16  Inflation

Objectives

  1. Know definition of consumer price index
  2. Compute the rate of inflation
  3. Identify challenges of inflation
  4. Compute real values using nominal values
  5. Compute real interest rate
Consumer Price Index (CPI)

An index that tracks the average price consumers pay over time for a representative ‘basket’ of goods and services.

Inflation

A rise in the overall price level.

Deflation

A decrease in the overall price level.

Inflation Rate

The annual percentage increase in the average price level.

\[ \text{Inflation Rate} = \frac{ \text{Price level this year} - \text{Price level last year} }{ \text{Price level this year} } \times 100 \]

16.1 Challenges

Challenge Description
Quality Improvements When products improve in quality over time, it’s difficult to determine if price increases reflect inflation or better quality
New Products The CPI basket may not quickly incorporate new products that consumers purchase, leading to measurement gaps
Substitution Bias Consumers may switch to cheaper alternatives when prices rise, but the CPI assumes a fixed basket of goods

16.2 Nominal and Real

16.2.1 Values

Nominal Value

A variable measured in dollars (whose value may fluctuate over time)

Real Value

A variable that has been adjusted to account for inflation

\[ \text{Today's dollars}=\text{Another time's dollar} \times \frac{\text{Price Level Today}}{\text{Price Level in Another Time}} \]

16.2.2 Interest Rates

2020 2021
Budget $1.00 $1.05
Price of Candies $1.00 $1.03
# Candies can buy 1.00 1.02
Nominal Interest Rate

The stated interest rate without a correction for the effects of inflation \[ \text{Nominal Interest Rate} = \text{Real Interest Rate} + \text{Inflation Rate} \]

Real Interest Rate

The interest rate in terms of changes in your purchasing power

Can compute using the formula

\[ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} \]

16.3 Conclusion

  • This lecture introduces inflation, a measure of how prices change over time
  • Our primary measure within the U.S. is the Consumer Price Index (CPI)
  • Accounting for inflation allows us to compute the ‘real’ price of different goods