Unit 4

L5: Analyzing Inflation

Joint Vienna Institute/IMF’s Institute for Capacity Presenter

Development Training Program Nina Biljanovska
Macroeconomic Diagnostics
GT16.02
This training material is the property of the International Monetary Fund (IMF) and is intended for use in
IMF Institute for Capacity Development courses. Any reuse requires the permission of the IMF and ICD.
 Lecture objectives

• Review facts about inflation

• Examine different measures of inflation
• Explore tools and models that explain inflation

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MDS
 Objective of the workshop

• Apply different measures of inflation to Turkey

• Examine the contribution of different components of
CPI to Turkey’s inflation
• Analyze the main elements of Turkey’s inflation and
explore possible inflation pressures in the near term

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I. Measuring Inflation

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 What is inflation?

Definition
Inflation is the rise in the general level of prices of goods
and services in an economy over a period of time
– When positive  inflation
– When negative  deflation

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 Why maintain low and stable inflation?

Inflation can have numerous effects on the economy

• Costs of (volatile and high) inflation
– Difficult to make sound decisions – uncertainty discouraging investment
and savings.
– Increases opportunity costs of holding money by eroding its future
purchasing power.
– Rising costs of hedging against soaring prices.
– Indexation and menu costs
– Taxation – failure for tax code to adjust for inflation
– (Dis)trust in government policies in general

• Benefits of low and stable inflation

– More easy to make long-range plans.
– Lower nominal and real interest rates.
– Self-reinforcing of sustained low inflation.

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What is deflation and why worry about it?

• Deflation is the opposite of inflation – over time general level

of prices get lower

• Deflation may be risky because

– A demand decline spiral
– Increases real interest rates; real debt burden
– Higher unemployment in the case of downward wage rigidity

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Is inflation similar around the globe?

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 Poll: What is inflation in your country?
33.3% 33.3% 33.3%

1 – Up to 2%,
2 – 2-10%
3 – More than 10%

1 2 3
20 20 20
Total: 60

www.jvi.org 9
 Poll: Has inflation increased since last year?
33.3% 33.3% 33.3%

1 – Increased,
2 – Stayed about the
same,
3 – Decreased
1 2 3
20 20 20
Total: 60

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 How do we measure prices?

• Consumer Price Index (CPI)

– Headline CPI Inflation
– Alternative CPI measures (e.g. core inflation)
• From the National Income Accounts
– GDP deflator
– Personal Consumption Expenditure (PCE) deflator

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 What are the key features of CPI?

• CPI compares the cost of a fixed basket of goods and services

purchased by consumers during the current period with the
cost of the identical basket of goods and services in the base
period
- Tells how much the cost of living has risen or fallen due to price changes
irrespective of changes in consumer behavior or good quality

• One of the most understood and widely used indicators of the

change in the general level of consumer prices (inflation)
- Consumers can compare movements in the CPI to changes in their
personal income to monitor and evaluate changes in their financial
situation

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 How is CPI computed?

• The CPI is a Laspeyres or base-weighted index that uses

historical weights
– Price movements of the goods and services represented in the
CPI are weighted according to the relative importance of goods
and services in the total expenditures of consumers
• Let 0 and t be the base and current periods respectively
N

pq i
t
i
0

CPI t = i 1
N
 100
pq i
0
i
0

q0i is the base period quantity of good i

i 1

p0i is the base period price of good i

pti is the time t price of good i
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CPI Weights: United States

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CPI Weights: Albania

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CPI Weights: Kyrgyz Republic

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 What are alternative CPI measures?
• Laspeyres index: uses historical quantities (weights):
N

 P (t )  Q (0)
i i
Laspeyres
CPI t  i 1
N

 P ( 0)  Q ( 0)
i 1
i i

• Paache index: uses current quantities (weights):

N

 P (t )  Q (t )
i i
CPI t Paache
 i 1
N

 P (0)  Q (t )
i 1
i i

• Fisher index: geometric average (the "ideal" price

index) CPI Fisher  CPI Laspeyres CPI Paache
t t t

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 How is a GDP deflator defined?

Index of the price level for all final goods and services
included in GDP, computed as a Paasche index: current
basket of goods at time t (not at time 0).
N

GDP at current pricest  t qt

p i i

GDP deflatort =  100 = i 1

N
 100
GDP at constant prices t
 0 qt
p i i

i 1

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 CPI vs. GDP deflator
Key Features

CPI GDP deflator

– Frequency: Monthly – Frequency: Quarterly and slow to be
produced
– Measures the prices of goods
purchased by consumers – Measures the prices of all final goods
and services produced
– Measures the prices of
consumer goods (including – Measures the prices of final goods
imports) and services produced domestically
(excluding imports)

– Laspeyres index, an index with a

fixed basket of goods – Paasche index, an index with a
changing basket of goods

– Tends to overstate the increase

in the cost of living – Tends to understate the increase in
the cost of living

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II. Computing and Analyzing Inflation

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 Computing “the” inflation rate
• Various inflation rates  CPI 2016 
=  1  100
– Annual average (or year-on-year)  CPI 2015 
inflation rate  CPI Dec., 2016 
=  1  100
– The end-of-year or December inflation  CPI Dec., 2015 
rate  CPI Feb., 2016 
– The 12-month inflation rate =  1  100
 CPI Feb., 2015 

 CPI Feb., 2016 

– The monthly (or the quarterly) inflation =  1  100
 CPI Jan., 2016 
rate
  CPI 
12

– The annualized monthly (or quarterly) =   CPI Feb., 2016
  1  100

inflation rate  Jan., 2016  

• Seasonal adjustment
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What is inflation?

Let us compute these inflation rates for

Turkey and compare

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What information can be extracted from
inflation data?
• Analysis of the component level data
• Alternative aggregation schemes
– Traded versus non-traded goods inflation
– Core inflation measures
• These measures help understand recent developments:
– Sources of changes in the inflation rate
– Transitory or permanent shocks to inflation

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What information can be extracted from an
analysis of CPI component level data?
• Analyze percentage changes for each component
– Identify components where the price change was greatest

• Compute the contribution made by each component to the

overall inflation rate
– More informative
– Captures both the size of the price change and the importance of that
component

• Caveat: Changes in specific components of the CPI do not

necessarily provide a good guide to their overall impact on
inflation, in part because other prices may change in response
(second round effects).

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 An example:
Price decomposition for Turkey

• Period: January 2005 January 2006

• Headline CPI changes: 114.5 123.6

– Headline inflation rate: 7.9%, Log approximation: 7.6%

– Of which 1.4% point increase is due to price increase in food

items

– More than half the inflation rate is due to food, alcoholic

beverages, and housing items

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What is the difference between headline and
core inflation?

• Headline inflation is the total movement of prices

• Core inflation is supposed to be the long-run, less volatile,
component of CPI
• Core inflation reflects general inflationary pressures in the
economy – it excludes some components
– Energy
– Food
– Regulated prices
• No firm theoretical basis; no generally agreed approach to
measuring core inflation

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 Core inflation: Permanent exclusions

• Depends on the purpose

– Forecasting accuracy
• Tax changes
• Regulated
• Energy
• Food
– Decision making
• Tax changes – yes
• Energy prices – questionable
• Food prices – highly questionable
– Typically a large part of the basket
– Huge spillovers to the rest

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Comparing Headline and Core CPI Inflation

13.00 Turkey: Headline and Core CPI Inflation, annualized

12.00
Headline CPI exc. Energy

11.00

10.00

9.00

8.00

7.00

6.00
Jan- Feb Mar Apr Jun- Jul- Aug Sep Oct Nov Dec Jan- Feb Mar Apr Jun- Jul- Aug Sep Oct Nov Dec Jan-
04 -04 -04 -04 04 04 -04 -04 -04 -04 -04 05 -05 -05 -05 05 05 -05 -05 -05 -05 -05 06

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III. Determinants of Inflation

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 What determines inflation?

• Components analysis
– Explain contribution of individual groups of prices to CPI
– May explain changes to inflation trend/”natural” level
– But does not explain why prices are moving
• Underlying factors/determinants of inflation
– Identify shocks that push prices up or down in the short run
– Can be used to explain propagation of inflation
– Forecast it for the near future

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 Long-run determinants of inflation
• Long-run determinant of inflation
– Monetary policy (e.g. broad money growth)
• “Inflation is always and everywhere a monetary phenomenon” (M.
Friedman)
• Quantity theory is the general theory of inflation

MV
P
Y
m   v     y     m   v   y

• Where M – money, P – prices, Y – output, V – velocity

• Constant velocity and money neutrality -> inflation follows money
growth
– In the long run, periods of hyperinflation
– Less so in the short run in normal times
 Short-run inflation: Why Care?

• Important to understand what determines inflation

in short-run

• Even temporary SR shock could ignite inflation spiral

– Example: oil price ↑ -> cost of production ↑ -> prices of
goods ↑ -> demand for higher wages ↑ -> labor cost ↑ …
– Also through inflationary expectations

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What are possible short-run determinants of
inflation?

• Past inflation (hysteresis)

• Expectations
• Domestic demand and supply pressures
– Business cycle factors (Phillips curve)
– Market structure
– Indirect taxes
• External spillovers
– Import prices
– Commodity prices
– Exchange rate movements

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 Inflation and policymakers

• Two goals of economic policymakers are low inflation

and low unemployment – sometimes goals conflict
• In the short run, if policymakers try to expand aggregate
demand (using monetary or fiscal policy) they will tend
to increase output (decrease unemployment) and raise
the inflation rate

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 Phillips Curve – a model of inflation

• A traditional Phillips curve relates price or wage

inflation to some measure of excess demand, either
an unemployment, output or capacity utilization gap
 t   E    ut  ut    t

Or
 t     yt  y    t
E

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 Poll: What are the expected signs of gamma
and delta?
 t      ut  ut    t  t     yt  y    t
E
E

33.3% 33.3% 33.3%

1 – Both positive,
2 – Both negative,
3 – Both zero

1 2 3
20 20 20
Total: 60

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Phillips Curve: What are possible short-run
determinants of inflation?
 t     yt  y    t
E

• Expected Inflation (πE)

• Deviations of unemployment from the natural rate
or the output gap  yt  y  - demand shocks
• Other shocks, in particular supply shocks (εt)

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 How does demand-pull inflation work?

Some examples:
 Unexpected monetary
expansion
 Increase in disposable
income
 Expansionary fiscal
stance, etc.
Leads to shift of demand
curve to new demand

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What drives cost-push (supply-side) inflation?

• Shortage of factors of
production:
• Industrial disputes
• Natural calamities
• Global supply-side shock:
 Import (in particular
commodity) prices

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What is the role of inflation expectations?
•• Help
  stabilize inflation, but can also destabilize it
– Even temporary shocks can have long-lasting effects on inflation
• Are determined by:
– Credibility of monetary and fiscal policy (
– Recent inflation ( – adaptive expectations
– Long-run trend/”natural” level of inflation
• Are not observable → Surveys
– Households, business, official forecasters and market analysts
• Financial data

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 Poll: What is your expectation about
Eurozone inflation in 2020?

33.3% 33.3% 33.3%

1 – -1 to 1%,
2 – 1-2.5%,
3 – more than 2.5%

1 2 3
20 20 20
Total: 60

www.jvi.org 41
Augmented New-Keynesian Phillips curve
Change in real
marginal cost

 t   t 1   1     e
t 1   rmct   t
• Prices are set via both backward and forward looking
expectation
– E.g. a subset of firms set prices according to a backward-looking
rule of thumb (contracts, wages)
• Transmission mechanism in real marginal cost (rmc)
– Demand rises
– Firms respond and produce more (no shortage on the market)
– However, firms face increasing marginal costs
– Firms must ask for higher price

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What are the components of real marginal
costs (RMC)?
• Real marginal cost can be approximated as a function of:
– Domestic producers
• Output gap, unemployment gap ( yˆ t )
– Importers
• Real exchange rate gap ( zˆt )
• Or import prices gap

• In the workshop we’ll use Augmented Phillips Curve

estimated for Turkey

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 Key takeaways

• We learned how to measure inflation

– Using CPI, PCE, GDP deflator and chained CPI
• We learned how to calculate core inflation
– Different measures and issues
• Determinants of inflation
– Demand and supply changes
– Theory
• Quantity theory of money vs. Phillips Curve
– Practice
• Expectations, real marginal costs (domestic and external)

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Appendix: CPI Weights, Kazakhstan

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 Appendix: Various Core Metrics
Country Official Core Measure
Canada CPI excluding Food, Energy and Indirect Taxes
Thailand CPI excluding Fresh Food and Energy (23%)
CPI excluding 20% with higher (-) variations and 8% with higher (+)
Chile
variations
New Zealand (90s) CPI excluding interest charges
CPI excluding costs of private road transport and costs of
Singapore
accommodation
Japan CPI excluding Fresh Food

Peru CPI excluding 9 volatile items (food, fruits and vegetables, and urban
transport, about 21.2 %)
United States CPI excluding food and energy
United Kingdom Retail price index excluding mortgage interest Rates (RPIX)

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