Economics
Session 8:
Measuring the Cost
of Living. Inflation.
Luis Maldonado
Concepts and definitions
Inflation: some preliminary concepts
Inflation - when the average level of prices in the
economy rises: means that the value of money is falling.
Deflation - when the average level of prices in the
economy falls: means that the value of fiat money
increases.
2
Spanish inflation rate. Year-to-year % change in the Consumer
Price Index (CPI): 2002-2015
Renewed danger of deflation
Deflation!
Source: INE 3
From the price index to an inflation rate
The inflation rate is the percentage change in the price
level from the previous period.
Expressed as changes in a price index from time
to time: e.g. if the price index changes from 100 to
103.5, we would say that the inflation rate has been
3.5%.
The consumer price index (CPI) is a measure of the
overall cost of the goods and services bought by a typical
consumer.
National statistical agencies report the CPI each month.
It is used to monitor changes in the cost of living over time.
4
Why does inflation
happen?
5
Types of Inflation
Demand-pull :
Inflation arising on the demand side of the economy (e.g., high
consumption, export demand).
Cost-push
Inflation caused by rising production costs
Hyperinflation undermines productive economic activity and
can lead to socio-economic breakdown. There is no consensus as
to the threshold level of inflation beyond which we say there is
hyperinflation (most commentators agree that a 50% or higher
inflation rate is hyperinflation).
6
Demand-Pull & Cost-Push Inflations in the context of the
Aggregate Demand and Aggregate Supply model
Demand-Pull OR Demand-side Cost-Push OR Supply-side
(inflation + growth) (inflation + stagnation)
STAGFLATION
AS
Price level Price level AS
(Index) AS (Index)
AD
AD AD
Real GDP Real GDP
(billions of €) (billions of €)
7
Which one is worse,
inflation or deflation?
8
Inflation versus Deflation
Although there is no consensus as to what is the “right”
rate of inflation most experts agree that deflation is
potentially more dangerous for an economy than
moderate rates of inflation.
Inflation is detrimental to an economy if it grows
uncontrolled and becomes difficult to forecast
(hyperinflation)
9
Deflation
Price level AS
(Index)
DEFLATION: the consensus is that
deflation is more destructive for an
economy than inflation. There are
several reasons for this, but the most Po
important one is that deflation can
lead to a vicious cycle of destruction P1
of employment and production:
deflationary spiral.
AD
AD’
Because the price of goods is falling, Real GDP
consumers have an incentive to delay (billions of €)
purchases and consumption until
prices fall further, which in turn
reduces overall economic activity -
contributing to the deflationary
spiral.
10
Rate of Inflation in Japan: The Persistent Threat of Deflation
% cambio del IPC anualizado
11
Effects of inflation
12
The effects of inflation
Loss of competitiveness – exports might fall
Economic collapse during hyperinflation episodes
Inflation causes income to be redistributed:
Inflation hurts:
i. those with incomes rising less than inflation.
ii. those with assets which value rises less than inflation.
iii. those that consume intensively the goods with prices rising
faster than others
13
Costs of Inflation
Who is hurt by inflation?
Creditors
Taxpayers
Individuals with fix income
Those competing internationally
Is anyone helped?
Governments
Debtors
14
The Real Value of Debt and Inflation (Deflation)
With an annual rate of inflation of 5%, the real value of debt decreases by almost 40% in just ten years
(inflating the debt away). Instead, in a context of 1% rate of deflation, the real value of debt increases 10%
in ten years.
120 Problems with the strategy of inflating the
debt away:
1. Interest rates tend to correlate positively
110 with inflation and therefore they will
increase if inflation increases.
Nominal value of Debt
100 2. Some countries have a large % of their
debt with a variable interest rate that
Real value of Debt with increases with inflation (for example, of
90 5% inflation all U.K.’s debt outstanding 22% is with an
interest rate linked to inflation.
Real value of Debt with
80 1% inflation
Real value of debt with
70 1% deflation
60
1 2 3 4 5 6 7 8 9 10
15
Calculating the
inflation rate
16
How the Consumer Price Index Is Calculated
Fix the Basket. Statistical agencies identify a market
basket of goods and services the typical consumer buys.
Agencies conduct monthly consumer surveys to set the
weights for the prices of those goods and services.
17
How the Consumer Price Index is Calculated
Choose a Base Year and Compute the Index :
Designate one year as the base year, making it the benchmark
against which other years are compared.
18
How the Consumer Price Index Is Calculated
Compute the inflation rate
The percentage change in the price index from the
preceding period
The inflation rate is calculated as follows :
𝐶𝑃𝐼! − 𝐶𝑃𝐼"
𝜋! = 𝑥100
𝐶𝑃𝐼"
19
How the Consumer Price Index Is Calculated
Calculating the Consumer Price Index and the inflation
rate: An example
Base Year is 2020.
Basket of goods in 2020 costs $1,200.
The same basket in 2021 costs $1,236.
CPI = (($1,236-$1,200)/$1,200) ´ 100 = 3
Prices increased 3 percent between 2020 and 2022
(π = (103-100) / 100 = 0.03 = 3%).
20
Problems with measuring inflation
Substitution bias
Introduction of new goods
Unmeasured quality changes
21
GDP Deflator vs. Consumer Price Index
Economists and policymakers monitor both the GDP
deflator and the CPI to gauge how quickly prices are
rising.
Two important differences between the indexes can
cause them to diverge:
The GDP deflator reflects the prices of all goods and services
produced domestically, whereas...
…the consumer price index reflects the prices of all goods and
services bought by consumers. Imports are included. Exports
are excluded.
22
Core inflation
There are goods whose prices could change significantly
(eg. Energy prices due to OPEC decisions, or
agricultural goods depending on weather). In these
situations the short-term effect of the price change is
isolated.
Core inflation is similar to the CPI inflation excluding
these effects but "short-term". Therefore, energy prices
and prices of unprocessed agricultural products are
excluded.
23
Practical aspects
24
Practical aspects
1 It is used to index. Danger!
2 Compare figures at different times.
3 Nominal variables vs. real.
25
1.- Indexing wages in Spain: the salary-labor productivity
gap.
16,00
14,00
12,00
10,00
8,00
6,00
4,00
2,00
-
1984
1985
1986
1987
1991
1992
1993
1994
1997
1998
1999
2000
2003
2004
2005
2006
1982
1983
1988
1989
1990
1995
1996
2001
2002
2007
2008
2009
-2,00
Salary increase - collective agreeement Inflation rate Labor productivity growth
Sources: salario incrementa: desde los convenios colectivos: Spanish Ministry of Labor; Inflation rate: IMF; labor productivity growth:26
O.E.C.D.
2.- Dollar Figures at Different Times
How to convert (inflate) a 10,000 US$ wage of
1950 to US$ in 2024:
𝐶𝑃𝐼!"!#
𝑆𝑎𝑙𝑎𝑟𝑦!"!# = 𝑆𝑎𝑙𝑎𝑟𝑦$%&" 𝑥 𝑥100 =
𝐶𝑃𝐼$%&"
$10,000𝑥13,395,5 = $133,955
Inflation calculator– by U.S. BLS (Bureau of Labor Statistics)
https://data.bls.gov/cgi-bin/cpicalc.pl
27
3.- Real and Nominal Interest Rates
The nominal interest rate is the interest rate
usually reported and not corrected for inflation.
It is the interest rate that a bank pays.
The real interest rate is the nominal interest
rate that is corrected for the effects of inflation.
28
3.- Real and Nominal Interest Rates
You borrowed $1,000 for one year.
Nominal interest rate was 15%.
During the year inflation was 10%.
ir = in - π
ir = 15% - 10% = 5%
29
Overview of inflation rates
across countries
30
Inflation rates in selected countries
The forecast is that most developed nations will
continue to have lower than target inflation
rates for the years to come.
The threat of deflation in 2009 spurred
aggressive reaction by central banks
Source: IMF World Economic Outlook. and governments around the world. 31
IMF forecasts of inflation rates in groups of countries
We have seen a surge in inflation in most economies
32
IMF forecasts of inflation rates in groups of countries
Inflation is moderating in some countries
33
U.S. inflation rate through history
50
U.S. Inflation Rate Through History
40 Inflation rates have become lower and less volatile over time. This is a
pattern observed in the US and in many other countries (mainly developed).
Many agree that this is due to one of the greatest economic achievements of
30 modern times (mainly in developed economies): macroeconomic stability.
20
10
0
1712
1725
1738
1751
1764
1777
1790
1803
1816
1829
1842
1855
1868
1881
1894
1907
1920
1933
1946
1959
1972
1985
1998
Year
-10
-20
-30
Source: Economic History Services; www.eh.net/hmit/inflation/inflationr.php 34
Macroeconomic stability has also reached Spain. Spanish
inflation rate over time
% de variación del nivel de precios (interanual)
Source: IMF,World Economic Outlook, 35
Inflation Rates in Latin America: 1985-2020
Bolivia
One of the greatest economic achievements of
LACs in recent times has been the defeat of
% de variación del nivel de precios (interanual)
hyperinflation
Peru
Brazil
Source: IMF, World Economic Outlook, April 2015 36
How CPI measures inflation
37
Conclusions
1. An adequate measurement of the price level and growth is
essential. Important practical effects.
2. Global consensus: it is desirable moderate and predictable growth
in the price level. Important advances in macroeconomic stability.
38
