(Macro) Episode 16: Inflation & Price Indexes

There are three macroeconomic goals that we
want to keep an eye on to determine the health of any economy: 1) stable prices, 2) low unemployment,
and 3) high and sustained economic growth. The challenge for us right now is to figure
out how each of these goals would be measured, and what each of these goals means. For now
let’s just address the first goal: stable prices. First of all, in this context, what do we
mean by “price”? Since is this a macroeconomic goal, we aren’t talking about the price
of a single product, but rather the price of all products — some kind of aggregate
price, or a weighted average of all the prices, a representative price index. While there
may price indices out there, which price index you use often depends on the type of question
you want to ask. The most common is the consumer price index, or CPI. Sometimes you hear about
the core index, which is essentially CPI that leaves out food and energy prices. These two
are typically the most volatile areas, i.e., changing or fluctuating the most, and can
make it look like the average of all prices is changing, when in fact everything other
than food and energy is pretty stable. How is such a price index constructed? Let me give you an overly simplistic view
of the CPI. Suppose that a “typical” household purchases 10 apples, 5 gallons of gas, and
3 pairs of jeans. I want to know overall, if prices are rising. To answer this question,
I need to know what this market basket cost initially, and what it costs now. Let’s say
that in our base year (this is our benchmark year, which will serve as a point of reference),
the price of an apple is $.20, the price of a gallon of gas is $1, in the price of a pair
of jeans is $10. This means that in the base year, the market basket would’ve cost $37;
$2 to purchase 10 apples at $.20 each, $5 to purchase 5 gallons of gas at $1 each, and
$30 to buy three pairs of jeans at $10 each. And in the current year? Let’s say that
in the current year, an apple costs $.70, a gallon of gas costs $4, and a pair jeans
costs $30. This means that in the current year, the same market basket will cost $117;
$7 for the apples, $20 for the gas, and $90 for the three pairs of jeans. Because the
entire cost of the market basket is higher than it used to be, this means that overall,
the price level must have gone up. In this particular example, this seems to
be belaboring the obvious; we can see that each individual price has gone up, so overall,
the average level of prices must have gone up. But this market basket approach is useful
if we can’t see individual prices or if, as is the case for the actual CPI, there are
hundreds of products, with some prices rising and some prices falling. How does the market basket idea help us in
finding a price index, or some indicator of what’s happening to the overall level of prices?
In this example, we can use the changing value of the market basket to construct a CPI, where
the CPI for the year in question is the ratio of the total expenditure in that year, over
the original total expenditure, or the expenditure in the base, or benchmark, year; and then
I have to multiply all of it times 100. In this case, that would be a current expenditure
of $117, over the base year expenditure of only $37, times 100. This means the CPI for
the current year is about 316. OK, so I could train just about anyone to
plug the numbers into this formula; in the end, what does a CPI at 316 mean? Before I
answer this question, let me ask you one more thing: What is the CPI of the base year? Well,
since the CPI we seek is base year CPI, we have to take base year expenditures, over
base year expenditures, all times 100. The CPI of the base year is going to be 100. What
does this mean? It means that base year prices are 100% of base year prices. The prices are
neither higher, nor lower, than we started. Of COURSE this is true; no change in the price
level has yet occurred! In the base year, the index is always 100. This helps me to
interpret index numbers that are not 100. If you find an index less than 100, then prices
have decreased compared to the base year. If you find a price index more than 100, prices
have gone up compared to the base year. Back to our current price index of 316, then, it
signifies that prices are over three times higher than they were originally. If a price index like the CPI indicates the
current level of prices, how do we measure changes in the price level? First of all,
we’re to need to look at percentage change rather than absolute change. Let me show you
what I mean. If I tell you that product price has gone up by $1, is this a big change, or
a small change? Well, as usual, it depends: if we’re talking about, say, a pack of gum,
where the original price was $1 and the new price is $2, that is an absolute change of
$1. But is a big change, or a small change? This will be a big change; price doubled,
or increased by 100%. What if instead, we’re talking about textbook? If the book originally
cost $100, and now it’s $101, that’s an absolute change of $1. But is it a big change,
or a small change? For the book, it’s a small change; price increased by 1%. In the end,
we need to know not only the dollar amount of the price change, but also how this compares
to where we started. The same is true of the overall price level. We need to look at percentage
change of the price index. The formula to calculate the percentage change
in the overall price level is the difference between the new CPI and the old CPI, all over
the old CPI, times 100 to get it in percentage terms. How do I use this formula? Let’s use
the CPI numbers were calculated earlier as an example: the percentage change in price
is the new CPI (316) minus the old CPI (100), over 100, times 100 to get it in percentage
terms — or an increase of 216%. This means that prices have risen 216% from the base
year to the current year. At this point you may be asking yourself,
“Why do we have to use this stupid formula? I could’ve gotten the same answer by just
taking the difference between the two CPI’s!” While that’s true for this particular example,
that little trick only works if you’re comparing against the base year. Let me show you. What if I want to know how much inflation
there was, that is, how much prices changed, from 1998 to 2008? In 1998, CPI was 163; the
CPI in 2008 was 215.3. The index is higher, so clearly the general price level has increased,
but by how much? It’s tempting to just take the difference between the two, and say that
inflation was 52.3% over the ten-year period, but that would be incorrect. Note that 1998
is not the base year. How do I know that neither of the two years as the base year…? Hmm… OK, let’s use the formula: percentage change
in price from 1998 to 2008 is the CPI in 2008, minus the old CPI in 1998, all over the CPI
in ’98, times 100… OR, [(215.3 – 163)/163]x100, which gives us approximately a 32.1% increase
in the price level from 1998 to 2008, NOT a 52.3% increase. By definition, inflation is a sustained increase
in the overall level of prices. If the percentage change in the prices is greater than zero
for a sustained period, typically two consecutive quarters (that’s six months or longer) we
call it inflation. If the percentage change in price is less than zero for a sustained
period, we call it deflation. Think back to the first macroeconomic goal:
stable prices. Notice that the goal is not low prices; deflation, or decreasing prices,
can be just as dangerous as inflation, or increasing prices. Think about this: lower
prices mean smaller quantity supplied of all goods and services. This means there’s less
need for labor, so workers get laid off. Unemployed workers spend less, bringing demand and prices
down, which means lower quantity supplied, which means… well, you get the picture.
In fact, the one decade in the 20th century that was characterized worldwide by deflation
was the 1930s: the Great Depression. NEXT TIME: Real Income.

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