Week 3: Inflation Flashcards
What is inflation?
a generalised increase in the overall level of prices
What does CPI stand for?
the Consumer Price Index
How is the most relevant measure of inflation calculated?
using the consumer price index (CPI)
What does the CPI measure?
the average prices people pay over time for the goods and services they buy in their everyday lives
How do you calculate the inflation rate? (equation)
inflation rate = ((price level this year - price level last year) / price level last year) x 100
How do you construct the consumer price index? (4 steps)
step 1 = find out what people typically buy
step 2 = collect prices from the stores where people do their shopping
step 3 = tally up the price of the basket of goods and services (cost column: do price in year x quantity)
step 4 = calculate the inflation rate
What are the challenges in measuring the true cost of living? (3)
quality improvements can hide price decreases
new products can make you better off, thus reducing your cost of living
you can save yourself money without sacrificing much
What do economists estimate on average about CPI?
that on average, CPI overstates the increase in the cost of living by around 1% per year
What are the different measures of inflation? (6)
Consumers Price Index (CPI)
Consumer Prices Index including Owner-Occupied Housing (CPIH)
CPIH excl energy, food, alcohol & tobacco (also referred to as Core CPI, Trimmed mean CPI)
Retail Prices Index (RPI)
Producer Prices Index (PPI)
GDP Deflator
What is CPIH (Consumer Prices Index including Owner-Occupied Housing) also include?
owner occupied costs (incl mortgage spending) and council tax
in doing so, CPIH better reflects the cost of living for most UK households
Why can Core CPI get a better measure of inflationary pressure in the economy?
policymakers often focus on this CPI with some more volatile goods and services excluded
so focuses on the more stable prices
What does RPI track?
a similar bundle of goods as the CPI
What is the problem with RPI, and what solves it?
it uses a statistical formula that generates biases in the inflation rate
Specifically, if a price rises, then falls by the same amount, this would generate positive inflation in the RPI, when the true inflation rate is zero
CPI fixes this problem
What does PPI measure?
the prices paid by businesses for intermediate inputs used in production (PPI input) and also the prices received by businesses for their outputs “at the factory gate” (PPI output)
Why is PPI often more volatile than consumer prices?
bc retailers try to keep retail prices more stable
so, it can be a predictor of consumer prices
What does the GDP deflator measure?
the prices of goods and services produced in the UK
excludes imports, which aren’t produced in the UK
Included public services which consumers don’t pay for
Who uses the consumer price index (CPI)?
Bank of England Target, News media
What are the benefits of the consumer price index (CPI)?
transparent
harmonised across countries
What are the drawbacks of the consumer price index (CPI)?
doesn’t include owner occupied housing, council tax, public services
Who uses / what are the uses of CPIH?
good measure of living costs
news media
What are the benefits of CPIH?
includes owner-occupied housing costs and council taxes
reflects underlying inflation pressure
What are the drawbacks of CPIH?
less transparent than CPI
Not harmonised
Who uses Core CPI?
economists
What are the benefits of Core CPI?
reflects underlying inflation pressure
What are the drawbacks of Core CPI?
doesn’t reflect living costs
Who uses / what are the uses of RPI?
legacy debt, pension + wage contracts
What are the drawbacks of RPI?
statistically biased
Who uses PPI?
measure of cost of doing business
economists
What are the benefits of PPI?
good measure of conditions for businesses
predictor of CPI
What are the drawbacks of PPI?
Not a measure of living costs
very volatile
Who uses/ what are the uses of the GDP deflator?
calculating Real GDP
What are the benefits of the GDP Deflator?
includes cost of public services (UK + few other countries only)
What are the drawbacks of the GDP Deflator?
measures production not consumption costs
What do real variables adjust for?
inflation
What is a nominal variable measured in?
pounds, but the value of a pound changes over time
What can nominal variables rise or fall due to?
either changing quantities or inflation
What are real variables not affected by?
changing prices; they change only in response to changes in physical quantities
What is the formula for adjusting for inflation? (from textbook)
real value in (year eg 2012) dollars = nominal value in year t dollars X Price level in 2012 / Price level in year t
How does the professor write the formula for adjusting for inflation?
Price in GBP 2011 = CPI GBP 2011 / CPI GBP 2020 X Price in GBP 2020
–> Price in GBP wy = CPI GBP wy / CPI GBP dwy X Price in GBP dwy
where wy = the year you want eg 2011 prices
where dwy = don’t want year eg 2020 prices
What do real variables give you a better sense of?
the underlying trade-offs, particularly when you’re making comparisons over time, such as:
To analyse whether you are becoming better paid, analyse your real salary, which adjusts for the effects of inflation, rather than your nominal salary.
To assess whether your stocks have become more valuable, focus on the real wealth in your portfolio, rather than its nominal value.
To evaluate whether your sales staff are performing better, focus on your company’s real revenues, rather than nominal revenues, which rise with inflation.
If the average weekly earnings (total pay) increased by 6.5% and the CPI increased by 9.6%, what was the change in real average weekly earnings?
(6.5% - 9.6%) = -3.1%
real average weekly earnings decreased by 3.1%
(total pay increase - CPI increase)
How do you work out the real interest rate?
real interest rate = nominal interest rate - inflation rate
What is the real interest rate if the nominal interest rate = 5% and the inflation rate = 3%
real interest rate = nominal interest rate - inflation rate
–> = 5% - 3% = 2%
What are the impacts of money illusion? (3)
it can distort decisions
it can lead to mis-pricing
it creates nominal wage rigidity
What is an example of money illusion distorting decisions?
A survey asked people to consider what choices they would make if all prices through out the economy - including their income - increased by 25%.
Caused people to be less likely to purchase a chair they had planned to buy for $400, now that it was $500 - even though the opportunity cost of buying the chair hadn’t changed
What is an example of money illusion leading to mis-pricing?
When people sell their house, many people think about the price they paid for it, but money illusion causes them to think about the price they paid in nominal dollars, without adjusting for inflation
so should instead focus on prices that similar houses in your neighbourhood sold for recently
What is an example of money illusion creating nominal wage rigidity?
people hate it when their wages get cut
smart managers understand this, so will try to get by with out ever cutting nominal wages when their business is struggling - a pattern known as nominal wage rigidity
What are the functions of money? (3)
1) money is a medium of exchange
2) money is a unit of account
3) money is a store of value
What is an example for a function of money being a medium of exchange?
If there were no such thing as money, you would either have to make everything you need for yourself, or barter for it.
But barter constrains you to only do business when there’s a double coincidence of wants: You can only trade your extra milk for bread if you can find someone who wants milk and coincidentally has extra bread.
What is an example for a function of money being a unit of account?
Putting everything in the same unit is useful because it makes it easier to apply the opportunity cost principle and ask, “Or what?”
If apples cost $1 a pound and oranges cost $1.25 a pound, then you know you have to give up more apples to get a pound of oranges.
What is an example of a function of money being a store of value?
Want to ensure that you have goods and services to consume in retirement?
You can do that by earning money today, saving or storing that money, and then using it in the future to buy stuff
What does inflation undermine?
the productive benefit of money
skyrocketing inflation can undermine the role of money as a medium of exchange
What happens when inflation is high or unpredictable?
problems emerge:
you’ll be less willing to use money as a storef the money you put into your bank will only buy half as much next week
money is a less effective unit of account when its value is uncertain bc a price denominated in dollars is less informative when you aren’t sure what a dollar is worth
What are the costs of hyperinflation?
makes aspects of life harder eg in Venezuela, people had to carry backpacks to fit money in
hyperinflation erodes all the functions of money
What are the costs of expected inflation? (3)
1) inflation creates menu costs for sellers
2) inflation creates shoe-leather costs for buyers
3) inflation confuses the signals that prices send
4) inflation redistributes
What are menu costs?
The marginal cost of adjusting your prices
eg the cost to a restaurant of raising prices is printing new menus
For the ‘inflation creates menu costs for sellers’ impact, what is the marginal benefit of adjusting your price?
you’ll shift to a price that covers the rising cost of your inputs. The higher inflation is—and the faster your costs rise—the larger this marginal benefit is. As a result, higher inflation leads to more frequent price adjustment.
What is Caffe Nero’s menu cost?
the rapid deterioration of their blackboards as they write the new prices over the smudges of the old prices
What are the other costs of rising prices that are more than just changing menus?
loss of trust, letting customers down, all hurt businesses
businesses try to reduce these costs by explaining price changes
What are shoe-leather costs?
the time + effort it takes to manage cash and to shop around as prices change, because they arise from running around town (which wears down the leather on your shoes)
Explain cost 3 - inflation confuses the signals that prices send
Did real wages for nurses fall because there is an increase in newly trained nurses and a decrease in the demand for nursing care?
Or did inflation increase prices reducing the real wages of nurses as their nominal wages are slow to adjust?
Explain cost 4 - inflation redistributes?
When people borrow and lend, they agree an interest rate taking into account expected inflation.
If inflation is higher than expected, then the real value of loan repayments will be less than what the borrower and lender expected when they agreed the loan.
This will favour the borrower, and hurt the lender.
