08 The Price Level and Inflation

pg 241-275

Misconception - Inflation is no big deal.

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How Is Inflation Measured?

The Consumer Price Index (CPI)

• Deflation occurs when overall price fall.
• The Consumer Price Index (CPI) is a measure of the price level based on the consumption patterns of a typical consumer. The CPI is is based on prices from a typical "basket" of all consumer goods and services.

Figure 8.1
Inflation in the United State, 1965-2015
From 1965-2015, inflation rates in the United State averaged 4%. This is high because of excessive inflation in 1970s. The inflation rate peaked at over 14% in 1980. More recently, inflation rates have averaged less than 3%.

Computing the CPI

Figure 8.3
Calculating a Simple Price Index
In calculating this entertainment price index (EPI), we use the same steps that the Bureau of Labor Statistics does when calculating the CPI. First, we determine the typical basket of goods. Then we calculate the total price of the basket in a base year, 2016 in this example, and set that base year at 100 (creating an index). For subsequent years, we add up the new prices for the same basket of goods, then divide by the basket price in the base year, and then multiply by 100 to determine the new index number.

$price \: index = \frac{basket \: price}{basket \: price \: in \: base \: year}$

Measuring Inflation Rates

The inflation rate(i) is calculated as the percentage change in the price level (P). Using the CPI as the price level, the inflation rate from period 1 to period 2 is as follows:

$inflation \: rate(i) = \frac{P_2-P_1}{P_1} \times 100$

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Using the CPI to Equate Dollar Values over Time

To compare the prices of goods over time, we convert all prices to today's prices, or "prices in today's dollars." Here is the formula:

$price \: in \: today's \: dollars = price \: in \: earlier \: time \times \frac{price \: level \: today}{price \: level \: in \: earlier \: time}$

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The Accuracy of the CPI

Because the typical basket keeps changing, it is difficult to measure its price. The most common concern is that the CPI overstates true inflation. There are three reasons for this concerns: the substitution of different goods and services, changes in quality, and the availability of new goods, services, and locations.

• Substitution - when the price of a good rises, consumers instinctively look to substitute less expensive alternatives. (upwards bias)
• Change in quality - over time, the quality of goods and services generally improves. (upwards bias)
• New Goods, Services, and Locations - in a dynamic, growing economy, new goods and services are introduces and new buying options become available.

In an effort measure this upward bias, the BLS began computing a chained CPI in 2000. The chained CPI is a measure of the CPI in which the typical consumer's basket of goods and services is updated monthly.

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What Problems does Inflation Brings?

• Shoe-Leather Costs - the resources wasted when people change their behavior to avoid holding money. (fuel costs and the time and effort that people expend when they make multiple trips to a bank or ATM).
• Money Illusion - people interpret nominal changes in wages or prices as real changes.
• Menu Cost - the cost of changing prices.
• Future Price Level Uncertainty - wage and loan contracts, lower economic output
• Wealth Redistribution - borrower and lender
• Price Confusion - Market prices are a signals to consumers and firms - signals that help allocate resources in a market economy.

Figure 8.8
"Why did My Price Change?"
Price change send information, or signals, to business. However, higher prices can be the result of either a real increases in demand or inflation. In upward pressure on price is the result of greater demand, the profit-maximizing firm should increase its output. But if the price increase is the result of inflation, the firm should not change it level of output.

• Tax Distortions - capital gains taxes

What is the cause of Inflation?

When the supply of money in an economy grows relative to the quantity of goods and services, then it takes more money to buy any particular good or service. Money then becomes less valuable relative to goods and services-and this relationship constitutes inflation.

Figure 8.9
Inflation and Money Growth Rates in 160 Countries, 1991-2011
The relationship between inflation rates and money growth rates is virtually one-to-one for many countries over long periods of time. This relationship applies to nations with low inflation rates and to nations with high inflation rates.

The Equation of Exchange

The equation of exchange specifies the long-run relationship between the money supply, the price level, real GDP, and the velocity of money. The actual equation is

$M \times V = P \times Y$

The right side of the equation is nominal GDP, or real GDP ($Y$) times the price level ($P$). The left side includes the quantity of money in the economy ($M$) and the velocity of money ($V$).

The velocity of money is the number of times a unit of money exchanges hands in a given year.
Consider another version of the equation of exchange:

$\%\Delta M + \%\Delta V \approx \%\Delta P+ \%\Delta Y$

Table 8.5
Four Scenarios for the Equation of Exchange

The Reason Why Government Inflate Money Supply

• large government debts - print more money to pay off debts
• short-term gains - temporarily stimulate an economy toward more rapid growth rates.

End