Introduction to Macroeconomics

5. Measuring Changes in Prices

Contents

1. Inflation and Deflation
2. Costs of Inflation
1. Purchasing Power
2. Menu Costs
3. Expected Versus Unexpected Inflation
3. Measuring Inflation with Price Indexes
1. GDP Deflator
2. Consumer Price Index (CPI)
3. GDP Deflator / CPI Differences
4. Problems With Traditional Price Indexes
5. Chain-Weighted Price Index
4. Causes of Inflation
1. Money Supply
2. Demand-Pull Inflation
3. Cost-Push Inflation
4. Expectations

1. Inflation and Deflation

When the average level of prices increases over time the economy is said to be experiencing inflation. When the average level of prices declines, as it did in the 1930s, we have deflation.

It is important to recognize that we can have inflation even though the prices on some products are falling. For example, during the 1990s, the rate of inflation in the United States averaged about 4 per cent per year even though the prices of computers and other electronic products declined significantly. Price increases in some sectors of the economy must have outweighed price declines in other sectors in order for the average level of prices to rise.

Hyperinflation is a term used to denote a very high rate of inflation. There is no firm definition of "very high." Some researchers define hyperinflation as a rate that exceeds 50 percent per month. Others describe hyperinflation as a rate that exceeds 200 percent per year. Hyperinflation is usually related to the need of governments to print paper money to finance large fiscal deficits caused by wars, revolutions, the establishment of new states, or exorbitant social programs.

The classic case of hyperinflation is that of Germany in 1923. Between July 1923 and November 1923, prices increased by over 300,000,000 percent. For example, the cost of a local postage stamp in Germany grew from 1,000 Reichsmarks on August 1, 1923 to 100,000,000,000 Reichsmarks by December 1, 1923 (http://www.lingens.com/articles/roy/germinfl.shtml). While the reparations for World War I set by the Allied Reparation Commission was blamed, the fault really was with the policies and political objectives of the German Reichsbank. At the end of 1923 a new monetary system was initiated with 1 Rentenmark replacing 1 trillion Reichsmarks. The hyperinflation quickly ended with the new currency backed by land and a new independent central bank created to control the amount of money printed.

2. Costs of Inflation

Inflation isn't necessarily detrimental to everyone. Who benefits and who is hurt from inflation? If one person wins and one person loses is the macroeconomy necessarily worse off?

Purchasing Power

The most obvious cost of inflation to individuals is that the cash you have in your pocket or bank account won't buy as many things after there has been an increase in prices. Let's say you have $100 in your checking account. This might buy 6 DVD videos. If prices go up by 15 percent, your $100 can now only buy 5 DVDs. The cash you hold loses purchasing power.

Purchasing Power - the quantity of goods and services that can be purchased with a given amount of money; the value of money.

The problem of declining purchasing power also applies to those on a fixed income such as retirees. Many company retirement programs supplement Social Security with a monthly payment. However, while Social Security benefit payments increase every year to keep up with inflation (payments are "indexed" to inflation to maintain purchasing power), corporate retirement programs often do not. Inflation erodes the value of fixed retirement pensions.

If inflation is high enough people may want to avoid holding money completely. This would force the economy to operate using barter transactions. Barter, as we discussed in an earlier chapter, is inefficient because it requires a double coincidence of wants and because of the problem of indivisibility of many products and services.

If inflation and the loss of purchasing power is bad does this mean that deflation is good? Probably not for the individual and certainly not for the macroeconomy. With deflation and an expected decline in product prices people have an incentive to hold their money and not make purchases. For an individual this means the enjoyment of goods and services must be delayed. For the macroeconomy it can be disastrous when consumer spending declines. A decline in consumer spending means less output, job layoffs, and a further deteriorating economy. Firms that have borrowed money find it more difficult to repay with reduced demand and lower product prices. Businesses default on their loans, banks fail, investment is curtailed, and the economy deteriorates further.

Menu Costs

Businesses incur costs when prices change. As the cost of inputs to the production process rise firms must increase their product prices to maintain a profit. In a simple example consider the restaurant or mail-order catalogue firm that has to print new menus or catalogues to keep up with changing prices. Relying on "call for a price" or a disclaimer such as "prices subject to change" can alienate customers. These firms face a problem in timing. How often should they change their product price menu? If inflation is low the lost profits from holding product prices steady may be less than their menu costs and they can avoid frequent price changes. If inflation is high then the loss in profits can motivate more frequent price changes.

Menu costs represent a cost to not only individuals but also the macroeconomy. Menu costs reduce overall economic efficiency in that they represent an unnecessary cost of transforming resources into final goods and services. How important menu costs are is difficult to say. But even firms that do not have explicit menu costs such as printing a catalogue still face uncertainty in deciding how much and how frequently to raise their prices.

Expected Versus Unexpected Inflation

The loss of purchasing power and menu costs occur whether inflation is expected or unexpected. Perhaps the most significant costs occur when price inflation is unexpected. Many contracts for the purchase of goods and services cover extended periods of time. For example, salaries and wages paid under labor contracts are usually adjusted only once a year and some labor contracts cover two or three years. Payments for the purchase of a car last three years or more while payments on a house usually last 30 years.

When long-term contracts such as loans are entered into the nominal interest rate charged includes the expected inflation rate. No lender would want to give you money for repayment at 4 percent nominal interest rate when they expect the inflation rate to average 5 percent. The money the lender eventually gets back in payments would have less purchasing power than when it was loaned out. The difference between the nominal interest and the expected rate of inflation is called the real interest rate.

Nominal Interest Rate - the market interest rate that is paid by borrowers to lenders. Real Interest Rate = nominal interest rate - expected rate of price inflation.

What happens when there is an unexpected surge in the inflation rate? Borrowers win and lenders lose. Consider someone who borrows $200,000 to buy a house with a mortgage (interest) rate of 7 percent. Now assume there was some unexpected event such that the inflation rate jumps to 100 percent. When the average level of prices doubles it is likely the value of the house likewise increased. The borrower now has a house worth about $400,000 but only borrowed $200,000 to buy it. When the lender gets the $200,000 plus 7 percent interest back doesn't it come close to matching the increase in the average level of prices. If the sudden surge in inflation were expected the interest rate on the loan would have been higher. Just the opposite would happen if the inflation rate comes in lower than expected. Whether higher or lower, unexpected changes in the inflation rate lead to arbitrary redistributions of income.

For the macroeconomy the problem is not that people win sometimes and lose at other times. The transfer of wealth from one person to another is not a net loss to the macroeconomy. The macro problem arises because uncertainty over the inflation rate makes it difficult to negotiate contracts and reduces the overall level of economic activity. Lenders and borrowers become reluctant to enter into long-term contracts. Fewer cars and houses are sold and firms become reluctant to borrow money for new capital investment. Labor negotiations become stalled over future pay increases possibly leading to strikes or work stoppages.

Unexpected changes in the inflation rate also make it difficult to distinguish changes in relative prices from changes in the average price level. The microeconomic supply and demand model depends on changes in relative prices. If the price of a particular good or service increases relative to the price of all other goods and services then firms have an incentive to produce more and consumers purchase less. A general price increase on the other hand means that relative prices possibly remain unchanged. As the price of a particular good rises so do the prices of other goods and services. In this situation firms and consumers may have no incentive to change their behavior since relative prices remain unchanged. Thus, when you have instability in the inflation rate, firms and consumers become less certain whether a change in the price of a particular good represents a change in its price relative to all other goods and services or if it is matched by a change in the prices of other substitute goods and services. The price mechanism that encourages equilibrium in the microeconomic model breaks down when there is uncertainty. If you do not have equilibrium in the markets for particular goods and services you do not have economic efficiency.

3. Measuring Inflation with Price Indexes

How is the "average level of prices" determined? Every month the Bureau of Labor Statistics sends out people to determine quantities and prices from producers, stores, and households nationwide. The prices on all the different goods and services are weighted according to quantities sold to arrive at an average price, or price index. Of course the devil is in the details. There are many different price indexes and different ways of calculating each one.

A price index does not directly measure the average level of prices. For example, suppose we sell one car at $20,000 and one doll at $20. Is the average price level $10,010 ($20,020 total sales divided by 2 products sold)? If the next year well sell one car and two dolls, does that mean the average price level then declines to $6,680 ($20,040 total sales divided by 3 products sold). Because we can't construct a meaningful average price based on total dollar sales divided by the total number of goods sold, we create a price index. A price index can be used to measure changes in the average level of prices.

To create a price index we (arbitrarily) assign one year as the base year. We determine all changes in prices from that base year then weight the change in price for each good by the total value of that good sold. For a simple example, assume we have an economy in which 80% of the total dollars spent go towards food and the other 20% goes to clothing. Now assume the price of food increases by 10% from one year to the next while the price of clothing remains unchanged. The average level of prices is then estimated to have increased by 8% (80% x 10% + 20% x 0%).

For a typical price index we follow four basic steps:

1. Select the kinds and quantities of goods and services to be included in the index. For example, with the Consumer Price Index we would identify only those goods and services that an average household would purchase. For a producer price index we would select goods and services that a manufacturer might purchase. Milk would be included only in the consumer index while rolled steel only included in the producer index. The selected goods and services is called the market basket.
2. Determine what it would cost to purchase the quantities of goods and services in the market basket in some year identified as the base year. The base year represents the period against which the prices in all other periods are compared. The selection of a base year is arbitrary. In general the base year selected will be fairly recent, say within the last five to ten years. For example, it wouldn't be useful to use 1900 as the base year since many goods and services sold in 1900 are not sold today and vice versa. Consequently, over time the selected base year may be changed to a more recent one and the price index values for every year updated.
3. Calculate the total cost to purchase the same market basket of goods and service in the current year.
4. Calculate the price index, which equals the current total cost divided by the base-year total cost for an unchanging quantity ("market basket") of goods. In effect what you have is an identical selection of goods and services in the base year and current year but with different prices. Prices time quantities for the current year divided by prices time quantities for the base year with quantities unchanged leaves only prices changing.

   Price Index =	current-year total cost of market basket of goods and services
   	base-year total cost of market basket of goods and services

The price index for the base year is (again arbitrarily) assigned a value of 100 (the price index calculated above times 100). The price index for years other than the base year indicates the change in the average level of prices between that year and the base year. In the example above where the average level of prices was estimated to have increased by 8% the price index may have increased from 100 to 108, an 8% increase.

GDP Deflator

Having identified "nominal" and "real" GDP in the preceding chapter we can calculate a price index. The GDP Deflator (also known as the Implicit GDP Deflator or Implicit Price Deflator) is a price index that represents the change in the average level of prices of all goods and services produced in an economy (i.e., included in GDP). The GDP deflator is measured by comparing the current value of total output (nominal GDP) to the value of the output if prices had not changed from the base year (real GDP).

GDP Deflator - the economy's aggregate price index, equal to the ratio of nominal GDP to real GDP. GDP Deflator = Nominal (current-dollar) GDP * 100 Real (constant-dollar) GDP The GDP Deflator is calculated and reported quarterly by the Bureau of Economic Analysis (http://www.bea.doc.gov)

The GDP Deflator is described as a variable-weight price index (also referred to as a Paasche price index) because the goods and services covered change from year-to-year. For example, the 1997 GDP deflator is based on a comparison of the total value of all goods and services sold in 1997 with what those same goods and services would have cost using base year prices. The 1998 GDP Deflator, on the other hand, makes the same calculation but uses 1998 quantities and prices (and base year prices).

Let's use the simple economy in Table 5-2 to calculate nominal GDP, real GDP, and the GDP deflator.

Table 5-2. A simple macroeconomy.
	Average Product Prices				Quantities Sold
	1992	1994	% Change		1992	1994
Food	$12	$14	17%		4	5
Housing	9	10	11%		3	3
Fun	4	5	25%		3	4
Machines	20	20	0%		2	2

It is not obvious by simply looking at Table 5-2 (originally presented in Chapter 4) what the average inflation rate was between 1992 and 1994. For example, consider just Fun and Machines. With the price of fun rising 25% and the price of machines not changing we can not say the average price level went up by 12.5%. First, there was more fun sold than machines, which implies that fun should be weighted more heavily when calculating average price changes. But, the price of machines was much higher so more money was spent on machines and machines should be given more emphasis.

First, we start by calculating nominal GDP and real GDP as we did in Chapter 4, using 1992 as the base year in calculating real GDP:

	1992	1994
Nominal GDP	127	160
Real GDP	127	143

Next we calculate the GDP Deflator for each year:

1994 GDP Deflator =	1994 Nominal GDP
	1994 Real GDP
=	sum of [(current prices) x (current quantities)]    * 100
	sum of [(base year prices) x (current quantities)]
=	($160 / $143) * 100
=	111.9

The GDP Deflator (and any price index) is equal to 100 in the base year:

1992 GDP Deflator =	1992 Nominal GDP
	1992 Real GDP
=	($127 / $127) * 100
=	100

Inflation is then calculated as the percent change in the GDP Deflator:

Inflation, percent =	(GDP Deflator Year 2 - GDP Deflator Year 1) * 100
	GDP Deflator Year 1
=	(111.9 - 100) * 100
	100
=	11.9 %

Inflation Rate - percentage rate of increase in the price index per period. Inflation Rate = Price Index Year 2 - Price Index Year 1 * 100 Price Index Year 1

Consumer Price Index (CPI)

An alternative measure of price inflation is the Consumer Price Index (CPI). The CPI is a specialized measure of inflation in that it measures only the inflation rate of goods and services purchased by the typical household. It excludes some products covered by the GDP Deflator such capital goods purchased by firms and goods and services purchased by the government. But the CPI includes household purchases of imports that are excluded from GDP and the GDP deflator.

Consumer Price Index (CPI) - an approximate measure of changes in the cost of living of consumers. The CPI is based on a typical "market basket" of goods and services purchased by the average household. The CPI is calculated and reported monthly by the Bureau of Labor Statistics (http://www.bls.gov)

One significant characteristic of the CPI is that the goods and services included in the index are assumed not to change over time. Consequently, the CPI is described as a fixed-weight price index (also referred to as a Laspeyres price index), which measures the cost of a fixed basket of goods relative to a base period. In other words, the quantities of goods and services included in the CPI do not change from year-to-year as they do in the GDP Deflator. The market basket of goods in the CPI is based on the Consumer Expenditure Survey, which is conducted about once every 10 years.

1994 CPI =	sum of [(current prices) x (fixed market basket quantities)]   * 100
	sum of [(base year prices) x (fixed market basket quantities)]

Assume in the simple economy in Table 5-2 above that 1992 is the base year and that the quantity of food, housing, and fun sold in 1992 represents the quantities in our fixed market basket of goods (machines are excluded because they are purchased by businesses and not households). Since 1992 represents both the base year for prices and the quantities of goods in our fixed market basket, we know that the CPI for 1992 equals 100.

1994 CPI =	[1992 Prices x 1992 Quantities] * 100 = 100
	[1992 Prices x 1992 Quantities]

We then calculate the CPI for 1994:

1994 CPI =	[1994 Prices x 1992 Quantities] * 100
	[1992 Prices x 1992 Quantities]
=	($14 x 4) + ($10 x 3) + ($5 x 3) * 100
	($12 x 4) + ($9 x 3) + ($4 x 3)
=	[$56 + $30 + $15] * 100
	[$48 + $27 + $12]
=	($101 / $87) * 100
=	116.1

Note: In the CPI calculation machines are not included because they are not "consumer" item

And the rate of inflation calculted using the Consumer Price Index is:

Inflation, % =	(CPI Year 2 - CPI Year 1) * 100
	CPI Year 1
=	(116.1 - 100.0) * 100
	100
=	16.1%

GDP Deflator / CPI Differences

	GDP Deflator	Consumer Price Index
Basket of goods	All goods	Fixed basket of Consumer goods
Include imports?	No	Yes
Does basket of goods change?	Yes - current quantities	No - fixed (base year)

Figure 5-1. CPI versus the GDP Deflator. Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (http://www.bls.gov/)

Problems With Traditional Price Indexes

The traditional calculation of the GDP Deflator and the Consumer Price Index presented above causes two significant problems:

1. Use of either the fixed-weight (CPI) or variable-weight (GDP Deflator) price index requires the specification of a base year. Over time the base year becomes more and more outdated. For example, if 1992 is the base year in the GDP deflator, what 1992 base year price do you use for personal computers that are sold today? Or, if 1992 is the base year that defines the consumer's market basket of goods in the CPI, how do we account for the recent rapid increase in sales of personal computers? While this is a problem for the economists calculating these indexes, it leads to a situation that confounds everyone. Every time the base year is redesignated to bring it up to date, the full history of GDP deflators and consumer price indexes must be recalculated and history changes. You can see this for yourself by recalculating 1992 and 1994 nominal and real GDP in the example above using 1994 as the new base year and find that the growth rate in real GDP and the inflation rate are significantly different.
2. It has long been known that the CPI overstates the inflation rate. The reason is substitution bias. Consider two substitutes in consumption, butter and margarine. Let's say 1992 is the base year for establishing the market basket of goods (the quantities households typically consume). Between 1992 and 1994 assume there is a large increase in the price of butter but not margarine. We should expect that in 1994 consumers purchase more of the lower-price margarine and less of the higher-priced butter. But, the CPI does not recognize this substitution to the lower-priced good. The CPI assumes households are still purchasing the same quantities in 1994 that they were in 1992. Thus the CPI reports that consumers are paying more for bread spreads in 1994 than they actually are.

   The GDP deflator has the opposite problem. The GDP deflator tends to understate the inflation rate (although the logic is a little trickier). Again consider the butter-margarine example. When calculating 1994 real GDP we use 1994 quantities and 1992 prices. But at 1992 prices people would buy more butter and less margarine. Consequently the 1994 real GDP includes more margarine for which prices rose slightly and less butter for which prices rose more sharply. Real GDP is larger and the GDP deflator is smaller than it should be.

Chain-Weighted Price Index

Extensive research in price index theory has developed several alternative indexes that have characteristics that are preferable to the traditional GDP deflator and Consumer Price Index. Unfortunately, there is no perfect or even best index. The CPI Advisory Commission (also called the Boskin Commission) appointed by the U.S. Senate in 1995, concluded the CPI overstates the change in the cost of living by about 1.1 percentage points per year. That is, if inflation as measured by the CPI is 5 percent, the true increase in the cost of living is about 4 percent. The Commission recommended that inflation indexes should change from fixed base year formulas to a moving base year method that accommodates consumer substitution. In short, the solution to the problem of an increasingly outdated base year is always use the previous year as the base year.

The Bureau of Economic Analysis switched to a chain-type index, also known as a Fisher index, in 1996 for calculating changes in real GDP and the GDP price deflator. Each year a quantity index and price index are calculated using a moving base year. For example, the 1996-97 change in real GDP (quantity index) is calculated using the average of 1996 and 1997 prices. Average prices in 1997 and 1998 are used to measure the growth rate of real GDP from 1997 to 1998. A time series of chain-weighted GDP (i.e., real GDP) is then created by multiplying a base year (1996) nominal GDP by the subsequent chained (multiplied) quantity indexes.

Beginning in January 1999, the Bureau of Labor Statistics converted from the traditional method for calculating the Consumer Price Index to a geometric mean method in categories that account for about 61 percent of total consumer spending represented by the CPI. Let's consider a simple approach (the actual process is slightly different). First an index is calculated using a market basket of goods (quantities) based on sales the year before. Then an index is calculated using the current year quantities as the representative market basket of goods. The CPI is the geometric mean of the two indexes, i.e., the square root of index 1 multiplied by index 2.

For more comprehensive explanations of the problems with price indexes and a description of chain-weighted price indexes refer to the analysis reports published by the Bureau of Economic Analysis (http://www.bea.doc.gov) and the Bureau of Labor Statistics (http://www.bls.gov). A very good discussion is also available in a series of articles published in the Journal of Economics Perspectives, Winter 1998 (Volume 12, Number 1).

4. Causes of Inflation

There is no simple answer to what causes inflation. Hopefully by the end of this course we will have a better idea about the complex interactions between aggregate demand, aggregate supply, government fiscal policy, money supply, international trade, prices, interest rates, and exchange rates. But we can make some general observations.

Money Supply

Money supply probably plays the number one role in inflation. Money supply refers to the quantity of currency in circulation. Governments increase money supply by printing currency and moving it to the market buy buying goods and services, by direct payments to citizens such as through tax refunds, and by other means. When the government increases money supply faster than the economy is growing you generally end up with inflation. When more and more currency is being used to purchase the same number of goods and services the cash prices of those goods and services go up.

Demand-Pull Inflation

In the simple microeconomic supply-demand model for a single good, the price of the good increases when there is an increase in demand (a rightward shift in the demand curve) for the good. The mechanism in the macroeconomic model is different but the result is the same. With an economy running at full capacity (on its production possibilities frontier) an increase in aggregate demand may result not in an increase in output but an increase in prices. The increase in prices reduces the purchasing power of money, which returns aggregate demand to equilibrium with aggregate supply. The increase in demand pulls prices up.

Cost-Push Inflation

The supply side can also be responsible for price inflation. When the price of resources in the production process increases, firms try to pass on these increases to the product price. The oil price shocks of the 1970s is the classic example of cost-push inflation. Increases in energy costs, first because of the Iranian revolution and then from the Arab oil embargo, pushed prices upwards.

Expectations

Demand-pull and cost-push inflation generally can't be sustained over a long period. Markets should adjust to return an economy to equilibrium. But consumer and business expectations can extend the inflationary experience. For example, when labor observes a period of unexpectedly high inflation their expectations may now be for continued high inflation. Labor demands new contracts with larger wage increases. Firms must pass the wage increase on to consumers and product prices rise further. An inflationary spiral can occur when expectations for high or increasing inflation become self-fulfilling.

File last modified: May 1, 2003

© Tancred Lidderdale (Tancred@Lidderdale.com)