Introduction to
Macroeconomics
Dr. Rania Moaaz
Price Level, Inflation, and Deflation
• The price level is the average level of prices and the value of
money.
• A persistently rising price level is called inflation.
• A persistently falling price level is called deflation.
• We are interested in the price level because we want to
‒ Measure the inflation rate or the deflation rate
‒ Distinguish between money values and real values of
economic variables.
Why Inflation and Deflation Are Problems
‒ Low, steady, and anticipated inflation or deflation is
not a problem.
‒ Unpredictable inflation or deflation is a problem
because it
▪ Redistributes income
▪ Redistributes wealth
▪ Lowers real GDP and employment
▪ Diverts resources from production
Why Inflation and Deflation Are Problems
• Unpredictable changes in the inflation rate redistribute income in
arbitrary ways between employers and workers and between
borrowers and lenders.
• A high inflation rate is a problem because it diverts resources from
productive activities to inflation forecasting.
• From a social perspective, this waste of resources is a cost of
inflation.
• At its worst, inflation becomes hyperinflation—an inflation rate
that is so rapid causing money to lose its value so quickly.
The Consumer Price Index
• The Consumer Price Index, or CPI, measures the average of the
prices paid by urban consumers for a “fixed” basket of consumer
goods and services.
• The CPI is defined to equal 100 for the reference base period.
• Constructing the CPI involves three stages:
▪ Selecting the CPI basket
▪ Conducting a monthly price survey
▪ Calculating the CPI
The Consumer Price Index
• The CPI basket today is based on data collected in the
Consumer Expenditure Survey.
• Calculating the CPI
‒ Find the cost of the CPI basket at base-period prices.
‒ Find the cost of the CPI basket at current-period
prices.
‒ Calculate the CPI for the current period.
Example
• In a simple economy, people
consume only oranges and
haircuts.
• The CPI basket is 10 oranges
and 5 haircuts.
• The table also shows the
prices in the base period.
• The cost of the CPI basket in
the base period was $50.
Example
• Table 22.1(b) shows
the fixed CPI basket
of goods.
• It also shows the
prices in the current
period.
• The cost of the CPI
basket at current-
period prices is $70.
Example
• The CPI is calculated using the formula:
• CPI = (Cost of basket at current-period prices ÷ Cost of basket at
base-period prices) × 100.
• Using the numbers for the simple example,
CPI = ($70 ÷ $50) × 100 = 140.
• The CPI is 40 percent higher in the current period than it was in the
base period.
Measuring the Inflation Rate
• The major purpose of the CPI is to measure
inflation.
• The inflation rate is the percentage change in the
price level from one year to the next.
• The inflation formula is:
• Inflation rate = [(CPI this year – CPI last year) ÷
CPI last year] 100.
The Biased CPI
‒ The CPI might overstate the true inflation rate for four
reasons:
▪ New goods bias
▪ Quality change bias
▪ Commodity substitution bias
▪ Outlet substitution bias
The Biased CPI
• New Goods Bias
‒ New goods that were not available in the base year appear
and, if they are more expensive than the goods they replace,
they put an upward bias into the CPI.
• Quality Change Bias
‒ Quality improvements occur every year. Part of the rise in the
price is payment for improved quality and is not inflation.
‒ The CPI counts all the price rise as inflation.
The Biased CPI
• Commodity Substitution Bias
‒ The market basket of goods used in calculating the CPI is fixed
and does not take into account consumers’ substitutions away
from goods whose relative prices increase.
• Outlet Substitution Bias
‒ As the structure of retailing changes, people switch to buying
from cheaper sources, but the CPI, as measured, does not
take account of this outlet substitution.
Practice
1. Suppose that the cost of the CPI basket of goods and services rises from $137 in
2010, which is the base year, to $159 in 2011. The CPI in 2011 is
________greater than that of 2010 and the inflation rate from 2010 to 2011 is
________.
• A) 86; 14 percent
• B) 86; 22 percent
• C) 116; 22 percent
• D) 116; 16 percent
• E) There is not enough information to answer this question.
• Answer: D (The formula for the CPI = Cost of CPI at current prices / cost of CPI at
base year x100) = (159 /137)x100 = 116. (The inflation rate = (CPI of current year
– CPI of last year / CPI of last year) x100) = (159 -137 / 137) x 100 = 16%)
Practice
• The data in the table above shows the
consumption by families in a small
(poor) economy. The families
consume only salt and bread. The
reference base period is 2011.
• Calculate the cost of the CPI market
basket in 2011
• Calculate the cost of the CPI basket in
2012
• Calculate the CPI in 2011. The
reference base period is 2011.
• Calculate the CPI in 2012
Answer
• Cost of CPI (2011) = (Qsalt x Psalt)+(Qbread x Pbread)= (2x1)+(20x2.5)= 52
• Cost of CPI (2012) = (Qsalt. X. Psalt)+(Qbread x. Pbread)= (2x2)+(20x3)= 64
• The CPI in 2011= (The cost of CPI in 2011/ The cost of CPI in base
year)x100= (52/52)x100=100
• The CPI in 2012= (The cost of CPI in 2012/ The cost of CPI in base
year)x100= (64/52)x100=100=123.1
End of Unit
