Notes on Principles of Macroeconomics

Vijaya Raj Sharma, Ph.D.

INFLATION, MEASUREMENT, AND EFFECTS
INFLATION
Inflation is a phenomenon of continuous rise in the general price level of goods and
services. Inflation is not a rise in the prices of one or just few goods, and it is also not a
just one-time rise in the prices of most commodities. During inflationary periods, prices
of few goods may fall, but prices of most goods rise.
Inflation can also be defined as a decline in the value or purchasing power of dollar. If the
supply of dollar (money) rises faster than the supply of goods and services in the country,
one would expect a decline in the value of dollar. Thus, an increase in money supply can
be a reason of inflation. But, there may be other reasons too. If the demand for goods and
services continuously rises faster than their supply, prices of goods and services shall rise
too. This is called demand-pull inflation. On the other hand, a continuous fall in supply of
goods and services or a continuous rise in cost of production pushes up the general price
level. This is called cost-push inflation.
CONSUMER PRICE INDEX (CPI)
For measuring inflation, an aggregate representation of prices of commodities is needed.
Such a general price level is represented through a price index; GDP deflator is one such
price index that we briefly introduced in an earlier chapter. There are other price indices
also, most notably the Consumer Price Index (CPI) and the Producer Price Index (PPI).
CPI is the cost of purchasing a hypothetical market basket of consumption goods bought
by a typical consumer during a given period of time (generally a month), relative to the
cost of purchasing the same market basket in the base year. The U.S. Bureau of Labor
Statistics publishes the CPI every month. The Bureau sends 250 surveyors to 21,000
stores around the nation to record prices of 364 consumption goods that go into the
market basket. Let us demonstrate the method of computing CPI with a hypothetical
example in Table 1.
Table 1: Market Basket and Construction of Price Index
Monthly Market
1985
1996
Cost of market basket in Cost of market basket in
Basket
Prices
Prices
1985
1996
60 hamburgers
$1.60
$3.20
$96.00
$192.00
4 T-shirts
10.00
18.00
40.00
72.00
2 jeans
24.00
24.00
48.00
48.00
1 compact disc
16.00
12.00
16.00
12.00
Total Cost of Basket
$200.00
$324.00
CPI
100
162
Let 1985 be the base year. When constructing a price index, its value is normalized to 100
in the base year. Then, the value of price index in any year t can be calculated as:

(Equation 1)

PI t

Cost of market basket in Year t

x100
Cost of market basket in Base Year

According to the above equation, CPI in 1996 = (324/200)*100 = 162, which implies that
the general price level increased by 62 percent during the 11-year period from 1985 to
1996. The above is a general formula for calculation of any price index. GDP deflator and
PPI also are calculated similarly. The formula is the same for any price index, the only
difference among different price indices is the items that go into the market basket.
In CPI the market basket consists of only the consumption goods, because the objective is
to measure the effect of inflation on households. In PPI, the market basket consists of
producer goods, like energy, raw materials, and intermediate goods. In GDP deflator, the
basket consists of all kinds of goods that go into the computation of GDP, which are
consumption goods, investment goods, goods purchased by the government, and the
goods internationally traded.
INFLATION MEASUREMENT
Inflation in any year t (t) is measured as the percentage change in price index from the
previous period:
(Equation 2)

Year
1990
1991
1992

PI t PI t 1
x100%
PI t 1

Table 2: Calculation of Inflation Rate

Price Index
Inflation Rate, %
100
110
{(110-100/100}*100=11%
121
{(121-110)/110}*100=10%

HYPERINFLATION
Hyperinflation is a run-away or out of control inflation, a very rapid and high growth
rate of prices. There is no universally accepted cut-off rate of inflation for hyperinflation.
Some economists consider 50 percent or higher monthly inflation as hyperinflation,
whereas some other economists consider an annual inflation rate of 200% or more as
hyperinflation.
PROBLEMS WITH CPI FOR MEASURING INFLATION
The use of CPI for measurement of inflation has some problems in truly measuring the
effect of inflation on households. They are:
1. If there has been a change in the lifestyle of consumers after the base year, such that
the market basket chosen in the base year does not any more correctly represent the
consumption habit of households, CPI may not reflect the true general price level and
inflation measured from such CPI may not truly measure inflation.
2. CPI generally overstates inflation. When prices of market basket goods rise,
consumers have been observed to substitute away from such market basket goods to

other cheaper goods, which may or may not have been included in the market basket
chosen for monitoring CPI. For example, when prices of beef rise, consumers may
substitute it with chicken. During the period of 1972-1980, energy prices in the USA
rose by 218 percent, but the actual energy expenses of households were observed to
have risen by only 140 percent. Households tend to substitute or conserve use of more
expensive goods. CPI ignores this behavior of households, by sticking to the same
quantity of consumption specified in the pre-determined market basket. According to
some economists, CPI overestimates inflation by about 1 to 1.5 percent. This is a
reason behind the often discussed proposal of lowering the cost of living adjustments
of social security payments to senior citizens, which are currently adjusted for
inflation as measured by CPI. Similarly, wages of government employees in some
states are revised by the rate of inflation measured by CPI; such adjustment of wages
is called the cost of living adjustment (COLA).
3. CPI also tends to overstate inflation because it ignores quality improvements. For
example, computers purchased in 2006 at a cost of $1,600 are far superior in quality
compared to computers purchased in 1985 at that cost.
NOMINAL MONEY BALANCE v. REAL MONEY BALANCE
We defined earlier that inflation was a decline in the value or purchasing power of
money. Therefore, $2,000 amount of nominal money balance stored in your safe in Year
2000 is not expected to have the same purchasing power or real value in 2006. Money
retains its nominal value, but the real value erodes with inflation. Real balance is the real
value of a nominal balance, which can be calculated by using Equation 3.
(Equation 3)
Re al Balance or Re al Value in Year t in prices of Year b No min al Balance or Value x

If the values of price index were 100 in Year 2000 and 144 in Year 2006, the purchasing
power or real balance of a nominal amount of $2,000 in Year 2006 is equal to $2,000 x
(100/144), i.e., $1,388.89, evaluated in terms of prices of Year 2000. In other words, the
goods that cost $1,388.89 in Year 2000 will now cost $2,000 in Year 2006. Or, you could
say that if you could buy 2,000 pounds of apples with $2,000 in Year 2000, you can only
buy 1,388.89 pounds with $2,000 in Year 2006.
REAL INTEREST RATE v. NOMINAL INTEREST RATE
Let us assume initially an inflation-free world, i.e., money loses no purchasing power in
such a world. Now, suppose that you lend me $1,000 for a year. This makes you forego
the opportunity of using that money for one full year. Therefore, it is reasonable for any
lender to ask certain compensation from the borrower for the loss of this opportunity.
Suppose you desire a real return of 4% on the sacrifice. That is, you demand me to return
you, besides the principal amount of $1,000, an additional $40 for compensation. Such
rate of return demanded by lenders from borrowers for compensation of loss of
opportunity to use the lent money is called the real interest rate.
Consider also a possibility that the borrower may default. In the event of default, the
lender either loses the principal amount or will have to proceed with a collection process

PI b
PI t

and even litigation in a court of law to recover the principal amount. Each lender faces
such risks of defaults and therefore may include a risk premium in the interest rate, on top
of the desired real return. Let this premium be 1%, which would raise the above interest
rate from 4 to 5%. In other words, real interest rate is the return a lender seeks for
compensation of loss of opportunity of using the lent money during the period of lending,
plus an appropriate risk premium.
Lastly, allow the possibility of inflation. Inflation may erode the real return. Suppose you
lent me $1,000 for a year at 5% interest rate. Accordingly, I returned you $1,050 at the
end of the year. You got a return of $50 over and above your principal amount of $1,000.
What if the prices of all goods increased by 3% during this year, i.e., what if the goods
that cost $1,000 a year ago now cost $1,030? Then, your real return on lending is not $50,
but $20 only after accounting for the loss of purchasing power ($50 minus $30). Lenders
regularly face this possibility of inflation; therefore, they also add a premium for
expected inflation on real interest rate. When the interest rate includes expected inflation
rate, this is called nominal interest rate.
(Equation 4)

planned i = desired r + expected

where i is the nominal interest rate, r the real interest rate, and e the expected inflation
rate. Lender adds the inflation premium simply to maintain the purchasing power of the
lent amount. Interest rates that banks and lenders quote to potential borrowers or interest
rates that are published in newspapers are nominal interest rates. If the actual inflation
during the period of lending happens to be equal to the expected rate, the lender realizes
the desired real interest rate. But, whenever the actual inflation rate is different from what
was anticipated by lender and borrower, the actual real interest rate collected by lender or
paid by borrower would be different from the desired level. To find the real interest rate
actually earned or paid, one needs to subtract actual inflation rate from the nominal
interest rate at which lending/borrowing happened:
(Equation 5)

actual r = i actual

EFFECTS OF INFLATION
People engaged in the business of lending and borrowing generally spend time and other
resources in predicting inflation, to form a judicious anticipation of future inflation to
appropriately determine nominal interest rate. In a world of low or no inflation, scarce
resources do not need to be wasted in such predictions. Therefore, controlling inflation is
often an objective of macro policy makers.
Suppose nominal interest rate in a transaction is fixed at 8%, expecting inflation rate of
3% and to have a real interest rate of 5%. But, if actual inflation during the period of
lending/borrowing exceeds the expected rate, the actual real interest rate earned by the
lender would be lower than 5%. The lender thus loses, whereas the borrower gains,
whenever actual inflation is higher than expected. On the other hand, borrower loses and
lender gains when actual inflation is below the anticipated rate. Thus, unanticipated
inflation redistributes income between lenders and borrowers.

If unanticipated inflation tends to remain high and uncertain, lenders may hesitate from
lending, which may retard investment in the economy, because investment often is
carried out with borrowed funds. Instead, people start accumulate assets in the form of
gold, real estate, and such other real goods to protect themselves from unanticipated
inflation.
HISTORICAL TREND OF INFLATION IN USA
Inflation rate as measured by CPI has remained below 5.5% annually in the last 20 years,
generally hovering around 2 to 3%. Except the period of 1972-1982 when inflation rate
was high, sometime double digit, USA has a history of generally low inflation in the last
six decades. Prior to the Second World War, inflation rate was generally %, and it is about
% in the recent years.

Source: US Bureau of Labor Statistics, 2005.

CORE INFLATION
Inflation statistics are published every month. Besides overall inflation rate, core inflation
is also reported. Core inflation is calculated by taking the CPI and excluding certain items
from the index, such as energy and food products, which can have temporary large price
fluctuations, because these fluctuations can diverge from the overall trend of inflation and
give a false measure of inflation. Core inflation is generally considered a better indicator
of underlying long-term inflation. The U.S. inflation rate in July 2006 was estimated as
0.4%, whereas the core inflation (after excluding energy and food products) was just
0.2%. The overall inflation rate was higher in July due to a sharp rise in energy prices.