Inflation

Inflation

Things cost more today than they used to. In the 1920's, a loaf of bread cost about a nickel. Today it costs more than $1.50. In general, over the past 300 years in the United States the overall level of prices has risen from year to year. This phenomenon of rising prices is called inflation.

While small changes in the price level from year to year may not be that noticeable, over time, these small changes add up, leading to big effects. Over the past 70 years, the average rate of inflation in the United States from year to year has been a bit under 5 percent. This small year-to-year inflation level has led to a 30-fold increase in the overall price during that same period.

Inflation plays an important role in the macroeconomic economy by changing the value of a dollar across time. This section on inflation will deal with three important aspects of inflation. First, it will cover how to calculate inflation. Second, it will cover the effects of inflation calculations using the CPI and GDP measures. Third, it will introduce the effects of inflation.

Calculating inflation

Inflation is the change in the price level from one year to the next. The change in inflation can be calculated by using whatever price index is most applicable to the given situation. The two most common price indices used in calculating inflation are CPI and the GDP deflator. Know, though, that the inflation rates derived from different price indices will themselves be different.

Calculating Inflation Using CPI

The price level most commonly used in the United States is the CPI, or consumer price index. Thus, the simplest and most common method of calculating inflation is to calculate the percentage change in the CPI from one year to the next. The CPI is calculated using a fixed basket of goods and services; the percentage change in the CPI therefore tells how much more or less expensive the fixed basket of goods and services in the CPI is from one year to the next. The percentage change in the CPI is also known as the percentage change in the price level or as the inflation rate.

Fortunately, once the CPI has been calculated, the percentage change in the price level is very easy to find. Let us look at the following example of "Country B."

Figure %: Goods and Services Consumed in Country B

Over time the CPI changes only as the prices associated with the items in the fixed basket of goods change. In the example from Country B, the CPI increased from 100 to 141 to 182 from time period 1 to time period 2 to time period 3. The percent change in the price level from the base year to the comparison year is calculated by subtracting 100 from the CPI. In this example, the percent change in the price level from time period 1 to time period 2 is 141 - 100 = 41%. The percent change in the price level from time period 1 to time period 3 is 182 - 100 = 82%. In this way, changes in the cost of living can be calculated across time. These changes are described by the inflation rate. That is, the rate of inflation from period 1 to period 2 was 41% and the rate of inflation from period 1 to period 3 was 82%. Notice that the inflation rate can only be calculated using this method when the same base year is used for all of the CPI's involved.

While it is simple to calculate the inflation rate between the base year and a comparison year, it is a bit more difficult to calculate the rate of inflation between two comparison years. To make this calculation, first check that both comparison years use the same base year. This is necessary to ensure that the same fixed basket of goods and services is used. Next, to calculate the percentage change in the level of the CPI, subtract the CPI for the later year from the CPI for the earlier year and then divide by the CPI for the earlier year.

In the example from Country B, the CPI for period 2 was 141 and the CPI for period 3 was 182. Since the base year for these CPI calculations was period 1, we must use the method of calculating inflation that takes into account the presence of two comparison years. We need to subtract the CPI for the later year from the CPI for the earlier year and then divide by the CPI for the earlier year. That gives (182 - 141) / 141 = 0.29 or 29%. Thus, the rate of inflation from period 2 to period 3 was 29%. Notice that this method works for calculating the rate of inflation between a base year and a comparison year as well. For instance, the CPI for period 1 was 100 and the CPI for period 2 was 141. Using the formula above gives (141 - 100) / 100 = 0.41 or 41%.

Calculating Inflation Using the GDP Deflator

The other major price index used to determine the price level is the GDP deflator, a price index that shows how much of the change in the GDP from a base year is reliant on changes in the price level. As covered in the previous SparkNote, the GDP deflator is calculated by dividing the nominal GDP by the real GDP (the details for calculating the nominal GDP and the real GDP are presented in Part 1 of this SparkNote).

For example, let's calculate, using the table above, the GDP deflator for Country B in period 3 using period 1 as the base year. In order to find the GDP deflator, we first must determine both nominal GDP and real GDP in period 3. Nominal GDP in period 3 is (10 X $2) + (9 X $6) = $74 and real GDP in period 3 using period 1 as the base year is (10 X $1) + (9 X $6) = $64. The ratio of nominal GDP to real GDP is ($74 / $64 ) - 1 = 16%. This means that the price level rose 16% from period 1, the base year, to period 3, the comparison year. Thus, the inflation rate from period 1 to period 3 was 16%. Notice that it is important to use the earlier year that you want to compare as the base year in the calculation of real GDP.

CPI vs. GDP Measures of Inflation

The inflation rate calculated from the CPI and GDP deflator are usually fairly similar in value. In theory, there is a significant difference between the abilities of each index to capture consumer's consumption choices when a change in price occurs. The CPI uses a fixed basked of goods from some base year, meaning that the quantities of goods and services consumed remains the same from year to year in the eyes of the CPI, whereas the price of goods and services changes. This type of index, where the basket of goods is fixed, is called a Laspeyres index.

The GDP deflator, on the other hand, uses a flexible basket of goods that depends on the quantities of goods and services produced within a given year, while theprices of the goods are fixed. This type of index, where the basket of goods is flexible, is called a Paasche index. While both of these indices work for the calculation of inflation, neither is perfect. The following example will help to illustrate why.

Let's say that a major disease spreads throughout the country and kills all of the cows. By dramatically limiting supply, this happenstance would cause the price of beef products to jump substantially. As a result, people would stop buying beef and purchase more chicken instead. However, given this situation, the GDP deflator would not reflect the increase in the price of beef products, because if very little beef was consumed, the flexible basket of goods used in the computation would simply change to not include beef. The CPI, on the other hand, would show a huge increase in cost of living because the quantities of beef and milk products consumed would not change even though the prices shot way up.

When the prices of goods change, consumers have the ability to substitute lower priced goods for more expensive ones. They also have the ability to continue buying the more expensive ones if they like them enough more than the less expensive ones. The GDP deflator takes into account an infinite amount of substitution. That is, because the index is a Paasche index where the basket of goods is flexible, the index reflects consumers substituting less expensive goods for more expensive ones. The CPI, on the other hand, takes into account zero substitution. That is, because the index is a Laspeyres index where the basket of goods is fixed, the index reflects consumers buying the more expensive goods regardless of the changes in prices. Thus, the GDP deflator method underestimates the impact of a price change upon the consumer because it functions as if the consumer always substitutes a less expensive item for the more expensive one. On the other hand, the CPI method overestimates the impact of a price change upon the consumer because it functions as if the consumer never substitutes. While neither the CPI nor the GDP deflator fully captures consumers' actions resulting from a price change, each captures a unique portion of the change.

The Effects of Inflation

There are two general categories of effects due to inflation. The first group of effects are caused by expected inflation. That is, these effects are a result of the inflation that economists and consumers plan on year to year. The second group of effects are caused by unexpected inflation. These effects are a result of inflation above and beyond what was expected by economics and consumers. In general, the effects of unexpected inflation are much more harmful than the effects of expected inflation.

Expected Inflation

The major effects of expected inflation are simply inconveniences. If inflation is expected, people are less likely to hold cash since, over time, this money looses value due to inflation. Instead, people will put cash into interest earning investments to combat the effects of inflation. This can be a bit of a nuisance, since people need money to take care of business. Thus, if consumers expect inflation, they are likely to hold less cash and travel more often to the bank to withdrawal a smaller amount of money. This phenomenon of changed consumer patterns is called the shoeleather cost of inflation, referring to the fact that more frequent trips to the bank will lessen the time it takes to wear out a pair of shoes. The second major inconvenient effect of expected inflation strikes companies that print the prices of their goods and services. If expected inflation makes the real value of the dollar fall over time, firms need to increase their nominal prices to combat the effects of inflation. Unfortunately, this is not always easy, as changing menus, catalogues, and price sheets takes both time and money. The problems of this sort are called the menu costs of inflation. Thus, the two major effects of expected inflation are merely inconveniences in the form of shoeleather costs and menu costs.

Unexpected Inflation

If the rate of inflation from one year to the next differs from what economists and consumers expected, then unexpected inflation is said to have occurred. Unlike expected inflation, unexpected inflation can have serious consequences for consumers ranging well beyond inconvenience. The major effect of unexpected inflation is a redistribution of wealth either from lenders to borrowers, or vice versa. In order to understand how this works, it is important to remember that inflation reduces the real value of a dollar (the dollar will not buy as much as it once did). Thus, if a bank lends money to a consumer to purchase a home, and unexpected inflation is high, the money paid back to the bank by the consumer will have less purchasing power or real value than it did when it was originally borrowed because of the effects of inflation. If a bank lends money and inflation turns out to be lower than expected, then the shoe is on the other foot and the lender gains wealth, since the money paid back at interest is of more value than the borrower expected. In volatile circumstances, when inflation seems to be moving unexpectedly, neither lenders nor borrowers will want to risk the chance of hurting themselves financially, and this hesitancy to enter the market will hurt the entire economy.