Module 2 - Inflation
Module 2 - Inflation
Module 2 - Inflation
Inflation
Learning Objectives:
• Define Inflation and its types
• Calculating CPI and GDP deflator and Measure inflation rate (With
the help of MS - Excel
• Explain the difference between demand-pull and cost-push
inflation
• Explain other types of inflation and their causes
• Define Inflation and its types
Module 2: Inflation 1
Inflation, Price Level and CPI
Module 2: Inflation 2
How the CPI Is Calculated
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How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
price of price of
year cost of basket
pizza Pepsi
2010 $10 $2.00 $10 x 4 + $2 x 10 = $60
2011 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2012 $12 $3.00 $12 x 4 + $3 x 10 = $78
Compute CPI (Inflation rate) in each year using 2010 as base year
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ACTIVE LEARNING 1
Calculate the CPI
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ACTIVE LEARNING 1
Answers
CPI basket: price price of
{10 lbs beef, 20 lbs chicken} of beef chicken
The CPI basket cost $120 2010 $4 $4
in 2010, the base year.
2011 $5 $5
2012 $9 $6
A. Compute the CPI in 2011:
Cost of basket in 2011
= ($5 x 10) + ($5 x 20) = $150
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Problems with the CPI:
Substitution Bias
• Over time, some prices rise faster than others.
• Consumers substitute toward goods that become relatively
cheaper, mitigating the effects of price increases.
• The CPI misses this substitution because it uses a fixed basket of
goods.
• Thus, the CPI overstates increases in the cost of living.
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ACTIVE LEARNING 2
Substitution bias
CPI basket:
cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2010 $4 $4 $120
2010–11:
2011 $5 $5 $150
Households
bought CPI basket. 2012 $9 $6 $210
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ACTIVE LEARNING 2
Answers
CPI basket:
cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2010 $4 $4 $120
Household
basket in 2012: 2011 $5 $5 $150
{5# beef, 2012 $9 $6 $210
25# chicken}
B. Compute % increase in cost of household basket over
2011–12, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
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Problems with the CPI:
Introduction of New Goods
• The introduction of new goods increases variety, allows
consumers to find products that more closely meet their
needs.
• In effect, dollars become more valuable.
• The CPI misses this effect because it uses a fixed basket of
goods.
• Thus, the CPI overstates increases in the cost of living.
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Problems with the CPI:
Unmeasured Quality Change
• Improvements in the quality of goods in the basket increase the
value of each dollar.
• The CDSI tries to account for quality changes
but probably misses some, as quality is hard to measure.
• Thus, the CPI overstates increases in the cost of living.
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Problems with the CPI
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Different Measures of Inflation
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Two Measures of Inflation for US, 1950–2010
15
10
Percent per year
-5
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Module 2: Inflation CPI GDP deflator 19
Contrasting the CPI and
GDP Deflator
Imported consumer goods:
– included in CPI
– excluded from GDP deflator
Capital goods:
excluded from CPI
included in GDP deflator (if
The basket:
produced domestically)
CPI uses fixed basket
GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.
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ACTIVE LEARNING 3
CPI vs. GDP deflator
In each scenario, determine the effects on the
CPI and the GDP deflator.
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ACTIVE LEARNING 3
Answers
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Hyperinflation
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Hyperinflation in Zimbabwe
Large govt. budget deficits date Zim$ per US$
led to the creation of Aug 2007 245
large quantities of money
Apr 2008 29,401
and high inflation rates.
May 2008 207,209,688
June 2008 4,470,828,401
July 2008 26,421,447,043
Feb 2009 37,410,030
Sept 2009 355
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Module 2: Inflation 25
The Costs of Inflation
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U.S. Average Hourly Earnings & the CPI
250 $20
Inflation causes $18
200 the CPI and $16
nominal wages
$14
to rise together
150 over the long run. Nominal wage
$12
(right scale) $10
100 $8
$6
50 CPI $4
(left scale) $2
0 $0
1965 1970 1975 1980 1985 1990 1995 2000 2005
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The Costs of Inflation
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The Costs of Inflation
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The Costs of Inflation
• Tax distortions:
Inflation makes nominal income grow faster
than real income.
Taxes are based on nominal income,
and some are not adjusted for inflation.
So, inflation causes people to pay more taxes
even when their real incomes don’t increase.
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A Special Cost of Unexpected Inflation
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The Costs of Inflation
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Types of Inflation
P
P AS2
AS1 AS
P2
P2
P1
P1
AD AD2
AD1
Y Y
Cost-push inflation Demand-pull inflation
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Cost-Push Inflation
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Demand-Pull Inflation
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