inflation basics dr. d. foster – eco 285. inflation defined a continuous rise in the general price...
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Inflation Basics
Dr. D. Foster – ECO 285
Inflation Defined
A continuous rise in the general price level.
• Not a rise in some prices.• Not a one-time rise in prices.• What is the “general price level”?
Price level is shown by a Price Index• Hold quantities constant over time
• Use old (“base year”) quantities
• Use new quantities
• Allow some quantity change
Laspeyres; CPI
Paasche
Chained CPI & GDP deflator
Laspeyres & Paasche price indexes
• Paasche:
∑(P1*Q0)∑(P0*Q0)
∑(P1*Q1)∑(P0*Q1)
= 103.34$456.00$441.25
=
$447.00$440.50
= = 101.48
The CPI uses a Laspeyres index like
this, so showing inflation of 3.34%.
x 100
x 100 x 100
x 100
PI0 = 100 and PI1 = ???
• Laspeyres:
The Consumer Price Index(es)• CPI-U: All urban consumers
– A fixed-weight index: consumption patterns rigid.
– Market basket is updated every two years.
– Represents about 87% of U.S. population.
– Used to adjust income tax brackets to account for inflation.
– Monthly, 60,000 prices are collected.
– Goods & services comprise 200 groups.
– Eight broad categories:
The Consumer Price Index(es)• CPI-U: All urban consumers
– A fixed-weight index: consumption patterns rigid.
– Market basket is updated every two years.
– Represents about 87% of U.S. population.
– Used to adjust income tax brackets to account for inflation.
– Monthly, 60,000 prices are collected.
– Goods & services comprise 200 groups.
– Eight broad categories:
• FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
• HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
• APPAREL (men's shirts and sweaters, women's dresses, jewelry)
• TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
• MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
• RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);
• EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
• OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).
CPI-U from 1947, 1970 and 2000
The Consumer Price Index(es)• CPI-W: Urban wage earners & clerical workers
– A fixed-weight index.
– Represents about 32% of U.S. population.
– Half of HH income from clerical, craft, service.
• Excludes salaried, part-time, self-employed …
– Records average spending on 80,000 items in 87 geographical areas around the country.
– Used to adjust Social Security payments to keep up with cost of living (COLAs).
The Consumer Price Index(es)• C-CPI-U: Chained CPI, all consumers
– A variable-weight index.
– Designed to account for “substitution bias.”
• When the price of pork rises, people buy more fish.
• CPI-U only accounts for narrow substitution, e.g., if the price of Granny Smith apples rise relative to Red Delicious.
– Designed to be a better measure of the cost of living.
– Records consumer expenditures each month and allows for changing composition of the basket.
Chained CPI-U from 2000
Comparing CPI-U with C-CPI-U
Using Price Indexes• Converts nominal values into real values:
• Example: Your income in 2013 is $32,000 and in 2014 it is $33,100.Q - Are you “better off?”
• Convert to “real income” by looking at CPI: Say it was 172.2 in 2013 and 179.9 in 2014
Nominal Income CPI Real Income$32,000 172.2 $18,583$33,100 179.9 $18,399
Features of Price Indexes
• CPI2003 = 184CPI2013 = 233
Inflation = (233-184)/184 = 26.6%
Approx. annual inflation = 2.66% (10 years)
Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%
•Must choose a base year (where index = 100)•Must choose a market basket of goods and services.•Comparisons across short periods of time are more
reliable than across long periods of time.• Inflation rate is [CPI2 – CPI1]/CPI1
•Average annual rate over “N” years is given as follows:
Features of Price Indexes
• CPI2003 = 184CPI2013 = 233
Inflation = (233-184)/184 = 26.6%
Approx. annual inflation = 2.66% (10 years)
Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%
•Must choose a base year (where index = 100)•Must choose a market basket of goods and services.•Comparisons across short periods of time are more
reliable than across long periods of time.• Inflation rate is [CPI2 – CPI1]/CPI1
•Average annual rate over “N” years is given as follows:
Calculating the C-CPI-U
L: 103.34P: 101.48
Inflation Basics
Dr. D. Foster – ECO 285