Inflation

Question 1

Inflation

Answer 1

An increase in the price of a good/service.

Question 2

Price

Answer 2

Price is a value of an object relative to another object

Question 3

Calculating Inflation: Exercise

A bottle of coke (at Loblaws) is $2.50 while a can of beer is $1: 1 coke = 2.5 cans of beer

A bottle of coke in Detroit is US$1.50, which is $1.90: 1 Loblaws coke = 1.3 “US” coke

Your hourly wage is $25: 1 hour of your time is worth 10 Loblaws cokes

Answer 3

The bottle of coke experiences inflation if the price of a bottle of coke increases.

Suppose it went from $2.50 to $25. Is it a good thing or a bad thing? Or nothing?

Bad: If your wage is stagnant. Then 1 hour of your time is worth 1 Loblaws cokes. You are poorer and need to work more to buy the same coke

Bad: If your wage rose from $25 to $50. 1 hour of your time = 2 Coke

Neutral: If 2 cans of beer give you the same happiness as 1 can of Coke, regardless of how much beer you are already drinking

Neutral: If you don’t drink coke.

Good: If your wage increased from $25 to $500.

Takeaway: Calculating inflation in isolation is not super meaningful

Question 4

Price indices

Answer 4

The “average” prices across a set of goods.

Set of Goods: Reflect the typical range of purchases of the target population for which the index is created for

Question 5

Price Indices to Measure Inflation

Answer 5

The price inflation of a single good is not very meaningful. Because of this, government report price indices, and inflation is measured using these price indices.

Examples:
Consumer Price Index (CPI)
Producer Price Index (PPI)
GDP Deflator

Question 6

Measurement: The Consumer Price Index (CPI)

Answer 6

CPI measures the cost of a typical consumer’s “baskets of goods.”

Basic idea: How affordable are goods to consumers?

The headline number is typically CPI-U

Question 7

CPI Calculation

Answer 7

Typically a two-part process.

One: The price of individual goods

Two: The basket of goods (via household survey, e.g., CEX in the US)

Basket + price = How much $ it costs to buy the basket

Question 8

CPI Inflation

Answer 8

A measure of price movements by comparing the prices of a representative “shopping basket” of goods and services at two different points in time.

Question 9

Core Inflation

Answer 9

Year-over-year growth of inflation that excludes the eight most volatile components in CPI —which account for 19 per cent of the CPI basket—(fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation, and tobacco products) as well as the effect of changes in indirect taxes on the remaining components.

Question 10

Inflation: Nominal & Real Variables

Answer 10

Question 11

Inflation: Challenges

Answer 11

Having timely data about inflation is important since the size of inflation is often symptomatic of “issues” with other aspects of the economy.

Problems:

1. For researchers and business analysts: Inputs into CPI are typically a “secret” and, therefore, hard to get access to.
2. Baskets are not immutable in real life, so does not fully reflect inflation in real-time.

Solution:
Recent advances in data collection have given researchers and companies more options.

Nielsen Scanner data: Observe prices AND baskets all at once.

Question 12

Inflation: Substitution Effect

Answer 12

Changing “baskets” give rise to a lack of comparability of CPI across years.

Baskets change in response to asymmetric changes in the prices of goods, even if your preferences have not changed (substitution effect).

Question 13

Costs of Inflation

Answer 13

1. Menu Costs
2. The impact on people with fixed incomes which are not indexed for inflation, ie. Pensioners.
3. Inflation in excess of other trading partners will generate a depreciation of the currency.
4. If inflation persists the only way to bring down expected π is through a recession.

Question 14

Long-Run Inflation

Answer 14

The rising costs of goods and services over long periods of time.

Question 15

Short-Term Inflation

Answer 15

The rising costs of goods and services over a shorter period.

Question 16

Short-Term Inflation: Philips Curve

Answer 16

Persistent demand generates growth in inflation

How do businesses set prices?

In previous years you have seen the economy growing steadily and prices growing
around 4%.

It is likely if you assume the economy (demand) continues to grow, you would raise prices
4 % again.

But what if it is expected that the economy won’t do well this year? ,
It is likely that the firm will raise prices less, trying to compensate for the weaker demand.

Question 17

Philips Curve

Answer 17

The Philips curve is a statistical relationship between wage inflation and unemployment
But extended to include simply general price inflations and unemployment / aggregate demand.

Inflation and unemployment are negatively correlated.

Question 18

Philips Curve: Drawback

Answer 18

Question 19

Personal Assessment

Answer 19

Why do we measure inflation?
Name alternative measures of inflation and their differences.
Exercises in slide 12-13.
What is one of the main challenges in measuring inflation?
What are the cost of unanticipated inflation?
What are the likely determinants of long-run inflation?
What are the likely determinants of short-run inflation?

Question 20

Producer price index

Answer 20

Cost of production for domestic firms