Review questions for this study guide can be found at:
Macroeconomic Measures of Performance Review Questions for AP Economics Exam
Main Topics: Consumer Price Index, Inflation, Is Inflation Bad, Measurement Issues
My "Latte Price Index" illustrates that a price index can be constructed to measure changes in the price of anything. Another price index, the GDP price deflator, measures the increase in the price level of items that compose GDP. But not all goods that fall into GDP are goods that the everyday household shops for. If United Airlines buys a 767 from Boeing, it falls in GDP, but the price of a new 767 doesn't exactly fall within what we might call consumer spending. We need a statistic that focuses on consumer prices.
The Consumer Price Index (CPI)
To measure the average price level of items that consumers actually buy, use the Consumer Price Index (CPI). The Bureau of Labor Statistics (BLS) selects a base year and a market basket is compiled of approximately 400 consumer goods and services bought in that year. A monthly survey is conducted in 50 urban areas around the country, and based on the results of this survey, the average prices of the items in the base year market basket is factored into the CPI. Confused yet? Let's do a simple example of a price index for a typical consumer using Table 12.5.
Price Index Current Year = 100 * (Spending Current Year)/(Spending Base Year)
2001 Price Index = 100 * (531)/(486) = 109.26
Inflation
In the above example, the price index increased from 100 in the base year to 109.26 in 2001. In other words, the average price level increased by 9.26 percent.
On a much larger scale, the official CPI is constructed and used to measure the increase in the average price level of consumer goods. The annual rate of inflation on goods consumed by the typical consumer is the percentage change in the CPI from one year to the next.
"So What Is the Difference Between the CPI and the GDP Deflator?"
This can be confusing. The difference between these two price indices lies in the content of the market basket of goods. The CPI is based upon a market basket of goods that are bought by consumers, even those goods that are produced abroad. The GDP deflator includes all items that make up domestic production. Because GDP includes more than just consumer goods, the index is a broader measure of inflation, while the CPI is a measure of inflation of only consumer goods.
Nominal and Real Income
As a consumer, I am also a worker and an income earner. Rising consumer prices hurt my ability to purchase the items that make me happy. In other words, rising prices can cause a decrease in my purchasing power. Ideally, I would like to see my income rise at a faster rate than the price of consumer goods. One way to see if this is happening is to deflate nominal income by the CPI to calculate my real income. Real income is calculated in the same way that real GDP is calculated.
- Real Income This Year = 8(Nominal Income This Year)/CPI (in hundredths)
Example:
In 2002 Kelsey's nominal income is $40,000 and it increases to $41,000 in 2003. Curious about her purchasing power, she looks up the CPI in 2002 and finds that at the end of 2002 it was 181.6 and at the end of 2003 it was 185. This is compared to the base year value of 100 in 1984.
Real Income 2002 = $40,000/1.816 = $22,026
Real Income 2003 = $41,000/1.850 = $22,162
After accounting for inflation, real income increased by $136. Her nominal income increased at a rate slightly faster than the rate of inflation, and so her purchasing power has slightly increased.
Example:
What if Kelsey's wages were frozen and she did not receive that raise in 2003?
Real Income 2003 = $40,000/1.85 = $21,622,
or a $404 decrease in purchasing power
Is Inflation Bad?
The previous example illustrates that inflation erodes the purchasing power of consumers if nominal wages do not keep up with prices. In general, inflation impacts different groups in different ways. It can actually help some individuals! The main thing to keep in mind with inflation is that it is the unexpected or sudden inflation that creates winners and losers. If the inflation is predictable and expected, most groups can plan for it and adjust behavior and prices accordingly.
Expected Inflation
If my employer and I agree that the general price level is going to increase by 3 percent next year, then my salary can be adjusted by at least 3 percent so that my purchasing power does not fall. This cost of living adjustment doesn't hurt my employer so long as the prices of the firm's output and any other inputs also increase by 3 percent. Many unions and government employees have cost of living raises written into employment contracts to recognize predictable inflation over time.
Banks and other lenders acknowledge inflation by factoring expected inflation into interest rates. If they do not, savers and lenders can be hurt by rising prices. For this reason, the bank adds an inflation factor on the real rate of interest to create a nominal rate of interest that savers receive and borrowers pay.
Nominal Interest Rate = Real Interest Rate + Expected Inflation
Savings Example 1:
When I see the bank offering an interest rate of 1 percent for a savings account and I put $100 in the bank, I expect to have $101 worth of purchasing power a year from now. But if prices increase by 2 percent, my original deposit is only worth $98. So even when I receive my $1 of interest, I have lost purchasing power.
If you have a savings account, the real rate is the rate the bank pays you to borrow your money for a year. You must be compensated for this because you do not have $100 to spend if you put it into the bank. Look at my savings example again with an inflation expectation of 2 percent and a real interest rate of 1 percent.
Savings Example 2:
- January 1: The purchasing power of my $100 is $100 and the bank offers me a 3 percent nominal interest rate on a savings account.
- Throughout the year, inflation is indeed 2 percent.
- December 31: My bank balance says $103, but $2 of purchasing power has been lost to inflation, leaving me with $1 as payment from the bank for having my money for one year.
Borrowing Example:
If you are looking for a loan of $100, the real interest is the rate the bank will charge you for borrowing the bank's money for a year. After all, if the bank lends the money to you, it will not have those funds for some other profitable opportunity. Again, let's assume that the expected inflation is 2 percent but the real rate of interest is 3 percent.
- January 1: The purchasing power of the bank's $100 is $100 and the bank lends it to me with a 5 percent nominal interest rate.
- Throughout the year, inflation is indeed 2 percent.
- December 31: I pay the bank back $105, but $2 of the bank's purchasing power has been lost to inflation, leaving it with $3 as payment from me for having its money for one year.
Unexpected Inflation
When price levels are unpredictable or increase by a much larger or much smaller amount than predicted, some sectors of the economy gain and others lose. Though not a comprehensive list, some of the groups that win and lose from unexpected inflation include the following.
- Employees and Employers. If the real income of workers is falling because of rapid inflation, it is possible that firms are benefiting at the expense of the workers. In a simple case, you work at a grocery store and the price of groceries unexpectedly rises by 10 percent a year, but your nominal wages rise by 8 percent. Your employer is clearly benefiting by selling goods at higher and higher prices but paying you wages that are rising more slowly.
- Fixed Income Recipients. A retiree receiving a pension can expect to see it slowly eroded by rising prices. Likewise a landlord who is locked into a long-term lease receives payments that slowly decline in purchasing power. If the minimum wage is not adjusted for inflation then minimum wage workers see a decline in their purchasing power.
- Savers and Borrowers. If I put my money in the bank and leave it for a year when inflation is higher than expected, and then withdraw it, the purchasing power is greatly diminished. On the other hand, if I borrow from the bank at the beginning of that year and pay it back after higher than expected inflation, I am giving back dollars that are not worth as much as they used to be. This benefits me and hurts the bank.
Difficulties with the CPI
Like all statistical measures, we should be careful not to read too much into them and acknowledge that they all have some problematic issues.
- Consumers substitute: The market basket uses consumption patterns from the base year, which could be several years ago. As the price of goods begins to rise, we know that consumers seek substitutes. This substitution might make the base year market basket a poor representation of the current consumption pattern.
- Goods evolve: Imagine if the CPI market basket were using 1912 as a base year. The basket would include the price of buggy whips and stove pipe hats in the inflation rate. The emergence of new products (DVD players) and extinction of others (manual typewriters) is understood by firms and consumers, but the market basket must reflect this or it risks becoming irrelevant.
- Quality differences: Some price increases are the result of improvements in quality. As automakers improve safety features, luxury options, and mechanical sophistication, we should expect the price to rise. Prices that increase because the product is fundamentally better are not an indication of overall inflation. Because the Bureau of Labor Statistics (BLS) has a difficult time telling the difference between quality improvements and actual inflation, the CPI can be overstated for this reason.
If the market basket is not altered to account for the above effects, the CPI is not very accurate. The BLS reviews the market basket from time to time and updates it if necessary. Comparisons over long periods of time are not very useful, but from month to month and year to year, the CPI is a fairly useful measure of how the average price level of consumer items is changing.
Review questions for this study guide can be found at:
Macroeconomic Measures of Performance Review Questions for AP Economics
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From 5 Steps to a 5 AP Microeconomics/Macroeconomics. Copyright © 2010 by The McGraw-Hill Companies. All Rights Reserved.
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