Inflation BasicsInflation Basics

Dr. D. Foster – ECO 285 – Spring 2014

Required Readings - CPI• Critiquing the CPI (St. Louis Fed)

• Overview of BLS Statistics on Inflation and Prices (BLS)

• Common misconceptions about the CPI – Q&A (BLS)

• Response to BLS (Shadow Gov’t Statistics)

• Alternative Inflation Measures (Shadow Gov’t Statistics)

• Differences between CPI-U and C-CPI-U (CBO)

• Chained, Chained, Chained (The Economist)

• Taking the Price Temperature (Mises.org)

• Peter Schiff on “inflation propaganda” (YouTube)

Inflation Defined

A continuous rise in the general price level.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 levelgeneral price level”?

Price level is shown by a Price IndexPrice Index•Hold quantities constant over time

• Use old quantities

• Use new quantities

•Allow some quantity change

Laspeyres; CPI

Paasche

Chained CPI & GDP deflator

Laspeyres & Paasche price indexes

• Laspeyres:

• Paasche:

∑(P1*Q0Q0)∑(P0*Q0Q0)

∑(P1*Q1Q1)∑(P0*Q1Q1)

= 103.34$456.00$441.25

=

$447.00$440.50

= = 101.48

The CPI uses a Laspeyres index like

this, showing inflation of 3.34%.

The Consumer Price Index(es)• CPI-UCPI-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-UCPI-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 FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)

• HOUSINGHOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

• APPARELAPPAREL (men's shirts and sweaters, women's dresses, jewelry)

• TRANSPORTATIONTRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

• MEDICAL CARE MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

• RECREATIONRECREATION (televisions, toys, pets and pet products, sports equipment, admissions);

• EDUCATION AND COMMUNICATION EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

• OTHER GOODS AND SERVICES 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-WCPI-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-UC-CPI-U: Chained CPI, all consumers

– A variable-weight index.

– Designed to account for “substitution biassubstitution 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: Example: Your income in 2013 is $32,000 and in 2014 it is $33,100.Q - Are you “better off?”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%26.6%

Approx. annual inflation = 2.66% (10 years)

Actual ave. annual inflation = (233/184)^(1/10)-1 = 2.39%2.39%

Calculating the C-CPI-U

L: 103.34P: 101.48

For further information (recommended)For further information (recommended)

• Wiki on Price Index• Wiki on Consumer Price Index• Wiki on Chained Consumer Price Index• The Chained CPI: What Is It …• Wiki on Producer Price Index• BLS on Producer Price Index FAQs• Wiki on GDP Deflator

Inflation BasicsInflation Basics

Dr. D. Foster – ECO 285 – Spring 2014