Lecture 3

Price Level and Inflation

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▸ Measuring inflation
Lecture ▸ Adjusting for inflation
Outline
▸ Does CPI measure “true” inflation?
▸ Costs of inflation
▸ Inflation and interest rates
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Measuring Inflation
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7 ▸ Rate of inflation is the annual
percentage rate of change in general
price level
▹ Rate of inflation between 2020 and 2021 is
Measuring given by:
𝑃𝑃2021 −𝑃𝑃2020
x 100
𝑃𝑃2020
Inflation
▸ How do we measure general price
level?
▹ Thousands of goods and services in the
economy
▹ How do we aggregate all the different
prices?
▹ How do we assign weightages?
8 ▸ Consumer price index (CPI)
▹ Most common measure of price level
▹ Other measurements of price level
include
Measuring
■ core inflation
Price Level
■ producer price index
■ import & export price index
9 ▸ The CPI measures
▹ The cost of a standard basket of goods and
services in current year relative to the cost of the
same basket of goods and services in the base year
Measuring CPI =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏−𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑜𝑜𝑜𝑜 𝑔𝑔&𝑠𝑠 𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
x 100
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏−𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑜𝑜𝑜𝑜 𝑔𝑔&𝑠𝑠 𝑖𝑖𝑖𝑖 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
Price Level
▹ The basket of goods and services is based on the
average consumption patterns of households in the
base-year
■ Collected via detailed expenditure survey
▹ Base year changes periodically
▹ Conventionally, CPI is multiplied by 100 to get rid of
decimal point
10 ▸ An example
▹ Base year is 2020, current year is 2024
▹ A typical basket of goods and services
consumed by a household consists of:
Calculating 1. 1 rental of a two-bedroom apartment
CPI
2. 60 hamburgers
3. 10 movie tickets
▹ To compute CPI, we need to compute the
cost of the basket of goods and services in
the current year and in the base year
11 Item Monthly Cost in 2020
Rent (2-bedroom apartment) $750
Hamburgers (60 at $2 each) 120
Calculating Movie tickets (10 at $7 each) 70
CPI Monthly expenditures $940

Item Monthly Cost in 2024

Rent (2-bedroom apartment) $945
Hamburgers (60 at $2.50 each) 150
Movie tickets (10 at $8 each) 80
Monthly expenditures $1,175
12 ▸ CPI = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏−𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑜𝑜𝑜𝑜 𝑔𝑔&𝑠𝑠 𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏−𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑜𝑜𝑜𝑜 𝑔𝑔&𝑠𝑠 𝑖𝑖𝑖𝑖 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
x 100

= (1,175/940) x 100 = 125

Calculating
▸ Cost of living in 2024 is 25% higher than in
CPI 2020
▹ CPI for the base year is always 100
▹ CPI for a given period is the cost of living in that
period relative to what it was in the base year
13 Year
2018
CPI
251.1
Inflation

▸ The rate of inflation is 2019 255.7 1.8%

the annual percentage
2020 258.9 1.3%
rate of change in the
Calculating price level 2021 271.0 4.7%
Inflation ▸ Inflation in 2019 2022 292.6 8.0%
= (251.1–255.7)/251.1
x 100 = 1.8% Year CPI Inflation
▸ The Great Depression 1929 17.1
▹ Period of falling output 1930 16.7 –2.3%
and prices
▹ When inflation rates are 1931 15.2 –9.0%
negative there is 1932 13.7 –9.9%
deflation
1933 13.0 –5.1%
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Adjusting for Inflation

15 ▸ Nominal quantity: measured in terms
of current dollar value; include effects
of inflation

Adjusting
▸ Real quantity: measured in physical
for Inflation terms; exclude effects of inflation
▸ 2 types of adjustment for inflation:
1. Deflating: convert nominal quantities
measured into real terms
2. Indexing: convert real quantities into
current-dollar terms
16 ▸ Deflating: divide a nominal quantity by
its price index to express the quantity in
real terms

Deflating ▸ When comparing values over time, use

real quantities instead of nominal
quantities to eliminate effects of
inflation from comparison
17 ▸ A family earned $40,000 in 2020, and
$44,000 in 2024. Is the family better off?
Year Nominal Income CPI/100 Real Income
2020 $40,000 1.00 $40,000/1.00 = $40,000
E.g.
2024 $44,000
Comparing 1.25 $44,000/1.25 = $35,200

Family
Income in ▸ To get real income: divide nominal income
by the CPI
2020 and
2024 ▸ Compare real income
▹ $40,000 in 2020 has the greater purchasing
power
18 ▸ 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
E.g. Real Year Average Wage CPI/100 Real Average Wage
Wages of 1970 $3.40 0.388 $3.40 / 0.388 = $8.76
U.S. 2022 $27.55 2.93 $27.55 / 2.93 = $9.40
production
workers ▸ U.S. production worker wages
▹ Real wages stayed roughly the same between 1970
and 2022 despite the fact that the nominal wage in
2022 was more than 8 times the nominal wage in
1970
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Production
Workers’
Wages,
1970 - 2022
20 ▸ Indexing increases a nominal quantity
each period by an amount equal to the
percentage increase in a specified price
index
Indexing ▹ 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
21 ▸ An indexed labour contract
▹ First year wage is $12 per hour
■ Real wages rise by 2% per year for next
2 years
▹ CPI is 100 in first year, 105 in the second,
E.g. and 110 in the third
Adjusting a ▹ Nominal wage is real wage times the CPI
Labour
Contract for
Year Real Wage CPI/100 Nominal Wage
Inflation
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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Does CPI Measure

“True” Inflation?
23 ▸ CPI may not properly measure inflation
due to:
1. Quality adjustment bias
2. Substitution bias
CPI and
Inflation ▸ Overestimation of inflation would lead to
1. Unnecessarily increases government
spending
2. Underestimation of increase in the
standard of living
24 ▸ Quality adjustment bias: failure to adjust
adequately for improvements in the quality
of goods and services
▹ PC with 20% more memory has 20% higher
Quality price
Adjustment ■ Not the same PC as the one with less
Bias memory
▹ If no adjustment is made for quality,
inflation will be overstated
▹ Adjusting for quality is difficult
■ Large numbers of goods
■ Subjective differences
25 ▸ CPI is calculated using a fixed basket of
goods and services
▹ When the price of a good increases, consumers
buy less and substitute other goods
Substitution ▹ Failing to account for substitution overstates
inflation
Bias
▸ Example: base year cost of market basket
Item 2015 price 2015 Spending
Coffee (50 cups) $1.00 $50.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.00 $100.00
Total $200.00
26 ▸ In 2020, coffee and scones are more
expensive
▹ Buying exactly the same basket of goods costs
$300, compared to $200 in 2015
Substitution ▹ CPI = 300/200 x 100 = 150
Bias Item 2020 price 2020 Spending
Coffee (50 cups) $2.00 $100.00
Tea (50 cups) $1.00 $50.00
Scones (100) $1.50 $150.00
Total $300.00
27 ▸ Actually, consumer substitutes tea for
coffee
▹ Purchase of scones remains constant
Item 2020 price 2020 Spending
Substitution Coffee (0 cups) $2.00 $0.00
Bias Tea (100 cups) $1.00 $100.00
Scones (100) $1.50 $150.00
Total $250.00

▸ True cost of living risen by $50, or 25%

▸ Lower than the 50% increase in the CPI
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Costs of Inflation
29 ▸ 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
Price Level comparison of its price to the prices of other
vs Relative goods and services
Price ▸ E.g. there is a huge increase in the price of new
car, but prices of other goods and services
remain stable
▹ Increase in the relative price of new car is large
▹ Overall price level and inflation increase by a small
amount
30 ▸ Inflation can be high without affecting relative
price
▸ E.g. all prices in the economy, including wages
(price of labour), go up by 10 percent each year
Price Level
▹ Inflation rate is 10 percent
vs Relative
▹ Relative prices remain unchanged
Price
▹ People’s ability to buy goods and services is
unaffected by inflation
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1. “Noise” in the price system

2. Distortions of the tax system

True Costs
of Inflation 3. “Shoe-leather” costs

4. Unexpected redistribution of wealth

5. Interference with long-term planning

(PLEASE READ)
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Inflation and
Interest Rates
33 ▸ The real interest rate is the annual
percentage increase in the purchasing
power of financial assets
▸ The nominal interest rate (market
Inflation interest rate) is the annual percentage
and increase in the nominal value of an
Interest asset
Rates ▸ Real interest rate
= nominal interest rate – inflation rate
▸ r=i–π
34 ▸ Your friend, Jane, is borrowing $1000 from you
for one year. She will pay you interest for the loan
▸ How much should the interest rate be?
▸ You would like to be compensated for deferring
Inflation your consumption
▹ Real interest rate
and
▸ You know that with inflation, a dollar in a year
Interest time worth less than a dollar today, and you
Rates would to be compensated for inflation
▸ Nominal interest rate = real interest rate +
inflation rate
▸ Say, r = 2%, π = 3%, i would be 5%, and Jane will
pay you an interest of $50 at the end of one year
35 ▸ Note that at the time when you lend Jane $1000,
actual inflation rate is not yet known
▹ You have to anticipate the inflation rate, i.e.
expected inflation rate
▸ High unexpected inflation hurt lenders, benefit
Inflation borrowers
and ▹ Say inflation rate turns out to be 10%, your real
interest rate is -5%
Interest ▸ High inflation rate, if expected, does not hurt
Rates lenders, as lenders will demand a higher nominal
interest rate
▹ What nominal interest rate would you demand from
Jane if you expected inflation rate to be 20%
▸ 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 -
2022
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