For Sheryl Hogan Economics-2

1

MBA 530 ECONOMICS

Unit 11: An Introduction to Measures of Macroeconomic Performance Part 3: Inflation: Measuring the Cost of Living

** This material is the copyrighted property of Peter W. Schuhmann** Any form of distribution without written permission from the author is

prohibited

These lecture notes contain links to further reading or data, highlighted in blue.

Topics in this lecture:

1. Purchasing power 2. Inflation 3. Index numbers and the Consumer Price Index (CPI) 4. Problems with the CPI 5. Real and nominal wages and income 6. Real and nominal interest rates

We all have a sense of what “inflation” means… The prices that we pay for goods and services are rising over time. The goal of this lecture is to carefully define the concept of inflation and understand how it is measured. Along the way, we’ll develop the idea of using an “index” that will allow us to distinguish changes in nominal output and real output. This can be applied to national output (GDP) or to firm-level output.

Why is an understanding of price changes and the “cost of living” an important concept?

Understanding how prices have changed over time allows for some insight into whether or not people are better off or worse off over time. For example, your grandparents might lament the relatively high prices of certain goods or services today compared to prices in “the old days”. In 1950, a new house could be purchased for around $8,000. Most new cars could be purchased for less than $2,000 and the price of a gallon of gasoline was less than 20 cents. Compared with prices today, these prices are quite low. Do today’s higher prices mean that we are worse off? Not necessarily. In 1950 U.S. per capita GDP was around $14,000.

2

Today it is well over $50,000. To decide whether the average person is better off or worse off than in the past, we need to look at purchasing power.

Purchasing power is the value of currency in terms of its ability to be traded for goods and services. In terms of the above example comparing the price of goods and services in 1950 to those same prices today, we’d ask how far the average income of 1950 went in terms of a consumer’s ability to purchase things compared to today’s average income.

How do we compare values over time?

In order to help with comparisons of value over time, economists often rely on index numbers. Index numbers indicate the value of something relative to a baseline value. The baseline value is usually a number that makes mathematical comparisons easy, like 100. A price index can be used to calculate the rate of inflation to help understand changes in the cost of living over time. Other examples include stock market indices like the Standard & Poor's 500 and the Nasdaq Composite Index.

For example, the consumer price index (CPI) allows us to make such comparisons for consumer goods. The CPI is a measure of the average cost of a standard “basket” (combination) of goods and services commonly purchased by consumers, and is used to measure the impact of changes in prices on households. The CPI is computed and reported by the U.S. Bureau of Labor Statistics (BLS) each month. Importantly for our purposes, the CPI can be used to measure inflation.

What goods are in the CPI?

The CPI market basket contains thousands of goods and services and is created once per decade based on a survey of urban households across the nation conducted by the BLS. The market basket includes items that households spend large portions of their budgets on such as housing, transportation, medical care and food, as well as items such as clothing, recreation and education. To accurately reflect the impact of price changes on household wellbeing, goods and services that households spend more money on are given more weight than those that use up less household income. The CPI is therefore a weighted average of consumer prices.

3

Aside: Steps to calculate an index for sales

Consider the five years of sales data shown below. Suppose we wish to create a sales index so that changes from year to year are easy to understand. Looking at the data, can you easily calculate the percentage increase in sales from 2010 to 2011?

Year Sales 2010 $205,000 2011 $217,000 2012 $238,000 2013 $242,000 2014 $243,000

To create an index of sales, we would follow these steps:

Step 1: Choose a base year. The base year serves as a reference point for comparing change over time. The choice of base year is arbitrary, but it makes sense to choose a year that is easy to remember. Let's choose 2010 for this example, the first year.

Step 2: Divide all sales values by the base year value of sales (205,000). This expresses each year's sales as a ratio relative to the base year.

Step 3: Next, multiply all of the values from Step 2 by 100, to create index values that make math comparisons easy.

We see that the value of the sales index in the base year is 100. Changes in sales relative to the base year are now easy to interpret. For example the index value in 2011 is 105.85. This tells us that sales in 2011 were 105.85 percent of the sales in 2010, which means that sales in 2011 were 5.85 percent higher than sales in 2010.

4

Calculating the rate of inflation

An important takeaway from the above example is that measuring change over time requires the use of a reference point, or a baseline that allows us to measure the degree of change from “then” until “now”. Extending the above example to the idea of price changes over time, we need to have a base period in which prices were measured for a certain set of goods and services. The value of the index number will always be 100 in the base period. The base period currently used for the CPI is 1982-1984.

As above, the CPI is calculated by dividing the cost of the market basket of goods and services in the current year by the cost of the market basket in the base year and multiplying by 100.

𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑰𝑰𝑰𝑰𝑰𝑰𝑷𝑷𝑰𝑰 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝒕𝒕 = � 𝑪𝑪𝑪𝑪𝑪𝑪𝒕𝒕 𝑪𝑪𝒐𝒐 𝑴𝑴𝒀𝒀𝑷𝑷𝑴𝑴𝑷𝑷𝒕𝒕 𝑩𝑩𝒀𝒀𝑪𝑪𝑴𝑴𝑷𝑷𝒕𝒕 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝒕𝒕

𝑪𝑪𝑪𝑪𝑪𝑪𝒕𝒕 𝑪𝑪𝒐𝒐 𝑴𝑴𝒀𝒀𝑷𝑷𝑴𝑴𝑷𝑷𝒕𝒕 𝑩𝑩𝒀𝒀𝑪𝑪𝑴𝑴𝑷𝑷𝒕𝒕 𝑷𝑷𝑰𝑰 𝑩𝑩𝒀𝒀𝑪𝑪𝑷𝑷 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 � ∗ 𝟏𝟏𝟏𝟏𝟏𝟏

We can now use the price index to calculate the percentage change in the price of goods and services over time, which is the inflation rate.

Inflation rate = the percentage change in a price index over time

If the inflation rate is positive, we say there is inflation, and if the inflation rate is negative, we say there is deflation. Deflation in the U.S. is rare, and really has not taken place since the Great Depression.

𝑰𝑰𝑰𝑰𝒐𝒐𝑰𝑰𝒀𝒀𝒕𝒕𝑷𝑷𝑪𝑪𝑰𝑰 𝑹𝑹𝒀𝒀𝒕𝒕𝑷𝑷 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝒕𝒕 = �𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑰𝑰𝑰𝑰𝑰𝑰𝑷𝑷𝑰𝑰 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝒕𝒕 − 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑷𝑷𝑰𝑰𝑰𝑰𝑷𝑷𝑰𝑰 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝒕𝒕−𝟏𝟏 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑰𝑰𝑰𝑰𝑰𝑰𝑷𝑷𝑰𝑰 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝒕𝒕−𝟏𝟏

� ∗ 𝟏𝟏𝟏𝟏𝟏𝟏

The table below shows the annual average CPI for the years 2006-2016. Given that the base period is 1982-1984, we can easily see that prices increased by 137% between the base period and 2015. We can also use this index to calculate inflation between periods. For example, let’s calculate the rate of inflation for 2015.

5

Year Annual CPI 2006 201.60 2007 207.34 2008 215.30 2009 214.54 2010 218.06 2011 224.94 2012 229.59 2013 232.96 2014 236.74 2015 237.02

𝑰𝑰𝑰𝑰𝒐𝒐𝑰𝑰𝒀𝒀𝒕𝒕𝑷𝑷𝑪𝑪𝑰𝑰 𝑹𝑹𝒀𝒀𝒕𝒕𝑷𝑷 𝟐𝟐𝟏𝟏𝟏𝟏𝟐𝟐 = � 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑰𝑰𝑰𝑰𝑰𝑰𝑷𝑷𝑰𝑰 𝑷𝑷𝑰𝑰 𝟐𝟐𝟏𝟏𝟏𝟏𝟐𝟐 − 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑷𝑷𝑰𝑰𝑰𝑰𝑷𝑷𝑰𝑰 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝟐𝟐𝟏𝟏𝟏𝟏𝟐𝟐

𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑰𝑰𝑰𝑰𝑰𝑰𝑷𝑷𝑰𝑰 𝑷𝑷𝑰𝑰 𝒀𝒀𝑷𝑷𝒀𝒀𝑷𝑷 𝟐𝟐𝟏𝟏𝟏𝟏𝟐𝟐 � ∗ 𝟏𝟏𝟏𝟏𝟏𝟏

𝑰𝑰𝑰𝑰𝒐𝒐𝑰𝑰𝒀𝒀𝒕𝒕𝑷𝑷𝑪𝑪𝑰𝑰 𝑹𝑹𝒀𝒀𝒕𝒕𝑷𝑷 𝟐𝟐𝟏𝟏𝟏𝟏𝟐𝟐 = � 𝟐𝟐𝟐𝟐𝟐𝟐. 𝟏𝟏𝟐𝟐 − 𝟐𝟐𝟐𝟐𝟐𝟐. 𝟐𝟐𝟐𝟐

𝟐𝟐𝟐𝟐𝟐𝟐. 𝟐𝟐𝟐𝟐 � ∗ 𝟏𝟏𝟏𝟏𝟏𝟏 = 𝟏𝟏. 𝟏𝟏𝟏𝟏𝟏𝟏𝟐𝟐

This means that prices increased by a little more than one-tenth of one percent between 2014 and 2015.

For context, the average inflation rate in the U.S. was over 7% in the 1970s, almost 6% in the 1980s and more than 3% in the 1990s. Prices are increasing very little from year to year these days!

In addition to the CPI the BLS calculates several other price indices, including the Producer Price Index (PPI) and several import price indices.

6

Problems with the CPI

The CPI is a useful tool for calculating the rate of inflation, which illustrates changes in the overall cost of living. However, it is not a perfect way to measure the average cost of living. Below are some of the issues and concerns with the CPI.

1. Substitution Bias One of the problems with the CPI is that the basket of goods that is used to derive prices only changes every 10 years. Why is a fixed market basket a problem? Because not all prices rise and fall by the same amounts over time (this would be “pure inflation” which is rare), consumers can be expected to shift their purchases away from goods and services for which prices have risen more, and substitute toward goods for which prices have risen relatively less or even have fallen. The CPI does not account for this substitution. For example, suppose that between 2014 and 2015 the average price of restaurant meals increased by 2% and the price of pre-packaged meals at grocery stores increased by 1%. We would expect that consumers would substitute away from restaurant meals and toward pre-packaged meals from grocery stores. But, because the market basket (and the weights assigned to different goods) in calculating the CPI is fixed over time, it will not account for this substitution. Hence, the impact of the restaurant meal price change may appear to be more problematic than it actually is, in terms of household wellbeing.

2. The CPI does not account for changes in product quality The CPI also does not account for changes in the quality of goods and services over time. One of the ways that suppliers implicitly increase prices is to reduce the quality of their products, leaving nominal prices unchanged. These changes would not be accounted for in the market basket and would not show up in the CPI.

3. The CPI does not account for the introduction of new goods and services Because the market basket of goods changes slowly, the introduction of new goods to consumer markets is not reflected in the CPI. For example, e-readers became widely available to consumers in the early 2000s and many consumers quickly adopted this new technology. This product made reading easier and more convenient, making people better off. However, this product was not included in the market basket of goods and services included in the CPI. The associated calculations of the average cost of living did not reflect this improvement.

7

Inflation and Wages & Income

Wages are the monetary compensation paid to labor in exchange for a unit of work (e.g. an hour of work). The sum total of wages earned in a year is income.

Nominal wages are the payments made to labor expressed in current dollars. This is the wage that is negotiated between the employee and employer and is reflected on the employee’s paycheck.

Real wages are nominal wages adjusted for changes in purchasing power that have occurred since a base year. The basic idea is to look backward at what people earned and people’s ability to buy things and answer the question: “What wage would you have earned then to have the same purchasing power that I have today?”

Taking this idea to a larger period of time such as a year, yields the idea of nominal and real income.

Nominal income is the sum of all payments to an employee over a year expressed in current dollars. This is the number that you think of when you think of your income and is what is reported on your tax forms.

Real income is nominal income adjusted for changes in purchasing power that have occurred since a base year. This is what your income means in terms of purchasing power then (base period) compared to now.

Note: The adjustment of nominal wages or income to derive real wages or

income is known as “deflating”, which should not be confused with deflation. Deflating is doing math to change the unit of measure.

Deflation is when prices are falling over time.

To calculate real wages or income, we deflate their nominal values by the rise in the price level that has occurred since the base year. The rise in prices since the base year is calculated as the ratio of the current CPI to 100 (which is the value of the CPI in the base year).

8

𝑹𝑹𝑷𝑷𝒀𝒀𝑰𝑰 𝑾𝑾𝒀𝒀𝑾𝑾𝑷𝑷 = 𝑵𝑵𝑪𝑪𝑵𝑵𝑷𝑷𝑰𝑰𝒀𝒀𝑰𝑰 𝑾𝑾𝒀𝒀𝑾𝑾𝑷𝑷 𝑪𝑪𝑪𝑪𝑷𝑷𝑷𝑷𝑷𝑷𝑰𝑰𝒕𝒕 𝑪𝑪𝑷𝑷𝑰𝑰

𝟏𝟏𝟏𝟏𝟏𝟏

𝑹𝑹𝑷𝑷𝒀𝒀𝑰𝑰 𝑰𝑰𝑰𝑰𝑷𝑷𝑪𝑪𝑵𝑵𝑷𝑷 = 𝑵𝑵𝑪𝑪𝑵𝑵𝑷𝑷𝑰𝑰𝒀𝒀𝑰𝑰 𝑰𝑰𝑰𝑰𝑷𝑷𝑪𝑪𝑵𝑵𝑷𝑷 𝑪𝑪𝑪𝑪𝑷𝑷𝑷𝑷𝑷𝑷𝑰𝑰𝒕𝒕 𝑪𝑪𝑷𝑷𝑰𝑰

𝟏𝟏𝟏𝟏𝟏𝟏

For example, suppose that your current income is $50,000. What would be the value of your real income in 2015 using 1982-1984 as the base period?

𝑹𝑹𝑷𝑷𝒀𝒀𝑰𝑰 𝑰𝑰𝑰𝑰𝑷𝑷𝑪𝑪𝑵𝑵𝑷𝑷 = 𝟐𝟐𝟏𝟏, 𝟏𝟏𝟏𝟏𝟏𝟏 𝟐𝟐𝟐𝟐𝟐𝟐. 𝟏𝟏𝟐𝟐 𝟏𝟏𝟏𝟏𝟏𝟏

= 𝟐𝟐𝟏𝟏, 𝟏𝟏𝟏𝟏𝟏𝟏 𝟐𝟐. 𝟐𝟐𝟐𝟐𝟏𝟏𝟐𝟐

= 𝟐𝟐𝟏𝟏, 𝟏𝟏𝟎𝟎𝟐𝟐

What does this value mean? This means that having an income of $50,000 in 2015 was equivalent to having an income of $21,097 in the early 1980s in terms of purchasing power.

The above formula works to deflate any value, including the value of a dollar, and therefore can be used to examine purchasing power in an easy-to-understand way.

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑜𝑜 $1 𝑡𝑡𝑃𝑃𝑡𝑡𝑎𝑎𝑡𝑡 𝑃𝑃𝑃𝑃𝑟𝑟𝑎𝑎𝑡𝑡𝑎𝑎𝑟𝑟𝑃𝑃 𝑡𝑡𝑃𝑃 𝑏𝑏𝑎𝑎𝑎𝑎𝑃𝑃 𝑝𝑝𝑃𝑃𝑃𝑃𝑎𝑎𝑃𝑃𝑡𝑡 = $𝟏𝟏

𝑪𝑪𝑪𝑪𝑷𝑷𝑷𝑷𝑷𝑷𝑰𝑰𝒕𝒕 𝑪𝑪𝑷𝑷𝑰𝑰 𝟏𝟏𝟏𝟏𝟏𝟏

Applying the above formula to derive the purchasing power of $1 in 2015 with 1982-1984 as a base period yields $0.42, meaning that $1 in 2015 purchases what could have been purchased in the early 1980s for 42 cents. Of course, this is an approximation, because people are buying different goods and services than they did in the 1980s. We spend a lot less on hair spray, hair crimpers and parachute pants today than we did then for example.

9

Inflation and Borrowing

Suppose you borrowed $1,000 from a friend today promising to them back $1,050 in one year (i.e. you will pay a 5% annual interest rate). Now suppose that the price of everything increases by 10% over the course of the year. Who got a better deal on the loan?

Even though you paid a nominal interest rate of 5%, the real interest rate you paid is -5% (negative 5%). As the borrower during a period of significant inflation, you got the better end of the deal.

Here is one way to think about it… Suppose that at the beginning of the loan you purchased a TV for $1,000. A year later the lender friend wants to purchase the same TV. How much will it cost? If inflation was 10%, the price of the TV would be $1,100. So the lender gave up 1 TV worth of purchasing power and got less than 1 TV worth of purchasing power in return. The borrower received 1 TV worth of purchasing power and paid back less than 1 TV worth of purchasing power.

The nominal interest rate is the annual percentage of the amount of a loan that is earned by the lender and paid by the borrower.

The real interest rate is the actual annual percentage of the amount of a loan that is earned by the lender and paid by the borrower in terms of the change in purchasing power that has transpired over the term of the loan.

𝑹𝑹𝑷𝑷𝒀𝒀𝑰𝑰 𝑰𝑰𝑰𝑰𝒕𝒕𝑷𝑷𝑷𝑷𝑷𝑷𝑪𝑪𝒕𝒕 𝑹𝑹𝒀𝒀𝒕𝒕𝑷𝑷 = 𝑵𝑵𝑪𝑪𝑵𝑵𝑷𝑷𝑰𝑰𝒀𝒀𝑰𝑰 𝑰𝑰𝑰𝑰𝒕𝒕𝑷𝑷𝑷𝑷𝑷𝑷𝑪𝑪𝒕𝒕 𝑹𝑹𝒀𝒀𝒕𝒕𝑷𝑷 − 𝑰𝑰𝑰𝑰𝒐𝒐𝑰𝑰𝒀𝒀𝒕𝒕𝑷𝑷𝑪𝑪𝑰𝑰 𝑹𝑹𝒀𝒀𝒕𝒕𝑷𝑷

This shows that inflation decreases the monetary returns to lenders in terms of the real value of currency and increases the purchasing power of borrowers.

10

Inflation and the macro economy

Is inflation a “problem” for the performance of the economy?

Consumers and producers often make purchasing decisions based on their expectations (we covered this in our discussion of Supply and Demand). If consumers think that prices will be higher in the future, today’s demand may increase as people attempt to purchase goods and services while prices are relatively low. Similarly, if consumers anticipate that prices will fall in the near future, current demand may decrease as buyers wait for a more favorable price. Hence, anticipated inflation affects the choices of buyers, including businesses who purchase goods and services as part of their operations.

In this regard, a little bit of steady inflation can be seen as a good thing for the macro economy to the extent that consumer purchases are an important component of economic growth. The anticipation that prices are rising will drive current consumption and stimulate business activity.

However, as we have seen above, inflation can mean that real wages and income are declining, meaning that consumers have less purchasing power. If the rate of inflation is higher than the increase in nominal wages or income over a given period of time, real wages and incomes are falling and income is essentially redistributed from workers to their employers. All else equal, this will reduce consumption.

We also learned that inflation can serve to transfer wealth from creditors to borrowers. Creditors will naturally attempt to predict inflation and incorporate their expectations into their nominal rates to account for an anticipated loss in purchasing power. This idea suggests that stable inflation is good for an economy in terms of circulating loanable funds, especially long-term loans, which can stimulate investment.

Unanticipated inflation will increase the purchasing power of borrowers and decrease the purchasing power of lenders. On a micro level, whether this is good or bad depends on who you are. If you are a net saver, unanticipated inflation is probably bad. If you are net borrower, it’s probably good. Keep in mind that if inflation is less than anticipated, the opposite holds true. If inflation reduces the supply of loanable funds (because returns to saving are eroded by higher prices), then inflation can be bad for an economy, because savings fund investment.