This chapter covers how to measure inflation, different price indices, adjusting for inflation effects, and the role of money in the economy.
Key Concepts
- Inflation is a generalized rise in the overall level of prices, not just individual price changes
- The Consumer Price Index (CPI) is the primary measure of inflation for consumers
- Nominal variables must be converted to real variables for accurate comparisons over time
- Money serves three key functions: medium of exchange, unit of account, and store of value
- Inflation imposes costs on the economy by undermining money’s functions
Measuring Inflation
The Consumer Price Index (CPI)
The CPI tracks the average price consumers pay over time for a representative basket of goods and services. The “basket” includes food, shelter, education, haircuts, streaming services, and other typical purchases.
Exam Alert
The inflation rate formula:
Constructing the CPI
Step 1: Find out what people buy
- Statistics Canada surveys thousands of people
- Goal: assemble a basket that represents the purchases of the average consumer
Step 2: Collect prices
- Surveyors visit thousands of retailers
- Click through online stores, call doctors’ offices, collect rental prices
Step 3: Tally up the cost of the basket
- The CPI puts more weight on products you buy more of
- Pick a base year, scale to $100, and track changes over time
Step 4: Calculate the inflation rate
- Calculate the percentage change in the price of that fixed basket over a year
Whiskers the Cat Example
Your cat’s basket includes 730 cans of food, 4 bags of dry food, 2 vet visits, and 3 toys.
Item 2021 Cost 2022 Cost 730 cans cat food $576.70 $584.00 4 bags dry food $56.00 $60.00 2 vet visits $140.00 $146.00 3 toys $24.00 $30.00 Total $796.70 $820.00 Inflation rate =
Challenges of Measuring the True Cost of Living
The CPI likely overstates changes in the cost of living because it tracks a fixed basket. Three things the CPI misses:
- Quality improvements - Measured price rises may reflect unmeasured quality improvements (e.g., iPhones are more expensive but have better features)
- New products - Doesn’t account for cost of living reductions from new products (e.g., smartphones replaced landlines, cameras, GPS devices, music players)
- Substitution bias - When prices rise, consumers substitute toward cheaper alternatives, but the fixed basket doesn’t capture this
Different Measures of Inflation
Consumer Price Measures
| Measure | Use |
|---|---|
| CPI | Cost-of-living adjustments, indexation clauses, government payments |
| Core Inflation | Excludes food and energy (volatile); used by forecasters for underlying trends |
| CPI-Median | Bank of Canada’s preferred measure; tracks 50th percentile of price changes |
Exam Alert
The Bank of Canada’s inflation-control target is to keep the year-over-year change in CPI close to 2%.
Business Price Measures
| Measure | Description |
|---|---|
| Producer Price Index (PPI) | Tracks prices of inputs into the production process |
| GDP Deflator | Tracks prices of all goods and services produced domestically; used to convert nominal GDP to real GDP |
Adjusting for the Effects of Inflation
Comparing Dollars Over Time
Use the inflation adjustment formula to convert dollar amounts from the past into today’s dollars:
Star Wars Box Office Comparison
The Force Awakens grossed
$1,198 millionin 2015 (CPI = 126.6). In 2020 dollars (CPI = 137.0):
Real vs. Nominal Variables
| Type | Description |
|---|---|
| Nominal variable | Measured in dollars (whose value may fluctuate over time) |
| Real variable | Adjusted to account for inflation |
To convert nominal to real using a base year:
Real and Nominal Interest Rates
Savings Example
You put 100 for a year made you $2 better off in purchasing power.
Money Illusion
Money illusion can:
- Distort decisions - What if all prices (including incomes) rose by 25%? Nothing real changed!
- Lead to mis-pricing - Incorrectly valuing assets bought years ago
- Create nominal wage rigidity - Workers feel okay with unchanged nominal wages even as real wages fall
The Role of Money and the Costs of Inflation
Three Functions of Money
Function 1: Medium of Exchange
- Used to buy goods and services
- Must be widely accepted
- Without it, you must barter (requires double coincidence of wants)
- Enables specialization in the economy
Function 2: Unit of Account
- Common unit to measure economic value
- Simplifies comparisons and trade-offs
- Must be stable to be useful
Function 3: Store of Value
- Allows shifting wealth to the future
- Should be easy to store and reliably hold value over time
The Costs of Hyperinflation
Examples: German hyperinflation of 1922-1923 (prices doubled every few days), Venezuela’s recent crisis.
Hyperinflation erodes all three functions of money, making most aspects of life harder.
The Costs of Expected Inflation
Cost 1: Menu Costs for Sellers The marginal cost of adjusting prices (reprinting menus, adjusting price tags, reprogramming vending machines).
Cost 2: Shoe-Leather Costs for Buyers The costs incurred trying to avoid holding cash.
People spend time moving money around to preserve value since inflation undermines money’s function as a store of value.
The Costs of Unexpected Inflation
Cost 3: Confuses Price Signals
- Prices help coordinate economic activity
- When all prices rise due to inflation, it’s hard to distinguish real demand signals
- Producers make mistakes interpreting price changes
Cost 4: Redistribution
- Unexpected inflation redistributes from savers and lenders toward borrowers
- Most loans specify repayment in nominal terms
- Higher-than-expected inflation means borrowers repay with less valuable dollars
Common Mistake
The inflation fallacy is the mistaken belief that inflation destroys purchasing power. Since wages also rise with inflation, purchasing power is roughly unchanged. People blame inflation for higher prices but attribute wage increases to their own hard work.
Definitions
Inflation A generalized rise in the overall level of prices; also described as a rise in the cost of living or a decline in the purchasing power of money.
Consumer Price Index (CPI) An index that tracks the average price consumers pay over time for a representative basket of goods and services.
Inflation Rate The annual percentage increase in the average price level.
Deflation A generalized decrease in the overall level of prices.
Nominal Variable A variable measured in dollars (whose value may fluctuate over time).
Real Variable A variable that has been adjusted to account for inflation.
Nominal Interest Rate The stated interest rate without a correction for the effects of inflation.
Real Interest Rate The interest rate in terms of changes in your purchasing power.
Money Any asset regularly used in transactions.
Menu Costs The marginal cost of adjusting prices.
Shoe-Leather Costs The costs incurred trying to avoid holding cash.
Inflation Fallacy The mistaken belief that inflation destroys purchasing power.
Producer Price Index (PPI) A price index that tracks the prices of inputs into the production process.
GDP Deflator A price index that tracks the prices of all goods and services produced domestically.
Substitution Bias The overestimate of the cost of living that occurs because people substitute toward goods whose prices rise by less.
Hyperinflation Extremely high rates of inflation.
Money Illusion The mistaken tendency to focus on nominal dollar amounts instead of inflation-adjusted amounts.