INFLATION-THE CONSUMER PRICE INDEX AND THE COST OF LIVING

Principles of MacroeconomicsLecture 5

What do you think?

1976: Starting salary for an economics professor was $15,000

2001: Starting salary for an econ. prof. was $55,000.

Considering the REALITY PRINCIPLE, who had a better life?

Reality Principle

What matters to people is the real value of money – its PURCHASING POWER – not the nominal or face value of money.

CPI:

Consumer Price Index

A price index that measures the cost of a fixed basket of goods chosen to represent the consumption pattern of individuals. Tracks the cost of

living over time.

What is in the “market basket”? Food and

Beverages Housing Apparel Transportation Medical Care Recreation Education Other goods and

services

Food and Beverages

Breakfast Cereal Milk Chicken Wine Coffee Service meals Snacks

Housing

Rent for primary residences

Owners equivalent rent

Fuel Oil (home heating)

Bedroom furniture

Apparel

Men’s shirts and sweaters

Women’s dresses Jewellery

Transportation

New cars Airline fares Gasoline Car insurance

Medical Care

Prescription drugs

Medical supplies Doctor services Eyeglasses Eyeglass services Hospital care

Recreation

Television Pets Pet products Sports equipment Admissions

Education and Communication

College Tuition Postage Telephone

Services Computer

Software Computer

accessories

Other Goods and Services

Tobacco and smoking products

Haircuts Other personal

services Funeral Expenses

CPI

Used by both government and the private sector to measure changes in prices facing consumers.

CPI versus GDP

CPI measures goods produced in prior years (older cars) as well as imported goods.

Chained GDP does not measure either of these. ONLY new goods and those produced in the country.

CPI vs GDP

Because consumers will cut back on goods that cost more – the CPI will tend to overstate true changes in cost of living. If chicken goes up

in price, we switch to hamburger.

CPI Problems

Does not “cut back” on higher priced goods like consumers do.

Would still count the same share of chicken as it did before the price index.

What Economists THINK

CPI may be overestimated by 0.5% to 1.5% each year.

BIG argument among the econ community.

Cost of Living Adjustments

Automatic increases in wages or other payments that are tied to a price index.

For Future Reference on contract negotiations: Called COLA.

COLA and CPI

As CPI goes up, our wages or Social Security makes adjustments to keep up with the cost of living.

INFLATION

Inflation Rate: The percentage

rate of change of the price level of the economy.

Calculating Inflation Rates

Inflation Rate = percentage rate of change of a price index.

See page 124 for more on how to calculate!

INFLATIONINFLATION

– The trade-off with more employment.

                                                                                              

                                                  

Types of InflationTypes of Inflation

Demand-Pull Inflation Cost-Push Inflation Monetary Inflation Stagflation Hyperinflation

Demand-Pull InflationDemand-Pull Inflation

When the demand for goods and services exceeds the production capacity.– Prices rising because

of shortages.

Cost-Push InflationCost-Push Inflation

Inflation can arise from changes in the costs of production of goods and services.– Increase in the price of raw

materials– Increase in the price of

labor– Increase in the cost of

capital.

Cost-Push v. Demand Pull Cost-Push v. Demand Pull

They push and pull prices up.– Labour contracts

containing COLA clauses.

Cost-Of-Living

Adjustments.

Monetary InflationMonetary Inflation

Inflation caused by excessive growth in the money supply.– Value of money

decreases if it isn’t that “rare.”

Rule for Monetary Inflation: Rule for Monetary Inflation: VELOCITYVELOCITY

Quantity Equation– M x V = T x P– Money supply times

the velocity at which it changes hands equals the number of transactions times the average level of prices.

M x V = T x PM x V = T x P

Direct relationship between the money supply and the price level.

What happens when the What happens when the quantity equation is quantity equation is ““offoff””??

Hyperinflation Money supply

increases much, much faster than an economy’s output of goods and services.– THINK RUSSIA in

1990s.– Zimbabwe in 2000s– Germany post WWI

Phillips Curve: The Phillips Curve: The relationship between relationship between

unemployment and inflation.unemployment and inflation.INVERSE relationship.

Unemployment goes UP, then inflation goes DOWN.

Stagflation: When things Stagflation: When things REALLY go wrong on the REALLY go wrong on the

Phillips CurvePhillips Curve Inflation and

unemployment were at higher levels.– Combination of

stagnation and inflation.

– Both were increasing.

1970s: What caused 1970s: What caused Stagflation?Stagflation?

Spending on the Vietnam War PLUS spending on domestic social programs.

Inflationary expectations Rise in energy costs caused by OPEC Monopolistic pricing

What is wrong with Inflation?What is wrong with Inflation?

Inflation reduces REAL INCOME of those whose incomes do not rise as fast as the price level.

Hurts:– People holding assets

in MONEY– Lenders

Special Note: Phillips Curve Special Note: Phillips Curve InternationalInternational

– Europe 1970s had higher inflation and unemployment.

– Worse because: Labour union practices Tax structures Government economic

policies

Consequences of INFLATIONConsequences of INFLATION

Income Effects:– Reduced purchasing

power of the dollar– Reduced real income

for fixed income receivers

– Reduced real wealth of savings

Income Effects of Inflation Income Effects of Inflation (cont.)(cont.)

Benefits those whose incomes rise faster than the inflation rate.

Benefits owners of real assets (real estate, precious metals (kinda!))

Benefits debtors

How Inflation effects Real How Inflation effects Real OutputOutput

Inflation initially stimulates output

Near full employment, there arise bottlenecks in supplies

Costs begin rising faster than prices

Interest rates accelerate, discouraging new investment.

Helpful Reading

Economics. Samuelson, & Nordhaus (2005) Ch. 29-30