Consumer Price Indices and GDP Deflators

Topic 2
 Consumer Price Indices and GDP Deflators

• What is inflation? Inflation refers to the rise in the prices of most goods
and services of daily or common use, such as food, clothing, housing,
recreation, transport, consumer staples, etc. Inflation measures the
average price change in a basket of commodities and services over time.
• Inflation is the decline of purchasing power of a given currency over time.
A quantitative estimate of the rate at which the decline in purchasing
power occurs can be reflected in the increase of an average price level of a
basket of selected goods and services in an economy over some period of
time.
• When inflation is too high of course, it is not good for the economy or
individuals. Inflation will always reduce the value of money, unless interest
rates are higher than inflation. And the higher inflation gets, the less
chance there is that savers will see any real return on their money.
• Who benefits from inflation? Inflation allows borrowers to pay lenders
back with money that is worth less than it was when it was originally
borrowed, which benefits borrowers. When inflation causes higher prices,
the demand for credit increases, which benefits lenders.
 Consumer Price Indices and GDP Deflators
• Effects of inflation Rising prices, known as inflation, impact the cost of living, the cost
of doing business, borrowing money, mortgages, corporate, and government bond
yields, and every other facet of the economy. Inflation can be both beneficial to
economic recovery and, in some cases, negative.
• How can we fix inflation? One popular method of controlling inflation is through a
contractionary monetary policy. The goal of a contractionary policy is to reduce the
money supply within an economy by decreasing bond prices and increasing interest
rates.
• What causes inflation? A surge in demand for products and services can cause
inflation as consumers are willing to pay more for the product.
• Five main causes of inflation Demand-Pull Inflation, Cost-push inflation, Supply-side
inflation Open Inflation, Repressed Inflation, Hyper-Inflation, are the different types of
inflation. Increase in public spending, hoarding, tax reductions, price rise in
international markets are the causes of inflation. These factors lead to rising prices.
• For example:
 Demand-pull inflation – aggregate demand growing faster than aggregate supply
(growth too rapid)
 Cost-push inflation – For example, higher oil prices feeding through into higher costs.
 Devaluation – increasing cost of imported goods, and also the boost to domestic
demand.
 Consumer Price Indices and GDP Deflators
• How does inflation hurt the poor? People with higher incomes can offset
rising inflation with rising incomes. Sadly, though, income inequality and
rising inflation can entrap lower-income households in poverty. In
addition, research has shown that prices may rise more quickly for those
who have lower incomes, a phenomenon called inflation inequality.
• How does inflation impact the economy? When the general price level
rises, each unit of currency buys fewer goods and services;
consequently, inflation reflects a reduction in the purchasing power per
unit of money – a loss of real value in the medium of exchange and unit of
account within the economy.
• Relationship between inflation and interest rate There is a general
tendency for interest rates and the rate of inflation to have an inverse
relationship. In general, when interest rates are low, the economy grows
and inflation increases. Conversely, when interest rates are high, the
economy slows and inflation decreases.
• How does inflation affects banks? A rising inflation rate tends to increase
the rates on loans. The cost of funds for banks rises. This leads to an
increase in home loan interest rates, among other loan rates.
 Consumer Price Indices and GDP Deflators
• How is inflation calculated? Subtract the starting date Consumer Price Index
(CPI) from the later date CPI and divide your answer by the starting date CPI.
Multiply the results by 100. Your answer is the inflation rate as a percentage.
• The Consumer Price Index (CPI) is a measure that examines the weighted
average of prices of a basket of consumer goods and services, such as
transportation, food, and medical care. It is calculated by taking price changes
for each item in the predetermined basket of goods and averaging them.
• An increase in CPI means that a household has to spend more money
(Emalangeni) to maintain the same standard of living; that's mostly bad for the
households, but it can be good for businesses and the government.
• How is CPI calculated? It is calculated by taking price changes for each item in
the predetermined basket of goods and averaging them.
• Why is CPI important? Broadly speaking, the CPI measures the price of
consumer goods and how they're trending. It's a tool for measuring how the
economy as a whole is faring when it comes to inflation or deflation. When
planning how you spend or save your money, the CPI can influence your
decisions.
• Uses of the CPI CPI is used to measure inflation and determine the cost of
living at a given time.
 Consumer Price Indices and GDP Deflators
• Strengths of the CPI Two critical strengths of the CPI are its consistency
and flexibility. Its consistency reflects that it is measuring the costs of a set
of goods that remains consistent in representing the costs that average
consumers face, even as the goods that are included in the CPI evolve with
changes in the marketplace.
• How to find the CPI To find the CPI in any year, divide the cost of the
market basket in year t by the cost of the same market basket in the base
year. The CPI in 1984 = $75/$75 x 100 = 100 The CPI is just an index value
and it is indexed to 100 in the base year, in this case 1984. So prices have
risen by 28% over that 20 year period.
• Weaknesses of CPI The first problem with the CPI is the substitution bias.
As the prices of goods and services change from one year to the next, they
do not all change by the same amount. The number of specific items that
consumers purchase changes depending upon the relative prices of items
in the fixed basket. Second problem is that the CPI cannot be used to
measure differences in price levels or living costs between one area and
another as it measures only time-to-time changes in each area. A higher
index for one area does not necessarily mean that prices are higher there
than in another area with a lower index.
 Consumer Price Indices and GDP Deflators
• How is CPI linked to inflation? How the CPI measures inflation. The
percentage change in the CPI is a measure of inflation. The 12-month
percentage change compares prices from one month with the same month
of the previous year—for example, March 2020 compared with March
2019.
• The changes in the prices of goods and services over time that households
consume are measured by using the CPI.
• The CPI is one of the frequently used statistics for identifying periods of
inflation or deflation.
• CPI gives the government, businesses and citizens an idea about price
changes in the economy, and it can act as a guide to make informal
decisions about the economy.
• The GDP deflator also called implicit price deflator, is also a measure of
inflation. It is the ratio of the value of goods and services an economy
produces in a particular year at current prices to that of prices that
prevailed during the base year.
 Consumer Price Indices and GDP Deflators
• The GDP deflator is calculated by dividing nominal GDP by real GDP and
multiplying by 100. GDP Deflator Equation: The GDP deflator measures price
inflation in an economy. It is calculated by dividing nominal GDP by
real GDP and multiplying by 100.
• Importance of the GDP deflator The GDP deflator will help identify how much
prices have inflated over a specific time period.
• The GDP deflator is similar to the CPI because both measure the impact of
price changes.
• Many economists favor the GDP deflator as a measure of inflation because it
reflects changes in production and consumer behavior.
• GDP deflator and the CPI generally seem to be the same thing, BUT they have
some few key differences:
1) GDP deflator measures a changing basket of commodities, while CPI always
indicates the price of a fixed representative basket.
2) GDP deflator frequently changes weights, while CPI is revised less frequently.
3) CPI will consider imported goods because they are still considered as
consumer goods, while GDP deflator will only contain prices of domestic
goods.