Low and stable rate of inflation

Problems in Measuring the Cost of Living

The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.

§ Substitution bias

§ Introduction of new goods

§ Unmeasured quality changes

Substitution Bias

The basket does not change to reflect consumer reaction to changes in relative prices.

Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution. Changes in relative prices lead consumers to change the items they buy. People cut back on items that become relatively more costly and increase their consumption of items that become relatively less costly.

For example, suppose the price of beef rises while the price of chicken remains constant. Now that beef is more costly relative to chicken, you might decide to buy more chicken and less beef. Suppose that you switch from beef to chicken, spend the same amount on meat as before and get the same enjoyment as before. Your cost of meat has not changed. But the CPI says that the price of meat has increased because it ignores your substitution between goods in the CPI basket.

In another arena, when confronted with higher prices, people use discount stores more frequently and non-discount stores less frequently. Suppose that petrol prices rise by 10 cents a litre. Instead of buying from your nearby petrol station for $1.50 a litre, you now drive farther to a petrol station that charges $1.40 a litre. Your cost of petrol has increased when you factor in opportunity cost but your cost has not increased by as much as the 10 cents a litre increase in the pump price.

Introduction of New Goods

The basket does not reflect the change in purchasing power brought on by the introduction of new products. New products result in greater variety, which in turn makes each dollar more valuable. Consumers need fewer dollars to maintain any given standard of living.

If you compare the price level in 2015 with that of 1995 you must somehow compare the price of a digital camera today with a film camera in 1995. Because digital cameras do a better job than film cameras you are better off with the new technology if the prices were the same. But digital cameras are more expensive than film cameras. How much of the higher price is a sign of higher quality? As the statisticians are not sure, they simply consider the price increase as a non-qualitative increase.

Unmeasured Quality Changes

If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. The Statistics bureau tries to adjust the price for constant quality, but such differences are hard to measure.

Cars and many other items get better every year. Central locking, airbags and antilock braking systems all add to the quality of a car. But they also add to the cost. Is the improvement in quality greater than the increase in cost? Or do car prices rise by more than can be accounted for by quality improvements? To the extent that a price rise is a payment for improved quality, it is not inflation. But the CPI probably counts too much of any price rise as inflation (overstates inflation).

As a result of the above, the CPI overstates inflation by about 1 percentage point per year.

The GDP Deflator versus the Consumer Price Index

The GDP deflator is calculated as follows:

§ 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.

§ The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)...

§ …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

Core/underlying rate of inflation

The question of the correct way to measure inflation is an important one. Price stability over time, along with "maximum" sustainable economic output and employment, are the Federal Reserve’s primary goals in making monetary policy. The maintenance of price stability—avoiding high inflation rates or deflation over time—is important because fluctuating prices distort the economy’s price signals and can result in the misallocation of scarce resources.

The Federal Reserve carefully reviews and analyzes the available inflation measures to monitor how well it is achieving its price stability goal. One common way economists use inflation data is by looking at “core inflation,” which is generally defined as a chosen measure of inflation (e.g., the Consumer Price Index or CPI, the Personal Consumption Expenditures Price Index or PCEPI, or the Gross Domestic Product Deflator) that excludes the more volatile categories of food and energy prices.

Why are food and energy prices typically more volatile than other prices?

To understand why the categories of food and energy are more sensitive to price changes, consider environmental factors that can ravage a year’s crops, or fluctuations in the oil supply from the OPEC cartel. Each is an example of a supply shock that may affect the prices for that product. However, although the prices of those goods may frequently increase or decrease at rapid rates, the price disturbances may not be related to a trend change in the economy’s overall price level. Instead, changes in food and energy prices often are more likely related to temporary factors that may reverse themselves later.

Fluctuations in energy prices reflect a change in those prices over time relative to other prices. This means, for example, that increases in the price of oil, an important input of many other goods, will make oil-dependent goods and services (e.g., automobiles) more expensive relative to less oil-intensive goods and services (e.g., bicycles). The important point to note is that the energy price fluctuations often resulted from factors other than an underlying trend increase in general prices. Therefore, the changes in energy prices are not necessarily a sign of inflation and, when they are included, can distort a trend increase in general prices. By measuring core inflation, economists are attempting to isolate what is happening to general prices without distraction from spikes in volatile energy prices.

Should food and energy prices ever be included in measures of inflation?

If economists were to look only at measures of inflation that include expenditures on food and energy, which would include their more-sensitive price fluctuations, they may be fooled into believing that general prices are rising or falling more rapidly than they really are. An additional argument for excluding changes in food and energy prices from measures of inflation is that, “although these prices have substantial effects on the overall index, they often are quickly reversed and so do not require a monetary policy response.” (Motley, 1997).

Having said this, measures of inflation that do incorporate food and energy prices are still useful in many circumstances and are closely followed by economists for clues to the behavior of the overall price level. For example, economists may view the sensitive nature of food and energy prices as a symptom of future overall price increases. “A rise in aggregate demand that might set off a period of higher inflation may initially show up in increases in certain sensitive prices that are set in more competitive markets. If these prices are ignored because they are ‘volatile,’ these early signals of inflation may be missed.” (Motley, 1997).

Determining when to use a core inflation measure versus an overall inflation measure can be a very complicated question

Source - http://www.frbsf.org/education/publications/doctor-econ/2004/october/core-inflation-headline/

Recent statistics on inflation in China

See - https://www.scmp.com/news/china/article/2163529/chinas-inflation-hits-six-month-high-trade-war-not-blame

Producer Price Index

Background

The Producer Price Index (PPI) is a weighted index of prices measured at the wholesale, or producer level. A monthly release from the Bureau of Labor Statistics (BLS), the PPI shows trends within the wholesale markets (the PPI was once called the Wholesale Price Index), manufacturing industries and commodities markets. All of the physical goods-producing industries that make up the U.S. economy are included, but imports are not.

The PPI release has three headline index figures, one each for crude, intermediate and finished goods on the national level:

1. PPI Commodity Index (crude): This shows the average price change from the previous month for commodities such as energy, coal, crude oil and the steel scrap. (For related reading, see Fueling Futures In The Energy Market.)
2. PPI Stage of Processing (SOP) Index (intermediate): Goods here have been manufactured at some level but will be sold to further manufacturers to create the finished good. Some examples of SOP products are lumber, steel, cotton and diesel fuel.
3. PPI Industry Index (finished): Final stage manufacturing, and the source of the core PPI.

The core PPI figure is the main attraction, which is the finished goods index minus the food and energy components, which are removed because of their volatility. The PPI percentage change from the prior period and annual projected rate will be the most printed figure of the release.

The PPI looks to capture only the prices that are being paid during the survey month itself. Many companies that do regular business with large customers have long-term contract rates, which may be known now but not paid until a future date. The PPI excludes future values or contract rates.

The PPI does not represent prices at the consumer level - this is left to the Consumer Price Index (CPI), which is released a few trading days after the PPI. Like the CPI, the PPI uses a benchmark year in which a basket of goods was measured, and every year after is compared to the base year, which has a value of 100. For the PPI, that year is 1982.

Changes in the PPI should always be presented on a percentage basis, because the nominal changes can be misleading as the base number is no longer an even 100.

What it Means for Investors

The biggest attribute of the PPI in the eyes of investors is its ability to predict the CPI. The theory is that most cost increases that are experienced by retailers will be passed on to customers, which the CPI could later validate. Because the CPI is the inflation indicator out there, investors will look to get a sneak preview by looking at the PPI figures. The Fed also knows this, so it studies the report intently to get clarity on future policy moves that might have to be made to fight inflation. (To learn more, read The Consumer Price Index: A Friend To Investors.)

Two downsides of the "basket of goods" approach are worth mentioning here. First, the PPI uses relative weightings for different industries that may not accurately represent their proportion to real gross domestic product (GDP); the weightings are adjusted every few years but small differences will still occur. Secondly, PPI calculations involve an explicit "quality adjustment method" - sometimes called hedonic adjustments - to account for changes that occur in the quality and usefulness of products over time. These adjustments may not effectively separate out quality adjustments from price level changes as intended.

PPI index data for capital equipment is used by the Department of Commerce to calculate the GDP deflator.

The removal of food and energy prices is almost implicit in most media releases today, but investors should determine on their own what the long-term rates of growth are for these two important items. We all have to purchase food and energy, so if these costs grow faster than the core PPI (or CPI) over time, consumers, and eventually GDP, are going to both feel the pinch. For investors who have holdings in these industries, there will be interest in seeing higher price levels, which should eventually lead to higher company revenues. (To learn more, read The Importance Of Inflation And GDP.)

While the PPI used to cover just the "physical goods" industries such as mining, manufacturing, and the like, many services-based industries have been brought into the index over time. Investors can now find PPI information on air and freight travel, couriers, insurers, healthcare providers, petroleum distribution and many more in the detailed release.

Strengths:

• Most accurate indicator of future CPI
• Long "operating history" of data series
• Good breakdowns for investors in the companies surveyed (mining, commodity info, some services sectors)
• Can move the markets positively
• Data is presented with and without seasonal adjustment

Weaknesses:

• Volatile elements, such as energy and food, can skew the data.
• Not all industries in the economy are covered.

The Closing Line

The PPI gets a lot of exposure for its inflationary foresight and, as such, can be a big market mover. As a result, the PPI is very useful for investors in the industries covered in terms of analyzing potential sales and earnings trends.

Source - http://www.investopedia.com/university/releases/ppi.asp

See - China factory prices surge most since 2008, boosting reflation - http://www.scmp.com/news/china/policies-politics/article/2077376/china-factory-prices-surge-most-2008-boosting-reflation

Task 4: Questions on measuring the rate of inflation

1: Suppose that people consume only three goods as shown in the following table:

Tennis Tennis Lucozade

Balls Racquets

2007 price €2 €40 €1

2007 quantity 100 10 200

2008 price €2 €60 €2

2008 quantity 100 10 200

1. What is the percentage change in the price of each of the three goods? What is the percentage change in the overall price level?
2. Do tennis racquets become more or less expensive relative to Lucozade? Does the well-being of some people change relative to the well-being of others? Explain.

2: Suppose that the residents of Vegopia spend all of their income on cauliflower, broccoli and carrots. In 2007, they buy 100 heads of cauliflower for €200, 50 bunches of broccoli for €75, and 500 carrots for €50. In 2008 they buy 75 heads of cauliflower for €225, 80 bunches of broccoli for €120, and 500 carrots for €100. If the base year is 2007, what is the CPI in both years? What is the inflation rate in 2008?

3: From 1947 to 1997 the consumer price index in the United States rose to 637. Use this fact to adjust each of the following 1947 prices for the effects of inflation. Which items cost less in 1997 than in 1947 after adjusting for inflation? Which items cost more?

Item 1947 Price 1997 price

University of Iowa tuition $130 $2470

Gallon of gasoline $0.23 $1.22

3-min phone call for NY to LA $2.50 $0.45

1-day hospital stay in ICU $35 $2300

McDonald’s hamburger $0.15 $0.59

4: The New York Times cost $0.15 in 1970 and $0.75 in 1999. The average wage in manufacturing was $3.35 per hour in 1970 and $13.84 in 1999.

I. By what percentage did the price of a newspaper rise?

II. By what percentage did the wage rise?

III. In each year, how many minutes does a worker have to work to earn enough to buy a newspaper?

IV. Did workers’ purchasing power in terms of newspapers rise or fall?

5: Income tax brackets were not indexed for inflation until 1985 in the USA. When inflation pushed up people’s nominal incomes during the 1970s, what do you think happened to real tax revenue?

6: When deciding how much of their income to save for retirement, should workers consider the real or the nominal interest rate that their savings will earn?

7: Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation turns out to be higher than they both expected.

I. Is the real interest rate on this loan higher or lower than expected?

II. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose?

III. Inflation during the 1970s was much higher than most people had expected when the decade began. How did this affect homeowners who obtained fixed rate mortgages during the 1960s? How did this affect the banks who lent the money?

The Quantity Theory of Money

Many economists argue that one of the main causes of inflation is excessive money supply growth. The origins of this theory lie with Monetarist economists. Perhaps the best known Monetarist is Milton Friedman, and much of the research on this theory was done by him at Chicago University.

This theory of inflation draws on the Quantity Theory of Money to suggest that if the amount of money in the economy grows faster than the growth in the level of potential output, then this will feed through to prices. In other words, if the money supply grows too fast there will be inflation.

QUANTITY EQUATION

M x V = P x Y

M = Quantity of Money (Money supply)

V = Velocity of money (The rate at which money changes hands)

P = The Price level

Y = Quantity of Output (Real GDP)

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:

• the price level must rise,

• the quantity of output must rise, or

• the velocity of money must fall.

The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money

• The velocity of money is relatively stable over time.
• When the monetary authorities change the quantity of money, it causes proportionate changes in the nominal value of output (P ´ Y).
• Because money is neutral, money does not affect output (Y).
• Thus when the central bank alters the money supply (M) it only induces proportional changes in the Price Level (P)
• Therefore, when the central bank increases the money supply with a less than proportionate change in money demand, the result is higher inflation.

MV = PY

$10bn x 6 = 3 x $20bn

Thus if V and T are constant, then a rise in M to $15bn (i.e. by 50%) will cause P to rise to 4.5 (50% increase).

$15bn x 6 = 4.5 x $20bn

Task 5: Questions on causes and consequences of inflation

1: Suppose that this year’s money supply is €500 billion, nominal GDP is €10 trillion, and real GDP is €5 trillion.

(a) What is the price level? What is the velocity of money?

(b) Suppose the velocity is constant and the economy’s output of goods and services rises by 5% each year. What will happen to nominal GDP and the price level next year if the central bank keeps the money supply constant?

(c) What money supply should the central bank set next year if it wants to keep the price level stable?

(d) What money supply should the central bank set next year if it wants inflation of 10%?

2: The economist John Maynard Keynes wrote: “Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” Justify Lenin’s assertion.

3: Hyperinflations are extremely rare in countries whose central banks are independent of the government. Why might this be so?

4: If the tax rate is 40%, compute the before-tax real interest rate and the after-tax real interest rate in each of the following cases:

(a) The nominal interest rate is 10% and the inflation rate is 5%

(b) The nominal interest rate is 6% and the inflation rate is 2%

(c) The nominal interest rate is 4% and the inflation rate is 1%

5: Suppose that people expect inflation to equal 3%, but in fact prices rise by 5%. Describe how this unexpectedly high inflation rate would help or hurt the following stakeholders:

(a) The government

(b) A homeowner with a fixed-rate mortgage

(c) A union worker in the second year of a three-year labour contract.

6: Explain whether the following statements are true, false or uncertain.

(a) Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate of interest.

(b) If prices change in a way that leaves the overall price level unchanged, then no one is made better or worse off.

(c) Inflation does not reduce the purchasing power of most workers.

Task 7: Questions on SRPC & LRPC

1: Illustrate the effects of the following developments on both the SRPC and LRPC. Give the economic reasoning underlying your answers.

(a) A rise in the natural rate of unemployment (NAIRU)

(b) A decline in the price of imported oil.

(c) A rise in government spending

(d) A decline in expected inflation.

2: Suppose that a fall in consumer spending causes a recession.

(a) Illustrate the changes in the economy using both an aggregate demand/aggregate demand diagram and a Phillips Curve diagram. What happens to inflation and unemployment in the short-run?

(b) Now suppose that over time expected inflation changes in the same direction that actual inflation changes. What happens to the position of the SRPC? After the recession is over, does the economy face a better or worse set of inflation-unemployment combinations?

3: Suppose the economy is in long-run equilibrium.

(a) Draw the economy’s short-run and long-run Phillips curves.

(b) Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on your diagram in part(a). If the monetary authorities undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate?

(c) Now suppose the economy is back in long-run equilibrium, and then the price of imported oil rises. Show the effect of this shock with a new diagram like that in part (a). If the central bank undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? If the central bank undertakes contractionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate?

4: Suppose the monetary authorities announced it would pursue contractionary monetary policy in order to reduce the inflation rate. Would the following conditions make the ensuing recession more or less severe? Explain.

(a) Wage contracts have short durations.

(b) There is little confidence in the monetary authorities’ determination to reduce inflation.

(c) Expectations of inflation adjust quickly to actual inflation.

5: Some economists believe that the SRPC is relatively steep and shifts quickly in response to changes in the economy. Would these economists be more or less to favour contractionary policy in order to reduce inflation?

6: Imagine an economy in which all wages are set in three-year contracts. In this world, the central bank announces a disinflationary change in monetary policy to begin immediately. Everyone in the economy believes the central bank’s announcement. Would this disinflation be costless?

7: Suppose the monetary authorities believed that the natural rate of unemployment was 6% when the actual natural rate was 5.5%. If the monetary authorities based its policy decisions on this belief, what would happen to the economy?

8: Suppose the central bank policymakers accept the theory of the SRPC and the natural rate hypothesis and want to keep unemployment close to its natural rate. Unfortunately, because the natural rate of unemployment can change over time, they aren’t certain about the value of the natural rate. What macroeconomic variable do you think they should look at when conducting monetary policy?

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