Key Concepts and Summary

Key Terms

adjustable-rate mortgage (ARM) a loan a borrower uses to purchase a home in which the interest rate varies with market interest rates base year arbitrary year whose value as an index number economists define as 100; inflation from the base year to other years can easily be seen by comparing the index number in the other year to the index number in the base year—for example, 100; so, if the index number for a year is 105, then there has been exactly 5% inflation between that year and the base year basket of goods and services a hypothetical group of different items, with specified quantities of each one meant to represent a “typical” set of consumer purchases, used as a basis for calculating how the price level changes over time Consumer Price Index (CPI) a measure of inflation that U.S. government statisticians calculate based on the price level from a fixed basket of goods and services that represents the average consumer's purchases core inflation index a measure of inflation typically calculated by taking the CPI and excluding volatile economic variables such as food and energy prices to better measure the underlying and persistent trend in long-term prices cost-of-living adjustments (COLAs) a contractual provision that wage increases will keep up with inflation deflation negative inflation; most prices in the economy are falling Employment Cost Index a measure of inflation based on wages paid in the labor market GDP deflator a measure of inflation based on the prices of all the GDP components hyperinflation an outburst of high inflation that often occurs (although not exclusively) when economies shift from a controlled economy to a market-oriented economy index number a unit-free number derived from the price level over a number of years, which makes computing inflation rates easier, since the index number has values around 100 indexed a price, wage, or interest rate is adjusted automatically for inflation inflation a general and ongoing rise in price levels in an economy International Price Index a measure of inflation based on the prices of merchandise that is exported or imported Producer Price Index (PPI) a measure of inflation based on prices paid for supplies and inputs by producers of goods and services quality/new goods bias inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not account for improvements in the quality of existing goods or the invention of new goods substitution bias an inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise considerably

Key Concepts and Summary

9.1 Tracking Inflation

Economists measure the price level by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. Economists often express the price level in terms of index numbers, which transform the cost of buying the basket of goods and services into a series of numbers in the same proportion to each other, but with an arbitrary base year of 100. We measure the inflation rate as the percentage change between price levels or index numbers over time.

9.2 How to Measure Changes in the Cost of Living

Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias, by which a fixed basket of goods does not allow for buying more of what becomes relatively less expensive and less of what becomes relatively more expensive; and the quality/new goods bias, by which a fixed basket cannot account for improvements in quality and the advent of new goods. These problems can be reduced in degree—for example, by allowing the basket of goods to evolve over time—but we cannot totally eliminate them. The most commonly cited measure of inflation is the Consumer Price Index (CPI), which is based on a basket of goods representing what the typical consumer buys. The Core Inflation Index further breaks down the CPI by excluding volatile economic commodities. Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all GDP components. The Producer Price Index is based on prices of supplies and inputs bought by producers of goods and services. An Employment Cost Index measures wage inflation in the labor market. An International Price Index is based on the prices of merchandise that is exported or imported.

9.3 How the U.S. and Other Countries Experience Inflation

In the U.S. economy, the annual inflation rate in the last two decades has typically been around 2% to 4%. The periods of highest inflation in the United States in the twentieth century occurred during the years after World Wars I and II, and in the 1970s. The period of lowest inflation—actually, with deflation—was the 1930s Great Depression.

9.4 The Confusion Over Inflation

Unexpected inflation will tend to hurt those whose money received, in terms of wages and interest payments, does not rise with inflation. In contrast, inflation can help those who owe money that they can pay in less valuable, inflated dollars. Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, even low rates of inflation can complicate future planning. High rates of inflation can muddle price signals in the short term and prevent market forces from operating efficiently, and can vastly complicate long-term savings and investment decisions.

9.5 Indexing and Its Limitations

A payment is indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with cost-of-living adjustments (COLAs) and loan agreements like adjustable-rate mortgages (ARMs). Examples of indexing in the public sector include tax brackets and Social Security payments.

Self-Check Questions

1 . Table 9.4 shows the fruit prices that the typical college student purchased from 2001 to 2004. What is the amount spent each year on the “basket” of fruit with the quantities shown in column 2? (2001) Amount (2002) Amount (2003) Amount (2004) Amount Items Qty (2001) (2002) (2003) (2004) Price Price Price Price Spent Spent Spent Spent Apples 10 $0.50 $0.75 $0.85 $0.88 Bananas 12 $0.20 $0.25 $0.25 $0.29 Grapes 2 $0.65 $0.70 $0.90 $0.95 Raspberries 1 $2.00 $1.90 $2.05 $2.13 $2.13 Total TABLE 9.4 2 . Construct the price index for a “fruit basket” in each year using 2003 as the base year. 3 . Compute the inflation rate for fruit prices from 2001 to 2004.