Understanding Inflation and Price Indexes

Inflation and Money

• Inflation and money are important concepts in economics

Measuring Inflation

• Inflation involves a persistent rise in the average level of prices
• Inflation is measured using price indexes

Price Indexes

• A price index is always defined relative to a base year
• The price index in the base year is normalized to 100
• Formula for price index: Pt = (Costt / Costbase) * 100

Example

• Typical purchase includes 200 apples, 50 grape bunches, and 100 peaches
• Year 1:
  • Price of apple: $0.20
  • Price of grapes: $0.60
  • Price of peach: $0.25
  • Cost of market basket: (200 × $0.20) + (50 × $0.60) + (100 × $0.25) = $95.00
  • P₁ = (95 / 95) * 100 = 100
• Year 2:
  • Price of apple: $0.40
  • Price of grapes: $1.00
  • Price of peach: $0.45
  • Cost of market basket: (200 × $0.40) + (50 × $1.00) + (100 × $0.45) = $175.00
  • P₂ = (175 / 95) * 100 = 184.2

Inflation Rate

• The inflation rate (π) represents the percentage growth rate in the price index
• Formula: πt = (Pt - Pt-1) / Pt-1
• Π2 = (184.2 - 100) / 100 = 0.842 = 84.2%

Consumer Price Index (CPI)

• The CPI basket reflects the share of a typical household's spending
• Housing accounts for 44.9%
• Food accounts for 16.2%
• Transportation accounts for 16.0%
• Recreation, alcohol, tobacco, and cannabis account for 9.4%
• Health and personal care account for 4.8%
• Clothing and footwear account for 4.0%
• CPI is used to calculate the official CPI inflation rate
• CPI reflects purchases of a typical Canadian household
• The cost of this basket has steadily been rising, reflecting inflation

Inflation, Deflation, and Disinflation

• Inflation is an increase in the price level (π > 0)
• Deflation is a decrease in the price level (π < 0)
• Disinflation is a slowdown in inflation (Δπ < 0)

Problems with CPI

• Substitution Bias
• New Goods Bias
• Changes in Quality Bias
• CPI might be too high by about 0.5%

Other Measures of Inflation

• Core Inflation involves CPI trim and CPI median
• CPI is the "headline" measure
• CPI excluding food and energy is less volatile
• CPI-Median tracks the 50th percentile of the basket

Producer Price Index (PPI)

• Measures price changes from the seller's perspective
• Measures industrial product price index and industrial product price index excluding energy and petroleum

GDP Deflator

• Formula: P = (Nominal GDP / Real GDP) * 100 = ($Y / Y) * 100
• GDP deflator is the weighted price of all domestically produced goods
• CPI includes foreign goods
• CPI exclude capital goods
• GDP deflator has flexible weights

Real and Nominal Variables

Real GDP

• Y real GDP = $Y / P (Nominal GDP / GDP Deflator)
• Real GDP adjusts for inflation

Real Wages

• W real wage = W / P (Nominal wage / price level)
• There is downward nominal wage rigidity.
• Reduction of labor input happens at the extensive margin (unemployment).

Real Interest Rate

• Fisher Equation: i = r + πe
  • i = nominal interest rate
  • r = real interest rate
  • πe = expected inflation rate

Real Money Balances

• Represents the purchasing power of money
• Mreal money balances = M / P (money balances / price level)
• Economic decisions are based on real variables
• There is no money illusion in the long-run
• In the long run, inflation generally has no impact on macroeconomic variables
• In the short run, inflation impacts macroeconomic variables, while sluggish wages slowly catch up

The Cost of Inflation

Menu Cost

• Cost of printing a new menu at a restaurant
• Real cost of changing prices

Shoe-Leather Cost

• Running to the bank to get cash
• Increased transaction cost (TAC)

Distortion of Price Signals

• Identification problem if an increase in nominal price is due to an increase in real price or inflation
• Distorted production decisions

Unintended Redistribution

• Inflation deflates debt
• Redistribution from lender to borrower

Hyperinflation

• Very high inflation rates are self-reinforcing
• Breakdown of the financial system

Note

• Deflation can be even worse

Money

• Money encompasses anything (stock of financial assets) widely accepted in exchange for goods and services

Functions of Money

Store of Value

• Eliminates the necessity for "double-coincidence of wants"

Unit of Account

• Preserves purchasing power over time

Medium of Exchange

• Eliminates the need for multiple prices

Types of Money

Commodity Money

• Has Intrinsic Value
• Examples: Barley, Shells, Gold/Silver

Commodity Backed Money

• Value backed up by a commodity
• Examples: Gold Coins, Paper Money (backed by gold), Cheques
• Italy: Money changers (banco)
• England: Gold smiths develop into banks

Fiat Money

• Value backed by central authority
• Examples: Currency (Notes and coins), Chequing and demand deposits, Debit Cards, eBanking

Cryptocurrency

• Is it potential money?
  • Could it be money if it is widely used?
  • Is it "good" money in terms of being:
    • A Unit of Account
    • A Medium of Exchange
    • A Store of Value