Lecture 5 Measuring Inflation Outline The price level

Lecture 5 Measuring Inflation

Outline • The price level and inflation • Measuring the rate of inflation – The construction of the consumer price index (CPI) – The construction of the GDP deflator 2

Inflation • What is it? 3

Inflation • Inflation is a situation in which economy’s overall price level is rising. • Inflation rate is the % change in the price level from the previous period – Why important? 4

Inflation • Inflation is a situation in which economy’s overall price level is rising. • Inflation rate is the % change in the price level from the previous period – Why important? • Rising prices and purchasing power • Standard of living 5

The Consumer Price Index • Consumer price index (CPI) – Measure of the overall level of prices – Measure of the overall cost of goods and services – Bought by a typical consumer 6

Calculating CPI 1. Fix the basket – Which prices are most important to the typical consumer – Different weights • If customers buy more yam than cassava, then this is weighted more heavily in the CPI basket 2. Find the prices – At each point in time 3. Compute the basket’s cost – Same basket of goods each year 7

Calculating CPI • 8

Illustration • Mathematical Illustration 9

Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers. 10

Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers. 11

Interpretations of Price Levels and Inflation rates • Price level in 2011 = 175 – This means that the price of the basket in 2011 is 175 percent of its price in the base year. – Put differently, a basket of goods that costs $100 in the base year costs $175 in 2011. • Price level in 2012 = 250 – Interpretation? 12

Interpretations of Price Levels and Inflation rates • Inflation rate in 2011 = 75% – Prices increased at a rate of 75% between 2010 and 2011 • Inflation rate in 2012 = 43% – Interpretation? 13

The Consumer Price Index • CPI measures price level • Inflation rate measures how fast this price level is changing – It is possible to calculate the inflation rate for an entire economy – Also possible to calculate for small geographical areas • What is the inflation rate in Ghana? 14

The Consumer Price Index • The goal of the consumer price index is to measure changes in the cost of living. – In other words, the consumer price index tries to gauge how much incomes must rise to maintain a constant standard of living. • The consumer price index, however, is not a perfect measure of the cost of living. • Three problems with the index are widely acknowledged but difficult to solve. 15

The Consumer Price Index • Substitution bias – Prices do not change proportionately – Consumers buy less of the goods whose prices have risen by relatively large amounts • and by buy more of the goods whose prices have risen less or perhaps even have fallen – If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution – Therefore, overstates the increase in the cost of living from one year to the next. 16

The Consumer Price Index • Introduction of new goods – As new goods are introduced, consumers have more choices – Yet because the consumer price index is based on a fixed basket of goods and services, it does not reflect the increase in standard of living that arises from the introduction of new goods – If CPI not revised to include introduction of new goods, citizen’s wellbeing will be understated 17

The Consumer Price Index • Unmeasured Quality Changes – If the quality of a good changes, without a corresponding change in its price, then the calculated CPI statistic not an accurate reflection of consumer well-being – If quality increases, consumers better off – If quality decreases, consumers worse off 18

Uses of the CPI • As a Policy Target – Price stability is an important goal in macroeconomics. – CPI used to gauge inflation • Index payments 19

Applications • Example: – Your father graduated from school and took his first job in 1972, which paid a salary of Ghc 70. Given CPI in 1972 and 2009 as 41. 8 and 214. 5, respectively, what is this salary worth in 2009 Ghc? 20

GDP Deflator • 21

Computing Inflation Using the GDP Deflator • Step 1 - Collect prices and quantities of all goods and services produced within the year • Step 2 - Calculate nominal GDP (? ? ? ) • Step 3 - Calculate real GDP (? ? ? ) • Step 4 - Calculate GDP deflator – Ratio of nominal to real GDP, times 100 • Step 5 - Calculate the inflation rate 22

GDP Deflator This table shows how to calculate real GDP, nominal GDP, and the GDP deflator for a hypothetical economy that produces only hot dogs and hamburgers. 23

GDP Deflator • 24

Calculating Inflation rates • Using CPI • Using GDP 25

GDP deflator vs. CPI • Why does GDP deflator diverge from CPI in measurement of inflation? 26

GDP deflator vs. CPI • Why does GDP deflator diverge from CPI in measurement of inflation? – Composition of goods and services included – Weighting of various prices 27

GDP deflator versus CPI • Composition of goods and services – GDP deflator • Reflects prices of all goods & services produced domestically – CPI • Reflects prices of goods & services bought by consumers 28

GDP deflator versus CPI • Weighting of various prices – GDP deflator • Compares the price of currently produced goods and services – CPI • Compares price of a fixed basket of goods and services 29

Discussion Questions • Suppose the Ghana government buys a Boeing plane. This transaction shows up in Ghana’s GDP deflator, but not in the Consumer Price Index. True/ False? Why? • If Ama buys Kofi’s used 2001 Toyota, this transaction may be captured in the CPI, but not in the GDP deflator. True/False. Why? 30

Discussion Question • Henry Ford paid his workers $5 a day in 1914. If the consumer price index was 10 in 1914 and 218 in 2010, how much is the Ford pay check worth in 2010 dollars? 31

Take-home Problem • A small nation of 10 people idolizes the TV show Mentor. All they produce and consume are karaoke machines and CD’s in the following amounts: Karaoke Machines CDs Quantity Price (Ghc) Quantity Price (ghc) 2011 10 40 30 10 2012 12 60 50 12 – Using the Consumer Price index, compute the percentage change in the overall price level. Set 2011 as base year, and fix the basket at 1 karaoke machine and 3 CDs – Using the GDP deflator, compute the percentage change of the overall price level. Set 2011 as base year – Is the inflation rate in 2012 the same using the two methods? Explain why or why not? 32

Next Class • Unemployment – Definition and Measurement – Types of Unemployment 33