CPI and Inflation

00:01 Welcome back to your online presentation of macroeconomics.

00:05 My name is James DeNicco.

00:06 This presentation will be about CPI, inflation.

00:10 CPI is the Consumer Price Index.

00:13 So as the name portends, we're going to be looking at how consumer prices change over time.

00:19 This is the second of our three major macroeconomic variables we're going to look at that we use to measure the health of the economy low and relatively stable. Rates of inflation are actually considered healthy for the economy, but too much inflation, inflation, there's costs associated with that.

00:36 So we want to understand those costs.

00:39 So what are we going to be looking at in this presentation? Well, we're going to look at what the CPI is, exactly how we measure the CPI. We want to know how you calculate inflation using the CPI. There's problems with the CPI.

00:54 It's not perfect. Again, it's another manmade measure like GDP.

00:59 We have accounting rules that we're subject to when we calculate the CPI.

01:04 So it's imperfect.

01:05 We want to understand those imperfections.

01:08 We're going to look at what the costs of inflate inflation are.

01:11 Why do we care about it? And finally, what's the main culprit of inflation? I'll give you a little bit of foreshadowing.

01:18 It's the printing of money.

01:19 Usually runaway inflation is highly correlated with the printing of money. So let's get into it first.

01:26 What is CPI? Again, it's always nice to start with the definition.

01:30 So for any given period, the CPI measures the cost in that period of a standard basket of goods and services relative to the cost of a basket of goods and services in a fixed year called the base year.

01:46 That standard, the word standard is very important here.

01:49 We're going to keep a consistent basket over time so we can see how the prices change for the same goods.

01:56 And we're going to have that all relative to this base year.

01:59 We're going to fix the year.

02:00 We'll say this is the year we want everything relative to how do prices change compared to that year.

02:06 So our equation for the CPI, it's going to be the price in the current year of that standard basket of goods divided by the price of that same standard basket of goods in our base year times 100.

02:20 Again, like when we use the GDP deflator, the Times 100 just turns it into an index for us.

02:26 So if the CPI is above 100, that means there has been inflation compared to the base year.

02:35 The GDP deflator was the other measure that we use to look at inflation, CPI we're looking at now.

02:41 They're a bit different. There's other measures of inflation as well.

02:45 So what are the differences between the GDP deflator and the CPI? Well, the GDP deflator looks basically at the prices of production.

02:54 The GDP deflator is subject to the rules of GDP.

02:58 So how do the prices of production goods and services go up over time? The CPI, as I said, is the Consumer Price Index, so it doesn't care about the rules of GDP, the GDP deflator.

03:11 It's everything produced within our borders.

03:13 The CPI doesn't care where something is produced.

03:16 If you're buying at the supermarket, they want to know about it.

03:19 It's a measure trying to look at the normal goods and services that we all buy in our daily lives to see how those prices go up over time.

03:28 So how we're affected in our normal lives and our purchasing by the increase in prices. So again, the GDP deflator is subject to the rules of GDP. The CPI is looking only at consumer goods, what you buy no matter where it was produced.

03:45 So how do we calculate the CPI? First, we want to fix our basket.

03:49 That's very important.

03:51 Obviously, if the basket change is what we're calculating in the prices of changes, the price of the basket is going to change.

03:58 So we want to keep that consistent over time.

04:01 So if we have eggs and bread and milk, just those three items in our basket one year, we just want eggs and milk and bread in that basket. The next year, if we allow that composition to change, of course there's going to be a difference in the price.

04:17 There's a difference in the value of different goods.

04:20 So we want the same goods with the same value and look at how those prices change over time.

04:26 So we fixed that basket.

04:28 So that gives us our consistent measure over time.

04:32 Next, we want to find the prices.

04:35 So the Consumer Price Index in the United States is calculated by the Bureau of Labor and Statistics.

04:41 Literally, they go out and they find out the prices of all these different thousands of items in the store. And look at the price tag.

04:48 How much does that item cost? So they go out and they find the price of the different items in that standard basket of goods.

04:57 So then they calculate the price of the basket of goods.

05:01 Now that we found all the items that we're going to have in there, we fixed our basket.

05:05 We found the price, the price of all those goods.

05:08 Now we're going to calculate the cost of the whole basket.

05:12 Finally, we compute our index again.

05:15 Our CPI equals the price of our standard basket of goods in our current year divided by the price or the cost of our standard basket of goods in our base year.

05:26 So it's all relative to that base year.

05:29 Our price is going up.

05:31 Relative to that base year.

05:32 We multiply it by 100 to put it into our index.

05:37 So let's do an example here.

05:38 First, we need to fix our basket of goods.

05:41 So in this example, I just have three goods.

05:44 I have one time rent of a two bedroom apartment.

05:49 I have 60 hamburgers and I have ten movie tickets.

05:53 Now, I guess we'll say this is per month.

05:55 That's a lot of hamburgers in a month.

05:57 But I like hamburgers, so we'll go with it.

05:59 I'm eating 60 hamburgers a month.

06:00 It's all on me. We only have three goods in here, so we fixed our standard basket of goods. Then we go out and we find our price.

06:08 So we have our prices.

06:10 In year 2000, the rent for our two bedroom apartment is $500.

06:15 Each of our 60 hamburgers cost $2 and our movie tickets, they cost $6. Then in 2005, we're going to want to do the same thing. We keep our basket the same the same goods in there so we don't change that composition. So we're looking how the price has changed for those same goods over time. In 2005, our our rent for our two bedroom apartment is $630.

06:41 Our hamburgers now cost $2.50 and our movie tickets cost $7.

06:47 Well, now that we fixed our basket and we found our prices, we can calculate the cost of that basket.

06:54 It's very simple.

06:56 So our bedroom, our rent here in 2000, one times 500 is 500. Our 60 hamburgers times $2 is $120.

07:05 Our ten movie tickets times are $6 is $60.

07:09 You add all those up and what you get is $680.

07:14 Our standard basket of goods and 2000 is $680 for 2005.

07:21 Again, the same goods one time rent of a two bedroom apartment times $630 is 630.

07:30 Our 60 hamburgers times are $2.50 is $150 are ten movie tickets.

07:38 Times are $7 comes out to $70.

07:41 You add all those up.

07:43 And now our standard basket of goods is gone from $680 to $850.

07:49 So now we can calculate our CPI.

07:53 We need to pick a base year.

07:55 So here we'll pick your 2000 as our base year.

07:59 So that's the year everything's going to be relative to.

08:02 So if we want to calculate our CPI or our consumer price index, it's the price in the current year over the price and the base year times 100.

08:11 Just like with the GDP deflator, our index in the base year is always going to be 100 because the price is in the current year and the and the base year for our standard basket of goods is the same.

08:23 Now for 2005 here, our price in our current year is $850. The price in our fixed year, our base year is $680. So 850 divided by 680 times 100 is 125.

08:39 So compared to our base year, we see that there's been some inflation, 125 is greater than 100.

08:47 So prices for that standard basket have gone up over time.

08:51 So now that we've calculator CPI, we can look at how we calculate our inflation rates.

08:58 So how do we do that? Well, it's going to be a percent change again, just like with the GDP deflator, it will be CPI in your T minus CPI in your T minus one divided by CPI in your T minus one times 100.

09:13 In other words, if we're using the inflation rate from 2000 to 2005, you want the CPI in 2005 minus the CPI in 2000 divided by the CPI in 2000 times 100.

09:27 So what was the inflation rate? What was the percent change in the CPI from 2000 to 2005? Well, here it's a pretty easy example, 125 -100 divided by 100 times 100.

09:41 Our inflation rate was 25% over five years.

09:46 So this is a quote that I like.

09:48 Inflation is when you pay $15 for the $10 haircut you used to get for $5 when you had hair.

09:56 I always like to talk about that and because it makes me feel good thinking about myself relative to my brothers.

10:01 So it's nice to see my brothers.

10:03 They're starting to lose their hair.

10:04 I can shave mine because I know it's always going to come back.

10:07 I have a nice full head of hair, so I like to show this to my brothers to remind them that they're going bald while I keep my hair.

10:15 You have to have fun with economics.

10:17 So let's do some more examples.

10:20 Let's calculate some more inflation rates.

10:22 All right. So let's look at the inflation rate from 1931 to 1932 in the United States.

10:28 So here, these are real numbers.

10:29 I went and pulled them from the Bureau of Labor and Statistics.

10:32 So from 1931 to 1932, let's take a look.

10:36 We have a CPI in 1931 of 15.2.

10:40 We have a CPI in 1932 of 13.7.

10:45 So to calculate our inflation rate, we just say CPI, T minus CPI, T minus one over CPI, T minus one times 100.

10:53 Here we're just going to have 13.7 -15.2 times 15.2 times 100. We see that the inflation rate is negative nine.

11:06 That's negative inflation.

11:08 It's what we call deflation.

11:10 So that's an example where the price level for our standard basket of goods has gone down over time.

11:16 The CPI also allows us to have some fun games.

11:19 All right. So when your grandfather complains about how so small his starting salary was compared to your starting salary, you can fact check your grandpa. You can take a look and see in real terms if he's telling the truth. Of course, he made less in nominal terms in dollar figures.

11:37 Of course he's going to make less starting out compared to what you're going to make starting out because there's inflation over time.

11:44 So what would your grandfather's salary be in today's terms? So let's do a little example.

11:50 So in year 1972, we have a CPI of 41.8. Your grandfather's starting salary was $25,000 in 2013.

12:01 The CPI is 130.

12:03 Your starting salary is 75,000.

12:07 Obviously, in nominal terms, in dollar terms, 75,000 is greater than 25,000.

12:14 But what about in real terms how much stuff you can buy? That's much more important than the dollar figure is how much stuff you can buy.

12:22 So let's turn Grandpa's $25,000 into today's terms to see who is actually doing better as far as purchasing power goes.

12:33 So there's two ways you can do this.

12:35 There's the longer way, and then there's a shortcut.

12:38 The shortcut works because the long way works, so we'll go through both.

12:42 So you would want to use your CPI equation and solve for your missing variable. So you have your grandfather's 25,000, you know, the CPI is 41.8.

12:54 You know the equation to find out the CPI, it's current year of that basket of goods divided by the base year times 100 equals 41.8. So what we would need to do is find the salary in the base year for your grandfather.

13:11 So when we solve that, we would find that the base year is 59,809, just using a little bit of algebra.

13:20 So now that we have the base year salary for your grandfather, we can take that and turn it into year 2013 terms.

13:28 Again, using the equation of the CPI.

13:31 Now we have the base year.

13:33 We know the CPI in 2013, we can find the wages in 2013.

13:38 So just using a little bit of algebra again, we find out that in purchasing power terms, your grandfather was making $77,752.

13:49 He was actually doing better than you with your starting salary of 75,000.

13:54 He was able to make more stuff than, buy more stuff than you, so he was actually better off than you.

14:01 So there's a shortcut to doing this as well.

14:04 So if you're calculating this, you don't have to go through those two steps.

14:08 You can use ratios to solve this much quicker.

14:12 And it works because everything is relative to our base year.

14:15 So you don't have to go through these two steps.

14:18 What you can do is say the dollars in one year over the CPI in that year has to equal the dollars in another year over the CPI in that other year.

14:28 So you can set it up like this.

14:30 So your 25,000 over your CPI of 41.8 has to equal that 25,000 in 2013 terms over the CPI in 2013 of 130. Again, you just use a little bit of algebra and you'll find the same answer. Your grandfather's wage was $77,750. So you can say, Relax, Grandfather, I'm not making any more than you in real terms.

14:59 You are actually doing better in what you can purchase than I was.

15:03 So a little bit of fun with the CPI there.

15:07 So policymakers actually use the CPI.

15:10 They use it for something called indexing.

15:13 Now, indexing is when you tie a nominal benefit to an inflation rate.

15:18 So why would you want to do that? So you're receiving some sort of benefit, say, in the United States, it's Social Security. So when people reach a certain age, they paid into Social Security and they get a certain amount of money from the government each month or each period.

15:35 So you want that real benefit to stay the same over time. If it was $100 you were receiving over time as there's inflation, that $100 can buy less and less amount of stuff.

15:49 So you want to go ahead and you want to tie that benefit to an inflation rate.

15:55 So in nominal terms, the benefit increases at the same rate of inflation, so that in real terms it stays the same.

16:04 You're able to buy the same amount of stuff over time.

16:08 So again, the nominal quantity that's in current dollars, the real quantity, that's the amount of stuff you can buy, which is much more important than the actual dollar figure.

16:18 If you're making $100 and everything costs $2, that's much better.

16:23 If you're making than if you're making $100 and everything costs $10, you're able to buy a lot less stuff as inflation goes up.

16:31 So they have this practice of indexing.

16:34 The trouble with indexing to the CPI, which is what the United States government ties Social Security to, is that the CPI overstates inflation. So now we're going to talk about some of the flaws in the CPI because we have this fixed basket of goods.

16:51 This measurement isn't perfect over time because it can account for changes in people's behavior.

16:57 The first problem with the CPI is this substitution bias.

17:01 We have this standard basket of goods, so that standard basket of goods doesn't allow us to account for people's change of behavior.

17:10 So there's probably a lot of coffee drinkers out there.

17:13 So say you go to the store to get your cup of coffee and coffee has gone from $2 to $15.

17:20 Well, there's some of you that may be very loyal to your coffee.

17:23 You're going to get your coffee anyway.

17:25 So I'm not talking I'm talking to everybody else who normally sees the prices go up.

17:30 We're going to change our behavior.

17:32 We're going to substitute away from that coffee.

17:35 We're not going to stop drinking our caffeine because we need our caffeine.

17:38 Without our caffeine, where it will be big, we'd have no energy left.

17:42 Right. But we're not going to keep drinking coffee when it's going from $2 to $15 a cup we might substitute to tea.

17:50 We'll start drinking more tea, which is cheaper.

17:53 Well, that standard basket of goods doesn't allow that.

17:55 If the basket says you drink ten cups of coffee at $2 is going to say you're drinking ten cups of coffee at $15.

18:03 It doesn't allow that substitution, which is going to exaggerate inflation.

18:08 In reality, you're probably not drinking ten cups of coffee anymore.

18:12 You're maybe drinking five cups of coffee and five cups of tea at that lower price. So your general spending, the inflation isn't going to be as much as it looks like with the CPI.

18:24 It doesn't allow for that change in people's behavior.

18:28 It doesn't allow for the substitution that we see that takes place.

18:32 We have that fixed basket of goods.

18:34 We're subject to those accounting rules.

18:36 So that's the first problem of the CPI and that overstates inflation.

18:41 The second problem with the CPI is what we call the quality adjustment bias.

18:46 So say you have a computer in 1970 in the basket and a computer in 2014 in the basket was going to say, there's a computer, there's a computer.

18:55 Maybe in 1970, it cost $1,000.

18:58 In the year 2014, it cost 1200 dollars.

19:01 But the computer in 2014 is way more powerful than the computer in 1970. My phone is probably more powerful than the computer in 1970. It doesn't see that increase in the quality of that good.

19:14 It just sees the increase in the price.

19:17 But the value of the good is going up.

19:19 So it's going to overstate inflation.

19:21 So the people that measure this inflation, they've tried to take steps to correct this.

19:26 So they'll take a computer and they'll take the different parts of it.

19:29 They'll say the ram or the gigs, the memory, the speed.

19:32 But look at those individual parts instead of just a computer here and a computer there. So they attempt to fix these problems.

19:41 But the problem still holds with some goods.

19:43 If you have a good in the past versus good in the future, they won't see the quality adjustment or the increase in the value of the good.

19:50 In the future, they'll only see the increase in the price.

19:53 So again, it's going to overstate inflation.

19:56 The third problem, which also overstates inflation, is what we call the introduction of new goods buys.

20:02 Again, we have the standard fixed basket of goods we don't allow.

20:07 It's in there. But with new technologies and new goods, we usually see an efficiency and efficiency with that technology that allows us to have better, higher quality goods at lower cost.

20:18 It doesn't allow for that.

20:20 So it says you can't substitute to these new goods.

20:23 It's like the substitution bias.

20:25 But with this with these new goods, with these efficiencies from technology.

20:29 So it doesn't allow for these lower cost, more valuable goods to be in that basket. So, again, it's going to overstate inflation, whether it's the substitution bias, the quality adjustment bias or the introduction of new goods bias, it's going to overstate inflation.

20:46 Now, when you're indexing benefits to the CPI, that's going to cause a problem in real terms.

20:53 People's benefits are going to be increasing over time.

20:56 If you tie the nominal or the dollar figure of those benefits to inflation, as inflation rises in real terms, the benefit goes up and they can buy more stuff. If you're the one receiving the benefit, you probably don't see that as a problem. But if you're the people paying for the benefit, that is a problem.

21:12 You're looking to keep the benefit in real terms the same over time.

21:16 You don't want it to increase over time.

21:18 So those are the flaws with our man made measure of the CPI.

21:23 So now why do we care about inflation? What are the problems? Inflation? Well, if there's too much inflation, we're going to see cost to the economy. The first is what we call our shoe leather cost.

21:34 And it comes from the fact that you're walking around with money in your pocket.

21:38 So your shoes, if they're made of leather, shoe leather costs.

21:41 So I have a dollar here.

21:44 All my money is big dollar I'm walking around with in my pocket.

21:48 So as I have this dollar in my pocket and I walk around, inflation's taking place. The purchasing power of this dollar is being eroded.

21:56 So if candy bars cost $0.50 today, I can get two candy bars with my dollar. If tomorrow, candy bars cost $0.55 today, now I can only buy one candy bar with my dollar.

22:09 I need to find some more money to get that second candy bar.

22:13 And it's especially acute with the money in your pocket as opposed to money you might keep in your savings account.

22:19 Because in your savings account, at least, you're earning interest to combat those shoe leather costs.

22:25 Normally, interest rates are associated with price levels.

22:29 So as prices go up, what you'll see the Federal Reserve in the United States or the central bank in any country, the Central Bank of Europe, they're going to try to raise interest rates to combat inflation.

22:41 So at least as there's inflation and shoe leather costs that are eroding the purchasing power of the dollar, your interest rates will go up and you'll be sheltered from some of those shoe leather costs.

22:52 Your money will be increasing with the interest rate to combat the erosion of your purchasing power.

22:58 So that's the first cost are shoe leather costs.

23:01 Our second cost here are distortions in the tax system.

23:05 So as inflation goes up, what you're often going to see is firms are going to increase your nominal wages that keep your real wages the same. So they're earning more for their products.

23:19 So they're going to want to keep your real wages or your purchasing power the same.

23:23 So they'll increase your nominal wages to keep your real wages the same so that you don't become dissatisfied and go look for work somewhere else.

23:32 The problem with that is it can bump you up into higher tax bracket.

23:36 So what that means is the government will be taking a larger percentage of your money in real terms. You're able to buy the same amount of stuff with that more money.

23:45 But now the government comes and takes a larger percent in taxes.

23:49 So actually you're able to buy a lower amount of stuff because of that inflation.

23:54 You're getting bumped up into that higher tax bracket and that's costing you.

23:58 That's our second cost of inflation.

24:01 We also have what's called our unexpected redistribution of wealth.

24:05 So we have banks out there and banks they're going to set their nominal interest rate or the interest you'll pay on a loan.

24:12 It's based on the real interest rate plus what they expect inflation to equal. This is called our Fisher Equation.

24:20 So you have the banks, they say, hey, I'm going to make this guy alone.

24:24 I wanted to figure out how much interest he should pay monthly on that loan.

24:28 I'm going to take a look at the real interest rate right now and what I expect inflation to be.

24:34 And that's what he's going to pay me per month on that loan.

24:38 However, when the realization of those payments come, it's no longer expected inflation. It's what actual inflation is.

24:45 So the real return or the real interest rate that they're earning on that loan equals the nominal interest rate minus the actual inflation rate.

24:56 So the actual inflation rate is higher than what they expected it to be.

25:01 Their real return is going to be lower.

25:03 Now, that's good for the people that took the loan out.

25:06 The banks who gave the loan, that hurts them.

25:08 That hurts their balance sheets.

25:10 Now, some people might have little sympathy for the banks, but if the banks are losing money, they're going to have to find a way to make that up through fees or through whatever else. Or they're going to be less likely to hand out loans.

25:22 So you don't want the banks to be in a bad position, even though some of us might not have that much sympathy for the banks.

25:29 So you had your shoe leather costs.

25:31 Now you have your unexpected redistribution of wealth.

25:34 We also had our distortions in the tax system, our cost of inflation.

25:40 Our last cost here is our noisy signal.

25:42 What the noisy signal is when firms look out there and they see prices going up, that can mean there's also higher demand.

25:50 As demand increases for a good or service, the price is going to go up.

25:55 However, that's not always the reason why prices are going up.

25:58 Say there's too much money printing going on, so there's just inflation across the board. Well, firms might misinterpret that increases inflation as an increase in demand.

26:08 So what they'll do is they'll ramp up their production.

26:12 But if there's no increase in demand, that production is going to go on sold.

26:16 They're going to produce be producing more goods when they shouldn't be.

26:20 That will cost them. It'll just be sitting on their cell- shelves as inventory.

26:23 They might have to lower the price of those goods, get rid of them.

26:26 So that's our that's our cost of inflation through the noisy signal noisy signal, because they're having a hard time interpreting that signal. Now, what's the cause of inflation? Oftentimes, the cause of inflation is going to be printing the money.

26:42 We see very strong linkages are very strong correlations between the printing of money and inflation.

26:49 So we have some examples of this throughout history in times we call hyperinflation.

26:54 Hyperinflation is a very, very bad and destabilizing thing for an economy.

26:59 You take a look at post-World War one Germany, and you saw this hyperinflation after the war.

27:06 They had to pay back these reparations, all these countries, they couldn't keep up.

27:10 So they started printing money.

27:12 So as they started printing money, price levels got out of control to the point where the currency became almost worthless.

27:19 I have a picture here of a woman burning money to stay warm because the money wasn't able to buy anything.

27:26 It got to that point where people were just throwing money away.

27:28 There's pictures of children playing the stacks of millions of dollars because the money is worthless.

27:34 That's a very destabilizing for an economy.

27:37 And then you also have Zimbabwe in the 2000s.

27:41 So you had what you call the million dollar economy, or people would go to the store, they would go to the market.

27:48 And in the morning you have a loaf of bread that costs thousands of Zim dollars. And then in the afternoon it caused millions of Zim dollars.

27:56 By the next day, it costs billions of dollars to the point where the money again was worthless and people weren't even accepting the money.

28:04 So in order to be able to buy something, people would have to go pan for gold in the rivers. If you couldn't find gold that day, you weren't eating.

28:12 So there's very bad consequences to this hyperinflation.

28:16 That's why we want to understand it and we want to know what goes into it so that we can combat those bad consequences, so that we can try to prevent this hyperinflation. Mm hmm.

28:27 So that was our presentation.

28:30 What did we learn? Well, we know the definition and the accounting rules for CPI.

28:35 We know how to calculate CPI, and we know how to calculate inflation rates using CPI.

28:42 We knew how to use the CPI to compare nominal quantities over time or real quantities over time.

28:49 We know how the CPI has a tendency to be biased towards overstating inflation and we also learn the cost of inflation.

28:56 The reason we really care why we use this macroeconomic variable to measure the health of the economy because there's costs associated with it.

29:05 Thank you very much.