Price indices and inflation

Question 1

Name two uses of price indices

Answer 1

1. Used for the construction of quantity indices by deflating statistics expressed in current prices
2. Are of independent interest as inflation indicators (e.g. CPI = consumer price index)

Question 2

How do we compare volumes over time?

Answer 2

We deflate nominal GDP using a GDP deflator. Is also called implicit price deflator.
Is in practice inferred from estimates of nominal GDP and real GDP

Question 3

Describe the two steps to obtain an estimate of GDP in volume

Answer 3

1. For each product, derive a statistic expressed in volume

2. Aggregate all products

Question 4

Name the three sources to obtain volume statistics of individual products

Answer 4

a. Statistics expressed in quantities (e.g. tonnes of steel or pork)
b. Statistics expressed in current prices (e.g. from company accounts)

c. Price indices
› Statistics of quantities are rarely available (ca. 20%), so for most products volume statistics are obtained through deflating statistics in current prices by a suitable price index

Question 5

How do we add up volume statistics of apples, clothes, haircuts or battle tanks and why does this way make economic sense?

When we are interested in the change in volume over time, what do we do?

Answer 5

We need a common metric: (market) prices

Weighing products by their prices makes economic sense:

Prices reflect relative cost of manufacturing the products and/or the relative utilities attributed to them by consumers

When we are interested in change in volume over time we need to “freeze” prices in one period: Constant-price accounting
A way to freeze prices are by quantity indexes

Question 6

Describe the changes in relative prices bias

Answer 6

Weighing by price structure in base period is inaedequate if relative prices change considerably over time

Question 7

How to obtain the chain-linked index (Laspeyres chain)?

Answer 7

Continuously update base period: For each year, compute Laspeyres index with previous year as base year
To obtain series: Multiply by nominal value of base year

Question 8

What does the price index represent?

Answer 8

The price index represents a total expression of the movement in prices for several goods or services

Question 9

Describe Laspeyres price index, i.e. what is in the numerator and what is in the denominator and what is the result?

Answer 9

The numerator indicates the expenditure on the quantities of n goods bought in the index base year (0) valued at the prices in the final year (t). I.e. the sum of pt*q0.

The denominator is the same quantities in the base year multiplied by the price in the base year i.e. the sum of p0*q0

The result is the price increase for the n goods from year 0 to year t. The index uses the quantities of the base year of the index as the standard, and thus measures price movements for a fixed goods combination

Question 10

Describe the Paashce price index, which weights does it use, and what is the denominator and the numerator?

Answer 10

The Paasche price index uses up-to-date weights, which means the weights derive from the current time period

The numerator is the sum of pt multiplied by qt

The denominator is p0 multiplied by qt

Question 11

Explain why the Laspeyres index overestimates the real price increase and why Paasche underestimates the real price increase

Answer 11

The Laspeyres index does not take into consideration this substitution that takes place when relative prices change (i.e. relative prices of good x becomes too high so consumers purchase good y). This results in a numerator that is too high, because price and quantities relate to different years. Overstates the true change in cost of living

How to fix this? - Paasche

The Paasche index underestimates the real price increase as the denominator is too high. The denominator is the amount needed to afford the new basket at old prices. If consumers take this amount and buy a new basket, they are equally as well off in the final period. But consumers will substitute and be better off than in the final period, which makes the denominator too large. I.e. the Paasche index understates the true change in cost of living

Question 12

Which index lies between the Paasche and Laspeyres index? Which bias does it mitigate?

Answer 12

The Fisher index, which calculates a geometric average of the two other indices. The Fisher index is used for calculating export and import price indices in the trade statistics from Statistics Denmark. I.e. the Fisher index mitigates the substitution bias

Question 13

How do we produce the implicit price index?

Answer 13

In the system of national accounts, the material is reported in both constant (Q) as well as current prices (V). Dividing the value index by the quantity index produces the implict price index. You can calculate this implict price index for many of the indices presented in the national accounts, for example the implict GDP deflator

Question 14

How to calculate the quantity index when you know the value and the price index?

Answer 14

Dividing the value index by the price index - such a calculation is called deflating

Question 15

Describe two other biases related to price indices

Answer 15

Quality (example: laptops)
• Improves over time for same product
• Better quality increases consumer’s well-being
• Price increase partly reflects quality increase
Results in increase in cost of living overstated

New products (example: iPad in 2010): 
• Not included in fixed basket index or with some delay 
• Increase well-being (otherwise consumers would continue buying old products)
Results in increase in cost of living overstated

Question 16

Distinguish between CPI and GDP deflator

Answer 16

CPI:
prices of
- consumer goods and services purchased by households
- no matter whether produced domestically or imported - Laspeyres index

GDP deflator: 
price
- all goods and services goods (including also e.g. military spending, machines, trucks etc.)
-  produced domestically 
- Paasche index

Question 17

Describe the Laspeyres quantity index

Answer 17

The numerator is the sum of pi0*qit

The denominator is the sum of pi0*qi0

I.e. the price is held constant

Question 18

Describe the harmonised index of consumer prices

Answer 18

Compiled by EU member states and Norway, Iceland and Switzerland
• Enables comparability across European countries
• HICP basket is updated on an annual basis to include new products that have become an important part of household consumption expenditure
• Aims at measuring “pure” price changes over time: quality adjustment
• used by European Central Bank as target for monetary policy: “HICP inflation rate of below 2% over the medium term”
• only difference with Danish CPI: owner-occupied dwellings are not included

Question 19

Describe core HICP

Answer 19

Excludes goods with:
› highly volatile prices (= temporary changes in prices): energy, food
› administered prices (= deliberate changes in prices): alcohol, tobacco

Question 20

Describe the redistributive effects of inflation

Answer 20

•Borrowers with nominal debt will benefit
› Loans/mortgages with nominal interest rate will benefit becausethe debt stays the same in nominal terms, but becomes smaller in real terms

• Lenders with nominal assets will lose
› Banks or others who have loaned money at fixed nominal interest rates willlosebecause when the sum is repaid it will be worth less in terms of the goods or services it can buy

Question 21

Describe the costs and benefits of inflation in relation to wages

Answer 21

Wages:
• Working contracts specify wage increases for several years in advance
• Often incorporate compensations for future inflation
• However: unexpected inflation lowers real value of wages - bad for workers, good for employers

• What is the real values of wages?
› Need to deflate nominal wages with price index
› Choose appropriate price index (consumption basket of workers possibly dependent on industry)

• Nominal vs. real wages

Question 22

Describe other costs of inflation

Answer 22

• menu costs: frequent updates of prices (e.g. restaurant menu)
• In an environment with high and volatile inflation, prices no longer signal relative scarcity of resources accurately - distorts investment and consumption decisions

Question 23

Describe other benefits of inflation

Answer 23

• anticipation of slightly higher prices in the future gives consumers an incentive to make purchase now rather than later - boosts economic activity
• conversely: deflation leads consumers to delay purchases - hampers economic activity (e.g. Japan 1995-2015)
• In a dynamic economy with declining sectors, real wages sometimes need to go down to avoid unemployment, but nominal wages are downward-rigid (workers are unwilling to accept nominal wage cuts) - only way to achieve real wage cuts is by inflation (“Inflation greases the wheels of the labour market”)

Question 24

Define inflation

Answer 24

Inflation is the rate of increase in price over a given period of time. Generally, inflation is wide measure e.g. the overall increase in prices or the increase in the cost of living in a country. However, can also be calculated in a more narrow way, for instance for certain goods.

Question 25

What are the costs of deflation?

Answer 25

When prices are falling, consumers delay making purchases if they can, anticipating lower prices in the future. For the economy this means less economic activity, less income generated by producers, and lower economic growth.

Question 26

What is the relationship between inflation and purchasing power?

Answer 26

To the extent that households’ nominal income, which they receive in current money, does not increase as much as prices, they are worse off, because they can afford to purchase
less. In other words, their purchasing power or real— inflation-adjusted—income falls. Real income is a proxy for the standard of living. When real incomes are rising, so
is the standard of living, and vice versa. In reality, prices change at different paces. Some, such as the prices of traded commodities, change every day; others, such as wages established by contracts, take longer to adjust. In an inflationary environment, unevenly rising prices inevitably reduce the purchasing power of some consumers, and this erosion of real income is the single biggest cost of inflation.

Question 27

What can cause inflation?

Answer 27

Long-lasting high inflation is often a result of a lax monetary policy. If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise. This relationship between the money supply and the size of the economy is called the quantity theory of money.

Other causes are supply shocks (disrupt production or raise production costs, e.g. high oil prices can reduce overall supply and lead to “cost-push inflation”). Demand shocks (e.g. expansionary policies when the central bank lowers interest rates or government increases spending. If the increase in demand exceeds the production capacity of an economy, the resulting strain on resources is reflected in “demand-pull” inflation). Lastly, expectations. If higher prices are expected they are build into wage negotiations and contractual price adjustments (e.g. rent increases) - the expectation becomes self-fulfilling.

Question 28

Why do the national accounts use the chain-linked method?

Answer 28

Constant prices are not fully satisfactory for economic analysis
The choice of a fixed year means that one is using price structures that become more and more remote from the current structure, the further one moves away from the base year
Leads to distortions in the evolution of volume, which become all the more significant when there are substantial variations in relative prices
Therefore, the national accounts now use the “chain-linked method”