Macro 2.4 & 2.5 Price Indices and Inflation & Costs of Inflation

Summary

In this video, Jacob Reed from reviewecon.com discusses inflation, focusing on the Consumer Price Index (CPI) as the primary inflation metric. He explains the concept of inflation, the difference between nominal and real values, and how CPI measures price changes for a basket of goods. The video also covers the potential issues with CPI, such as substitution and quality change biases, and the impact of inflation on real wages, purchasing power, and different economic actors like borrowers and savers.

Takeaways

• 📈 Inflation is a general increase in average prices across an economy, with deflation being the opposite.
• 💼 Nominal values are not adjusted for inflation and tend to increase faster than real values, which are adjusted.
• 📊 The Consumer Price Index (CPI) measures inflation by tracking price changes in a basket of goods and services.
• 🧮 CPI is calculated by dividing the value of the market basket in the current year by the value in the base year, then multiplying by 100.
• 🛒 The market basket used for CPI includes a weighted average of goods reflecting typical household purchases.
• 📉 The base year's CPI is always set at 100, representing a benchmark for comparison.
• 📚 To find the inflation rate, subtract the old CPI from the new CPI, divide by the old CPI, and multiply by 100.
• 🛍️ CPI has limitations like substitution bias, quality change bias, and new products bias, which can affect its accuracy.
• 💼 Inflation impacts real wages by decreasing their purchasing power unless nominal wages increase at a higher rate than inflation.
• 💵 Inflation reduces the purchasing power of money, meaning each unit of currency buys fewer goods and services over time.
• 🏦 Unexpected inflation benefits borrowers as they repay loans with dollars worth less, but it hurts lenders and savers who receive less real value back.

Q & A

What is inflation?

Inflation is a general increase in average prices throughout an entire economy, referring to the average prices of many goods and services over time.

How is deflation different from inflation?

Deflation is a decrease in average prices for goods and services throughout an economy, as opposed to inflation which is an increase.

What is the difference between nominal and real values in economics?

Nominal values are those that have not been adjusted for inflation and tend to increase over time. Real values, on the other hand, have been adjusted for inflation and are considered more important in economics as they reflect the actual purchasing power.

What is the Consumer Price Index (CPI) and how is it used to measure inflation?

The CPI is the primary way to measure inflation by tracking price changes in a market basket of goods and services. It is calculated as the value of the market basket in the current year divided by the value of the market basket in the base year, multiplied by 100.

What is a market basket in the context of the CPI?

A market basket is a selection of goods and services that a typical household might purchase. The CPI uses the changes in prices of this basket to measure inflation.

Why is the base year's CPI always set at 100?

The base year's CPI is set at 100 because it serves as a reference point. The value of the market basket in the current year is compared to the value in the base year, and since they are the same in the base year, the CPI is 100.

How can the inflation rate between two years be calculated using CPI?

The inflation rate between two years can be calculated using the formula: (New CPI - Old CPI) / Old CPI * 100. This gives the percentage change in prices over the period.

What are some problems with the CPI as a measure of inflation?

Some problems with the CPI include substitution bias, quality change bias, and new products bias. These can cause the CPI to overestimate or underestimate the true impact of price increases on average households.

How does inflation impact real wages?

Inflation can decrease the real value or purchasing power of wages. If wages increase at a slower rate than inflation, the real wage effectively decreases, meaning that the purchasing power of the wage earner is reduced.

Who benefits from unexpected inflation?

Borrowers benefit from unexpected inflation because they end up repaying their loans with money that has less purchasing power. This means they effectively pay back fewer real dollars.

Who is hurt by unexpected inflation?

Lenders and savers are hurt by unexpected inflation. Lenders receive fewer real dollars when loans are repaid, and savers find that their savings buy fewer goods and services over time due to decreased purchasing power.

Outlines

00:00

📈 Understanding Inflation and CPI

In this segment, Jacob Reed from reviewecon.com introduces the concept of inflation as a general increase in average prices across an economy. He explains the difference between inflation, deflation, and disinflation. The importance of distinguishing between nominal and real values is highlighted, with real values being adjusted for inflation. The Consumer Price Index (CPI) is presented as the primary measure of inflation, tracking changes in a market basket of goods and services. The video uses a simplified market basket to demonstrate how CPI is calculated by comparing the value of the basket in the current year to the base year, multiplied by 100. The script also covers how to calculate the inflation rate between two years using the CPI.

05:01

💸 The Impact of Inflation on Society

This paragraph discusses the real-world implications of inflation. It begins by addressing the limitations of the CPI, such as substitution bias, quality change bias, and new products bias, which can lead to overestimating or underestimating the impact of inflation. The paragraph then explores how inflation affects real wages, causing a decrease in purchasing power. It also touches on how inflation can benefit borrowers by reducing the real value of debt repayments, while it can hurt lenders and savers by decreasing the value of money over time. The video concludes by encouraging viewers to visit reviewecon.com for further resources on understanding inflation and preparing for economics exams.

Keywords

💡Inflation

Inflation refers to a general increase in average prices throughout an entire economy, affecting goods and services. It's a key economic indicator that signifies the erosion of purchasing power over time. In the video, inflation is central to understanding the cost of living and its impact on real values versus nominal values. For example, the script mentions that inflation can lead to a decrease in real wages if wage increases do not keep pace with rising prices.

💡CPI

CPI stands for Consumer Price Index, which is the primary way economists measure inflation. It tracks price changes in a basket of goods and services. The video uses a simplified market basket to illustrate how CPI is calculated by comparing the value of the basket in the current year to the base year. The script explains that the CPI for 2012 is 100, and for 2022, it's 125, indicating an increase in the cost of living.

💡Nominal Values

Nominal values are figures that have not been adjusted for inflation. They represent the face value of money without considering the impact of inflation over time. The video emphasizes the importance of distinguishing between nominal values and real values to understand the true economic picture. For instance, a nominal wage increase might not reflect a real increase in purchasing power if inflation is high.

💡Real Values

Real values are economic figures that have been adjusted for inflation to reflect their purchasing power. They provide a more accurate measure of economic growth and individual welfare than nominal values. The video script uses the concept of real values to explain how inflation affects the value of money and the cost of goods and services over time.

💡Deflation

Deflation is the opposite of inflation, representing a decrease in the average level of prices for goods and services. It is mentioned in the video as a scenario where prices generally decrease over time, which is less common but still an important economic concept to understand.

💡Disinflation

Disinflation occurs when there is a reduction in the rate of inflation. It is characterized by prices still increasing but at a slower pace than before. The video script uses the term to illustrate how inflation can change and its implications for economic planning and policy.

💡Market Basket

A market basket is a selection of goods and services used to calculate the CPI. It represents the typical consumption patterns of a household. The video script uses a simplified market basket of milk, chicken, and shoes to demonstrate how the CPI is calculated by comparing the cost of these items over different years.

💡Substitution Bias

Substitution bias refers to the tendency of consumers to switch to alternative goods when the price of a particular good increases. This behavior can affect the accuracy of the CPI as it may not fully account for changes in consumer behavior. The video script mentions substitution bias as one of the issues with the CPI, where consumers might buy cucumbers instead of more expensive carrots.

💡Quality Change Bias

Quality change bias is the discrepancy that arises when improvements in product quality are not adequately reflected in the CPI. This can lead to an overestimation of inflation because the CPI might not accurately capture the increased value consumers receive from better quality goods. The video uses the example of televisions to illustrate how quality changes over time can affect the CPI.

💡New Products Bias

New products bias occurs when new goods are introduced to the market but are not immediately included in the CPI market basket. This can lead to an underestimation of inflation as the CPI might not capture the price changes of these new goods. The video script mentions how cellular phones, when they first appeared, were not immediately included in the CPI, potentially affecting the accuracy of inflation measurements.

💡Real Wages

Real wages refer to the purchasing power of wages adjusted for inflation. They indicate how much an individual can buy with their wages after accounting for price changes. The video script explains how inflation can erode real wages, as nominal wage increases might not keep up with the rising cost of living, effectively resulting in a decrease in the purchasing power of wages.

Highlights

Inflation is a general increase in average prices throughout an entire economy.

CPI is the primary way we measure inflation.

Deflation is a decrease in average prices for goods and services throughout an economy.

Disinflation occurs when the rate of inflation decreases.

Nominal values are values that have not been adjusted for inflation.

Real values have been adjusted for inflation and are more important in economics.

The difference between real values and nominal values is inflation.

CPI tracks price changes in a market basket of goods and services.

The U.S. market basket for CPI includes over 80,000 different goods.

CPI is calculated by dividing the value of the market basket in the current year by the value in the base year, then multiplying by 100.

The base year's CPI is always 100.

Inflation rate can be calculated using the formula: (New CPI - Old CPI) / Old CPI * 100.

CPI has some problems that can cause it to overestimate or underestimate the true impact of price increases on average households.

Substitution bias is a problem where consumers buy other goods when the price of one increases.

Quality change bias indicates that changes in product quality are not always reflected in the CPI.

New products bias means new products take time to show up in the market basket that tracks inflation rate.

Inflation impacts real wages by decreasing their purchasing power.

Unexpected inflation helps borrowers and hurts lenders or banks.

Inflation also hurts savers as their savings will be worth fewer real dollars over time.

Transcripts

hi everybody jacob reed here from

reviewecon.com today we're going to be

talking about inflation the cpi is the

primary way we measure inflation and

we're also going to talk about the cost

of inflation as well if after watching

this video you still need a little more

help head over to reviewecon.com and

pick up the total review booklet he has

everything you need to know to ace your

microeconomics or macroeconomics ap exam

let's get into the content

now the first thing we're going to do is

talk about a few different definitions

the first definition you need to know is

the definition of inflation inflation is

a general increase in average prices

throughout an entire economy we're

talking about average prices of lots of

goods and services not the average price

of one particular good or service and

since prices generally increase over

time inflation is what we're going to

see most often in the real world economy

of course sometimes prices decrease as

well and when that happens we call that

deflation that's a decrease in average

prices for goods and services throughout

an economy you could also see the term

disinflation that occurs when there is a

high level of inflation say eight

percent and then the rate of inflation

decreases to let's say five percent

prices are still increasing but they're

increasing at a slower rate and when it

comes to understanding inflation it's

all about understanding the difference

between nominal values and real values

nominal variables are values that have

not been adjusted for inflation they

tend to go up over time way faster than

if we had adjusted for inflation but in

economics real values are more important

real variables have been adjusted for

inflation and so of course that tells us

that the difference between real values

and nominal values is inflation and so

adjusting between nominal values and

real values is all about deleting the

price changes caused by inflation

when it comes to measuring inflation the

cpi or the consumer price index is the

primary way that we measure inflation

the cpi tracks price changes in a market

basket of goods and services in the

united states that market basket is

comprised of over 80 000 different goods

that a typical urban household purchases

urban household meaning people living in

and near cities in order to help us

understand how to calculate a cpi we're

going to have a market basket that is

comprised of just three items a gallon

of milk a chicken and a pair of shoes

and here we have different prices for

those items in 2012 and 2020. now just

like the real market basket this market

basket is weighted meaning that some

items are more heavily counted than

other items and they are more heavily

counted by the quantity that we see

within the market basket when it comes

to calculating the cpi we're going to

calculate the value of that entire

market basket twice because the formula

for consumer price index is the value of

the market basket in the current year

divided by the value of the market

basket for the base year times 100 so

we're going to take a look at all of

those prices and all of those quantities

first thing we're going to do is

calculate the cpi for 2012 using the

market basket we have here so the first

thing we're going to do is calculate the

value of the market basket in the

current year so for 2012 we're going to

use 2012's prices that's the 10 gallons

of milk times the three dollars those

cost the eight chickens times the five

dollars and the two pairs of shoes times

the 25 dollars that gives us 120 for the

market basket value in 2012 for those

quantities and those prices and then

we're going to calculate the value of

that market basket using base year

prices since the year we are focusing on

is the same year as the base year the

value is going to be the same so the

market basket value in the base year is

also 120 so that's going to be our

denominator here and then times that by

100 that gives us a consumer price index

of 100 for the year 2012 and that's

because the base year's cpi is always

going to be 100 and that's because the

value of the market basket in the

current year will be the same value as

the market basket in the base year next

we're going to calculate the value of

the cpi for 2022 for this market basket

so for the current year prices in the

market basket we're going to use the

same quantities but this time with the

2022 prices of five dollars for a gallon

of milk six dollars for a chicken and

twenty six dollars for that pair of

shoes ten times five eight times six and

two times twenty six added together

gives us a hundred and fifty dollars for

the market basket in 2022 and for the

market basket value in the base year we

have the same quantities and the base

year prices it's the same value we

already calculated and that was 120

take the 150 divided by the 120

times 100 that gives us a cpi of 125 for

2022. on your ap macroeconomics exam you

could be asked to calculate the

inflation rate between two years if they

give you two different cpi's here's the

formula for you you take the new cpi

minus the old cpi divided by the old cpi

then times 100 and that will give you

the amount of inflation between those

two years so if in 1997 we had a cpi of

160 and then two years later in 1999 we

had a cpi of 176 how much inflation was

there between those two years well

you're going to take the new cpi of 176

minus the old cpi of 160 divided by that

160 times 100 and that gives us 10

inflation over those two years between

1997 and 1999.

now the cpi is an attempt to capture the

impact on average households when prices

increase but it does have some problems

and it's not perfect and those problems

can cause an inflation rate to either

overestimate or underestimate the true

impact of price increases on average

households one of those problems is the

substitution bias when prices go up we

have the substitution effect that you

may have learned about in microeconomics

when this price of one thing increases

consumers tend to buy other things

instead so for example when i go to the

store to buy some carrots and i see that

the price has gone up i might buy

cucumbers instead if the price of

cucumbers hasn't increased next we have

the quality change bias and that tells

us that changes in quality for products

are not always reflected in the cpi

televisions have dramatically changed

over my lifetime and those quality

changes may not be fully reflected in

the consumer price index and lastly we

have the new products bias new products

may be introduced into the market but it

will take some time for them to show up

in the market basket that tracks our

inflation rate so when cellular phones

came out they were not immediately

included in the cpi market basket even

though they were part of typical

consumer purchases

so why do we care why does it matter

that prices are going up well inflation

has some real costs in our society the

first big impact is the impact on real

wages when we have inflation the real

value or the purchasing power of wages

decreases and sometimes wages aren't

increasing nearly as fast let's say i

get a nominal increase in my wage of

five percent but we have a seven percent

inflation rate as a result in order to

find out the impact on my real wages

we're going to have to subtract that

inflation rate so the five percent

nominal increase in my wages minus the

seven percent inflation rate that means

that the approximate impact on my real

wages is actually a two percent decrease

and so the real impact of the nominal

wage increasing slower than prices means

in this example i'm actually two percent

worse off and that's what inflation does

it changes the purchasing power of our

money purchasing power is the ability of

your money to buy goods and services and

inflation decreases the purchasing power

of your money in other words it

decreases the real value of that money

now inflation isn't bad for everyone

some people are actually helped by

inflation in fact unexpected inflation

actually helps borrowers and that's

because they're going to pay back fewer

real dollars and that means that

unexpected inflation is going to hurt

lenders or banks and that's because

they're going to be paid back fewer real

dollars you can learn more about the

impact of the inflation rate on

borrowers and lenders when you learn

about the fisher formula in a future

unit and that unexpected inflation is

also going to hurt savers because they

have set aside money and as time goes on

their savings will be worth fewer real

dollars and that's because those dollars

have less purchasing power and buy fewer

goods and services and there you have it

that's everything you need to know about

the cpi and the cost of inflation if

after watching this video you still need

a little more help head over to

reviewecon.com and pick up the total

review booklet it has everything you

need to know to ace your microeconomics

and macroeconomics ap exam that's all

for now i'll see you all next time