Prices and CPI

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This is an article from Macroeconomics. To get back to the list of all topics click here.

In order to measure whether the economy is maintaining the real value of the economy, the idea of the consumer price index or CPI is used though it's sometimes referred to as the GDP Deflator. The object of the CPI is to measure the 'cost of living' during a particular period[1]. As part of this objective, CPI only takes into account the price of a specific, constant amount of goods (constant basket of good) between time periods rather than all of them. As with GDP, CPI uses a base year from which the prices for goods are compared with.

Contents

Textbook Readings

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 23-35

Calculation

[2]In order to calculate CPI, two values are needed:

  1. Cost of fixed goods in current year
  2. Cost of fixed goods in base year

Then:

CPI = (cost of fixed good in current year)/(cost of fixed goods in base year)

In Australia, the base year is generally changed every five years.

Inflation

[3]CPI can be used to calculate the inflation rate which is usually calculated over a period of one year. Generally,

Inflation rate = (CPI1 - CPIl2)/(CPI1) x100

Where,

CPI1 = CPIcurrent year
CPI2 = CPIlast year

Costs of Inflation

[4]Inflation, when very high, can be devastatingly costly to the economy. Some of these costs are:

  1. Shoe Leather Costs - when inflation rates are high, purchasing power of currency decreases. Under these conditions, individuals do not want to hold on to their money as it loses value and so they keep it in banks where the interest rates counteract the loss. However this involves costs of going back to the bank to take out money which for businesses involves hiring more staff to do the leg work. Also it means that people will try maintain their money in the bank for as long as possible, which means less spending in the economy.
  2. Noise in the Price System - when inflation is high, it is difficult to see whether price increases mean better demand or whether other factors are involved. This confusion is the same with determining whether supply is higher or lower. Such confusion causes volatility and businesses to make decisions based on little assumptions rather than data.
  3. Distortions of Tax System - in Australia, the tax system in not indexed according to inflation. That means that for people who earn more money but due to inflation don't actually have more purchasing power, still have to pay more tax.
  4. Unexpected Redistribution of Wealth - high inflation rates can cause wealth to be redistributed unexpectedly. This happens because wages are not necessarily indexed according to inflation so that over a period of time, some people earn less for their services. However as the buying power of workers decreases, the employer's buying power increases so that wealth is redistributed. The opposite would happen if deflation occurred.
  5. Menu Costs - whenever a firm publishes its prices, or its menu, the prices are set. But if inflation is high, then those prices will have to change in order for the firm to continue making its buying power. However this in turn means that firms have to spend money to change those prices. On a large scale this means a loss in the economy.

It should be noted that in general, menu costs and shoe leather costs are the only costs that economists can directly measure.

Inflation and Interest Rates

[5]In general there seems to be a correlation between inflation and interest rates such that when inflation rates are high, interest rates are high as well. Interest rates are of particular importance as many decisions in the economy are based these rates. For example a business needing $10m to upgrade facilities will often base its decision based on how much interest that loan would acquire.

More importantly, individuals and government care about interest rates because it has the power to increase the amount of money at hand. However if inflation rates are even higher, then the interest earned may increase the amount of money, but it will not increase buying power. To illustrate this, imagine if interest rates were %5, while inflation rates were 10%. An investment of $100 would increase by 5% to $105, but because inflation is 10%, the price of goods has gone up by more than what the interest was.

A distinction should be made between real and nominal interest rates. The distinction is that:

  • Real interest rates is the annual percentage increase in the purchasing power of assets while
  • Nominal interest rates is the annual percentage increase in the dollar value of assets

In macroeconomics, the relationship between inflation, real, and nominal interest rates is given by:

r = i - π
Where
r = real interest rates
i = nominal interest rates
π = inflation rate

In general, investors look at getting the highest real interest rate rather than the nominal as it guarantees greater purchasing power. If investors would base their decisions based on high nominal interest rates, then if inflation rates are high, investments might "increase" in dollar value, but really the purchasing power might decrease.

[6]A problem arises when the economy is going through deflation, that is when the purchasing power of assets or currency increases. Under these circumstances, real interest rates increase (as in the equation above, two negatives give a positive) causing individuals and firms to save rather than spend. This can be costly to the economy as wealth is not being traded or circulated and businesses don't expand or spend on new equipment. Another situation is where deflation occurs, but real interest rates remain constant. Under such circumstances the nominal interest rates become zero, or if deflation increases, nominal interest rates can become negative. Under such situations lending money becomes useless since the lender will receive less money in return. Hence economists talk about nominal interest rates having a lower limit of zero for interest rates.

Discussion

[7]Because CPI uses a fixed number of goods for its measurement, it is often difficult to measure it accurately as three main biases exist. They are:

  1. New Goods Bias - CPI does not take into account the entrence of new goods into the market between years. The value of these goods is estimated and adjusted in order to compare CPI with previous/base years.
  2. Quality Adjustment Bias - CPI estimates the value of modified goods that have been redesigned to have added or better features in comparison to their earlier models in the base year.
  3. Substitution Bias - CPI does not take into account that rising prices of goods may cause consumers to substitute goods for other, cheaper goods.

All these biases usually means that the value of inflation is overstated.

References

"Textbook" refers to Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011)

  1. Textbook, p.23
  2. Textbook p.24
  3. Textbook p.25
  4. Textbook pp. 27-29
  5. Textbook, p.30
  6. Textbook, p.33
  7. Textbook, pp. 33 - 34
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