1930s. Since inflation is a time when the buying power of money in terms of goods and services is reduced, deflation will be a time when the buying power of money in terms of goods and services increases.

Figure 9.2 The Weighting of CPI Components

Of the eight categories used to generate the Consumer Price Index, housing is the highest at 41%. The next highest category, transportation at 16.8%, is less than half the size of housing. Other goods and services, and apparel, are the lowest at 3.4% and 3.6%, respectively. (Source: www.bls.gov/cpi)

Inflation during recessions

Times of recession or depression often seem to be times when the inflation rate is lower, as in the recession of 1920-1921, the Great Depression, the recession of 1980-1982, and the Great Recession in 2008-2009. Also, recessions are typically accompanied by higher levels of unemployment, and the total demand for goods falls, pulling the price level down. Conversely, the rate of inflation often, but not always, seems to start moving up when the economy is growing very strongly, like right after wartime or during the 1960s. The frameworks for macroeconomic analysis (discussed in later chapters) will explain why recession often accompanies higher unemployment and lower inflation, while rapid economic growth often brings lower unemployment but higher inflation.

indexed

When a price, wage, or interest rate is adjusted automatically with inflation, it is said to be

indexing

When a price, wage, or interest rate is adjusted automatically with inflation, it is said to be indexed. An indexed payment increases according to the index number that measures inflation. A wide array of indexing arrangements is observed in private markets and government programs. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing will take some of the sting out of inflation.

The calculated inflation rate is only accurate for an individual who purchases all the goods and services in the basket

Which of the following is an objection of using the Consumer Price Index to measure changes in the cost of living

add all items in basket together for the base year and the CPI year, divide the cpi year by the base year and multiply by 100

how to calculate the consumer price index

Quality / new Goods bias

Another problem with this technique is that it fails to recognize changes in the caliber of goods overtime as an example consider cable television service though the cost has remained relatively constant over time the development of high-definition programming and more channels and Plies substantial difference in caliber this problem is known as

Table 9.2 A College Student's Basket of Goods

In any given month, a typical college student spends money on 20 hamburgers, one bottle of aspirin, and five movies. Prices for these items over four years are given in the table through each time period (Pd).

Table 9.2 A College Student's Basket of Goods

Find the percentage change in the cost of purchasing the overall basket of goods between the time periods. The general equation for percentage changes between two years, whether in the context of inflation or in any other calculation, is: Percentage change= (Level in new year - Level in previous year) / Level in previous year *100 Period 1 to 2: (106.50 - 100) / 100.0 * 100 = 0.065 * 100 = 6.5% Period 2 to 3: (107 - 106.50) /106.50 *100 = 0.0047 * 100 = 0.5% Period 3 to 4: (117.50 - 107) / 107 *100 = 0.098 * 100 = 9.8%

The process of making payments dependent upon the overall price

In an economic context what is indexing

hyperinflation

an outburst of high inflation that is often seen when economies shift from a controlled economy to a market oriented economy

base year

arbitrary year whose value as an index number is defined as 100; inflation from the base year to other years can easily be seen by comparing the index number in the other year to the index number in the base year- for example, 100; so if the index number for a year is 105, then there has been exactly 5% inflation between that year and the base year.

Table 9.3 Calculating Index Numbers When Period 3 is the Base Year

Because the index numbers are calculated so that they are in exactly the same proportion as the total dollar cost of purchasing the basket of goods, the inflation rate can be calculated based on the index numbers, using the percentage change formula. For period 1 to 2: (99.5 - 93.4) / 93.4 * 100 = 0.065 * 100 = 6.5%. This is the same answer that was derived when measuring inflation based on the dollar cost of the basket of goods for the same time period.

take the cpi year and divide by the starting year and then multiply the starting salary

How to calculate rate increase for cost of living

Analysis measure the cost of a bundle of goods representative of overall spending at two points in time and compare the difference in cost

Which of the following most accurately characterizes the method used to calculate inflation

When there is hyperinflation the overall economy is not affected in any significant manner

Which one of the following statements is false with respect to hyperinflation

Consumers can see the general increase in price over time by using a basket of goods

Why is a hypothetical basket of good to use to measure inflation

basket of goods and services

a hypothetical group of different items, with specified quantities of each one meant to represent a ypical set of consumer purhcases, used as a basis for calculating how the price level changes over time

index number

a unit free number derived from the price level over a number of years which makes computing inflation rates easier since the index number has values around 100

A cost-of-living adjustment

In an economic context what is Cola

The Eight Major Categories in the Consumer Price Index (Cpi)

. Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks) 2. Housing (renter's cost of housing, homeowner's cost of housing, fuel oil, bedroom furniture) 3. Apparel (men's shirts and sweaters, women's dresses, jewelry) 4. Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance) 5. Medical care (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) 6. Recreation (televisions, cable television, pets and pet products, sports equipment, admissions) 7. Education and communication (college tuition, postage, telephone services, computer software and accessories) 8. Other goods and services (tobacco and smoking products, haircuts and other personal services, funeral expenses)

Unintended Redistributions of Purchasing Power*****

Inflation can cause redistributions of purchasing power that hurt some and help others. People who are hurt by inflation include those who are holding a lot of cash, whether it is in a safe deposit box or in a cardboard box under the bed. When inflation happens, the buying power of cash is diminished. But cash is only an example of a more general problem: anyone who has financial assets invested in a way that the nominal return does not keep up with inflation will tend to suffer from inflation. For example, if a person has money in a bank account that pays 4% interest, but inflation rises to 5%, then the real rate of return for the money invested in that bank account is negative 1%. real interest rate = nominal interest rate - inflation

Inflation

Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change in relative prices. A relative price change occurs when you see that the price of tuition has risen, but the price of laptops has fallen. Inflation means that there is pressure for prices to rise in most markets in the economy. In addition, price increases in the supply-and demand model were one-time events, representing a shift from a previous equilibrium to a new one. Inflation implies an ongoing rise in prices. If inflation happened for one year and then stopped—well, then it would not be inflation any more. Inflation has consequences for people and firms throughout the economy, in their roles as lenders and borrowers, wage-earners, taxpayers, and consumers.

hyperinflation

Many countries in Latin America experienced raging hyperinflation during the 1980s and early 1990s, with inflation rates often well above 100% per year. In 1990, for example, both Brazil and Argentina saw inflation climb above 2000%. Certain countries in Africa experienced extremely high rates of inflation, sometimes bordering on hyperinflation, in the 1990s. Nigeria, the most populous country in Africa, had an inflation rate of 75% in 1995. In the early 2000s, the problem of inflation appears to have diminished for most countries, at least in comparison to the worst times of recent decades. In recent years, the world's worst example of hyperinflation was in Zimbabwe, where at one point the government was issuing bills with a face value of $100 trillion (in Zimbabwean dollars)—that is, the bills had $100,000,000,000,000 written on the front, but were almost worthless. In many countries, the memory of double-digit, triple-digit, and even quadruple-digit inflation is not very far in the past.

The Land of Funny Money

Read the example on page 223 (section 9.4). What are the economic problems caused by inflation, and why do economists often regard them with less concern than the general public? Economists note that over most periods, the inflation level in prices is roughly similar to the inflation level in wages, and so they reason that, on average, over time, people's economic status is not greatly changed by inflation. If all prices, wages, and interest rates adjusted automatically and immediately with inflation, as in the Land of Funny Money, then no one's purchasing power, profits, or real loan payments would change. However, if other economic variables do not move exactly in sync with inflation, or if they adjust for inflation only after a time lag, then inflation can cause three types of problems: unintended redistributions of purchasing power, blurred price signals, and difficulties in long-term planning.

Indexing Social Security

Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the Consumer Price Index. Also, Social Security is funded by payroll taxes, which are imposed on the income earned up to a certain amount—$117,000 in 2014. This level of income is adjusted upward each year according to the rate of inflation, so that the indexed rise in the benefit level is accompanied by an indexed increase in the Social Security tax base. In 1996 the U.S., government began offering indexed bonds. Bonds are means by which the U.S. government (and many private-sector companies as well) borrows money; that is, investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation, because it could then repay its past borrowing in inflated dollars at a lower real interest rate. But indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs.

1. Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks) 2. Housing (renter's cost of housing, homeowner's cost of housing, fuel oil, bedroom furniture) 3. Apparel (men's shirts and sweaters, women's dresses, jewelry) 4. Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance) 5. Medical care (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) 6. Recreation (televisions, cable television, pets and pet products, sports equipment, admissions) 7. Education and communication (college tuition, postage, telephone services, computer software and accessories) 8. Other goods and services (tobacco and smoking products, haircuts and other personal services, funeral expenses)

The Eight Major Categories in the Consumer Price Index (Cpi)

Additional Price Indices (GDP deflator)

The GDP deflator, measured by the Bureau of Economic Analysis, is a price index that includes all the components of GDP (that is, consumption plus investment plus government plus exports minus imports). Unlike the CPI, its baskets are not fixed but re-calculate what that year's GDP would have been worth using the base-year's prices. MIT's Billion Prices Project is a more recent alternative attempt to measure prices: data are collected online from retailers and then composed into an index that is compared to the CPI.

Figure 9.3 U.S. Price Level and Inflation Rates since 1913 (base year = 1982-84)

The U.S. price level rose relatively little over the first half of the twentieth century but has increased more substantially in recent decades. The upward slope of the price level was especially steep in the 1970s, which reflects the high rate of inflation in that decade. Inflation during the twentieth century was highest just after World Wars I and II, and during the 1970s. Deflation—that is, negative inflation, when most prices are falling—occurred several times in the first half of the century and in 2009 as well. Inflation rates since the 1990s have been in the low single digits. (Source: http://data.bls.gov/cgi-bin/surveymost)

Price index

To simplify the task of interpreting the price levels for more realistic and complex baskets of goods, the price level in each period is typically reported as an index number, rather than as the dollar amount for buying the basket of goods. Price indices are created to calculate an overall average change in relative prices over time. To convert the money spent on the basket to an index number, economists arbitrarily choose one year to be the base year, or starting point from which we measure changes in prices. The base year, by definition, has an index number equal to 100.

Problems with fixed basket price indices (CPI) -- substitution bias *****

When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important. Consider, as an example, a rise in the price of peaches by $100 per pound. If consumers were utterly inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to whether they have peaches or other types of fruit. Now, if peach prices rise, people completely switch to other fruit choices and the average price of food does not change at all. A fixed and unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption. Thus, substitution bias—the rise in the price of a fixed basket of goods over time—tends to overstate the rise in a consumer's true cost of living, because it does not take into account that the person can substitute away from goods whose relative prices have risen.

GDP deflator

a measure of inflation based on the prices of all the components of GDP

cost-of-living adjustments (COLA)

In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs) which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages.

Figure 9.3 price level and Inflation since 1913

In the last three decades, inflation has been relatively low in the U.S. economy, with the Consumer Price Index typically rising 2% to 4% per year. Looking back over the twentieth century, there have been several periods where inflation caused the price level to rise at double-digit rates, but nothing has come close to hyperinflation. Graph a shows the trends in the U.S. price level from the year 1916 to 2014. In 1916, the graph starts out close to $10, rises to around $20 in 1920, stays around $16 or $17 until 1931, when it jumps to around $15. It gradually increases, with periodic dips, until 2014, when it is around $236. Graph b shows the trends in U.S. inflation rates from the year 1916 to 2014. In 1916, the graph starts out at 7.7%, jumps to close to 18% in 1917, drops drastically to close to -11% in 1921, goes up and down periodically, until settling to around 1.5% in 2014.

Problems of Long-Term Planning*****

Inflation can make long-term planning difficult. Problems arise for all people trying to save for retirement, because they must consider what their money will really buy several decades in the future when the rate of future inflation cannot be known with certainty. Inflation, especially at moderate or high levels, will pose substantial planning problems for businesses, too. A firm can make money from inflation—for example, by paying bills and wages as late as possible so that it can pay in inflated dollars, while collecting revenues as soon as possible. A firm can also suffer losses from inflation, as in the case of a retail business that gets stuck holding too much cash, only to see the value of that cash eroded by inflation. But when a business spends its time focusing on how to profit by inflation, or at least how to avoid suffering from it, an inevitable tradeoff strikes: less time is spent on improving products and services or on figuring out how to make existing products and services more cheaply. An economy with high inflation rewards businesses that have found clever ways of profiting from inflation, which are not necessarily the businesses that excel at productivity, innovation, or quality of service. In the short term, low or moderate levels of inflation may not pose an overwhelming difficulty for business planning.

Problems with fixed basket price indices (CPI) -- quality/new goods bias (cont.)

The arrival of new goods creates problems with respect to the accuracy of measuring inflation. The reason people buy new goods, presumably, is that the new goods offer better value for money than existing goods. Thus, if the price index leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the price of a new good is often higher when it is first introduced and then declines over time. If the new good is not included in the CPI for some years, until its price is already lower, the CPI may miss counting this price decline altogether. Taking these arguments together, the quality/new goods bias means that the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer's true cost of living, because it does not take into account how improvements in the quality of existing goods or the invention of new goods improves the standard of living.

Figure 9.1 Big Bucks in Zimbabwe

This bill was worth 100 billion Zimbabwean dollars when issued in 2008. There were even bills issued with a face value of 100 trillion Zimbabwean dollars. The bills had $100,000,000,000,000 written on them. Unfortunately, they were almost worthless. At one point, 621,984,228 Zimbabwean dollars were equal to one U.S. dollar. Eventually, the country abandoned its own currency and allowed foreign currency to be used for purchases. (Credit: modification of work by Samantha Marx/Flickr Creative Commons). Read Page 209 about the hyperinflation in Zimbabwe.

Consumer Price Index (CPI).

a measure of inflation calculated by U.S. government statisticians based on the price level from a fixed basket of goods and services that represents the purchases of the average consumer

core inflation index

A core inflation index is typically calculated by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living. Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. During Hurricane Katrina in 2005, a key supply point for the nation's gasoline was nearly knocked out. Gas prices quickly shot up across the nation, in some places up to 40 cents a gallon in one day. This was not the cause of an economic policy but rather a short-lived event until the pumps were restored in the region. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged.

Other Indexing in Private Markets

A number of ongoing or long-term business contracts also have provisions that prices will be adjusted automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected; buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price to be paid, rather than a nominal price.

Consumer Price Iindex VS. core inflation index

As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, "It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level." Bernanke also noted that it helps communicate that every inflationary shock need not be responded to by the Federal Reserve since some price changes are transitory and not part of a structural change in the economy. In sum, both the CPI and the core inflation index are important, but serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is a preferred gauge from which to make important government policy changes.

Practical Solutions for the Substitution and the Quality/New Goods Biases

By the early 2000s, the Bureau of Labor Statistics (BLS) was updating the basket of goods behind the CPI more frequently, so that new and improved goods could be included more rapidly. For certain products, the BLS was carrying out studies to try to measure the quality improvement. The substitution bias and quality/new goods bias had been somewhat reduced, so that since then the rise in the CPI probably overstates the true rise in inflation by only about 0.5% per year. Over one or a few years, this is not much; over a period of a decade or two, even half of a percent per year compounds to a more significant amount. In addition, the CPI tracks prices from physical locations, and not at online sites like Amazon, where prices can be lower. When measuring inflation (and other economic statistics, too), a tradeoff arises between simplicity and interpretation. If the inflation rate is calculated with a fixed basket, then the calculation of an inflation rate is straightforward, but biased. When the basket of goods is allowed to shift and evolve to reflect substitution toward lower relative prices, quality improvements, and new goods, the technical details of calculating the inflation rate become complex.

percentage change in price index period 1 to 2 = (price index in period 2 - price index in period 1) / price index in period 1 * 100

Inflation between period 1 and 2 =

Figure 9.7 U.S. Inflation Rate and U.S. Labor Productivity, 1961-2014

Over the last several decades in the United States, there have been times when rising inflation rates have been closely followed by lower productivity rates and lower inflation rates have corresponded to increasing productivity rates. As the graph shows, however, this correlation does not always exist.

False

Well theoretically possible deflation has never been observed in the United States true or false

Core inflation does not include goods and services included in the CPI that experience frequent price shocks

What is the difference between measures of inflation which only use CPI and the core measures of inflation

Table 9.2 A College Student's Basket of Goods

Market basket = 20 hamburgers, one bottle of aspirin, and five movies Value of market basket in any period = quantities in that period * prices in that period Value of market basket in period 1 (Pd1) = 20 hamburgers * $3 + 1 bottle of aspirin * $10 + 5 movies * $6 = $60 + $10 + $30 = $100 Value of market basket in period 2 (Pd2) = 20 hamburgers * $3.2 + 1 bottle of aspirin * $10 + 5 movies * $6.25 = $64 + $10 + $32.5 = $106.50 Value of market basket in period 2 (Pd2) = 20 hamburgers * $3.1 + 1 bottle of aspirin * $10 + 5 movies * $7 = $62 + $10 + $35 = $107 Value of market basket in period 2 (Pd2) = 20 hamburgers * $3.5 + 1 bottle of aspirin * $10 + 5 movies * $7.5 = $70 + $10 + $37 = $117.5

Pensions or defined benefits VS. 401(K/403B or defined contribution

One sizable group of people has often received a large share of their income in a form that does not increase over time: retirees who receive a private company pension. Most pensions have traditionally been set as a fixed nominal dollar amount per year at retirement. For this reason, pensions are called "defined benefits" plans. Even if inflation is low, the combination of inflation and a fixed income can create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1%. Pensions and other defined benefits retirement plans are increasingly rare, replaced instead by "defined contribution" plans, such as 401(k)s and 403(b)s where the employer contributes a fixed amount to the worker's retirement account on a regular basis (usually every pay check). The employee often contributes as well. The worker invests these funds in a wide range of investment vehicles. These plans are tax deferred, and they are portable so that if the individual takes a job with a different employer, their 401(k) comes with them. To the extent that the investments made generate real rates of return, retirees do not suffer from the inflation costs of traditional pensioners.

Borrowers may Gain from inflation lenders may lose as a result of inflation****

Ordinary people can sometimes benefit from the unintended redistributions of inflation. Consider someone who borrows $10,000 to buy a car at a fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then the loan must be repaid at a real interest rate of 6%. But if inflation rises to 9%, then the real interest rate on the loan is zero. In this case, the borrower's benefit from inflation is the lender's loss. A borrower paying a fixed interest rate, who benefits from inflation, is just the flip side of an investor receiving a fixed interest rate, who suffers from inflation. The lesson is that when interest rates are fixed, rises in the rate of inflation tend to penalize suppliers of financial capital, who end up being repaid in dollars that are worth less because of inflation, while demanders of financial capital end up better off, because they can repay their loans in dollars that are worth less than originally expected. Similarly, when homeowners benefit from inflation because the price of their homes rises, while renters suffer because they are paying higher rent

Price index and inflation

Price index in current year = value of market basket in current year / value of market basket in base year) * 100 Inflation between period 1 and 2 = percentage change in price index period 1 to 2 = (price index in period 2 - price index in period 1) / price index in period 1 * 100 Two final points about index numbers are worth remembering. First, index numbers have no dollar signs or other units attached to them. Although index numbers can be used to calculate a percentage inflation rate, the index numbers themselves do not have percentage signs. Index numbers just mirror the proportions found in other data. They transform the other data so that the data are easier to work with. Second, the choice of a base year for the index number—that is, the year that is automatically set equal to 100—is arbitrary. It is chosen as a starting point from which changes in prices are tracked. In the official inflation statistics, it is common to use one base year for a few years, and then to update it, so that the base year of 100 is relatively close to the present. But any base year that is chosen for the index numbers will result in exactly the same inflation rate.

Additional Price Indices (Ppi, IPI, ECI)

The basket of goods behind the Consumer Price Index represents an average hypothetical U.S. household, which is to say that it does not exactly capture anyone's personal experience. The BLS also calculates several price indices that are not based on baskets of consumer goods. For example, the Producer Price Index (PPI) is based on prices paid for supplies and inputs by producers of goods and services. It can be broken down into price indices for different industries, commodities, and stages of processing (like finished goods, intermediate goods, crude materials for further processing, and so on). There is an International Price Index based on the prices of merchandise that is exported or imported. An Employment Cost Index measures wage inflation in the labor market.

Cause of Inflation and policies to fight inflation

The cause of inflation can be summed up in one sentence: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. On the other hand, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, slowdowns in economic activity, as in major recessions and the Great Depression, are typically associated with a reduction in inflation or even outright deflation. If inflation is to be avoided, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power—through taxes, spending, and regulation of interest rates and credit—can thus cause inflation to rise or reduce inflation to lower levels.

Consumer Price Index (CPI)

The most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI). The CPI is calculated by government statisticians at the U.S. Bureau of Labor Statistics based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four. In recent years, the statisticians have paid considerable attention to a subtle problem: that the change in the total cost of buying a fixed basket of goods and services over time is conceptually not quite the same as the change in the cost of living, because the cost of living represents how much it costs for a person to feel that his or her consumption provides an equal level of satisfaction or utility.

Problems with fixed basket price indices (CPI) -- quality/new goods bias

The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and minerals—and also if a box of the cereal costs 5% more. It would clearly be misleading to count the entire resulting higher price as inflation, because the new price is being charged for a product of higher (or at least different) quality. Ideally, one would like to know how much of the higher price is due to the quality change, and how much of it is just a higher price. The basket of goods and services used in the Consumer Price Index (CPI) is revised and updated over time, and so new products are gradually included. But the process takes some time.

Real interest rate, nominal interest rate and the effect of tax******

The problem of a good-looking nominal interest rate being transformed into an ugly-looking real interest rate can be worsened by taxes. The U.S. income tax is charged on the nominal interest received in dollar terms, without an adjustment for inflation. So, a person who invests $10,000 and receives a 5% nominal rate of interest is taxed on the $500 received—no matter whether the inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate is 5% and all $500 is a gain in buying power. But if inflation is 5%, then the real interest rate is zero and the person had no real gain—but owes income tax on the nominal gain anyway. If inflation is 10%, then the real interest rate is negative 5% and the person is actually falling behind in buying power, but would still owe taxes on the $500 in nominal gains.

Figure 9.5 Countries with Relatively High Inflation Rates, 1980-2013

These charts show the percentage change in consumer prices compared with the previous year's consumer prices in Argentina, Brazil, China, Nigeria, and Russia. Of these, Argentina, Brazil, and Russia all experienced hyperinflation at some point between the mid-1980s and mid-1990s. Though not as high, China and Nigeria also had high inflation rates in the mid-1990s. Even though their inflation rates have come down over the last two decades, several of these countries continue to see significant inflation rates. (Source: http://www.tradingeconomics.com/)

How to calculate the price level

To calculate the price level, economists begin with the concept of a basket of goods and services, consisting of the different items individuals, businesses, or organizations typically buy. The next step is to look at how the prices of those items change over time. In thinking about how to combine individual prices into an overall price level, many people find that their first impulse is to calculate the average of the prices. Such a calculation, however, could easily be misleading because some products matter more than others. Changes in the prices of goods for which people spend a larger share of their incomes will matter more than changes in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket, where the weights are based on the actual quantities of goods and services people buy.