Unit 4 Inflation and unemployment

4.2 Measuring the economy: Inflation

Inflation is a general increase in prices across the economy. The commonly used ‘consumer price inflation’ is measured by the percentage increase in the cost of a representative basket of household goods and services, usually over a year.

To understand what this means, take your favourite chocolate bar. If its price goes up during the year from 50p to 55p, how do you know that is a symptom of inflation in the economy? It could just be that the chocolate bar has become more expensive relative to everything else. Some companies may have left the chocolate bar market, reducing competition, which would allow those remaining to increase their prices. Alternatively, customers may have changed their preference for chocolate relative to other sweet treats, increasing the demand which would increase price, or there may have been a crop failure in an important cocoa-growing region leading to higher-priced cocoa beans. None of these reasons—specific to chocolate bars alone—represent inflation. It would be a symptom of inflation if it was not only the price of chocolate that was increasing, but the prices of a wide basket of goods and services.

Read Unit 7 of the microeconomics volume for details on how firms selling differentiated products set their prices, and Unit 8 of the microeconomics volume to learn how supply and demand changes in a price-taking market affect the price of a good or service.

To investigate what has happened to the prices across the economy that are relevant to you, you could take a giant shopping basket and fill it with every product and service that you buy in January. Has the price of this same giant basket increased when you check the prices in the following month or year? And what about the baskets of other people? You can explore this later in Exercise 4.1.

consumer price index (CPI)
A measure of the general level of prices that consumers have to pay for goods and services, including consumption taxes.

The consumer price index (CPI) measures the general level of prices that consumers have to pay for goods and services, including consumption taxes. The basket of goods and services is chosen to reflect the spending of a typical household in the economy. For this reason, the change in the CPI, or CPI inflation, is often considered to measure changes in the ‘cost of living’.

The CPI is based on what consumers actually buy. It includes the prices of food and drink, housing, clothing, transportation, recreation, education, communications, medical care, insurance, and other goods and services. The goods and services in the basket are weighted according to the fraction of household spending they account for. The CPI excludes exports, which are consumed by foreign residents, but includes imports, which are consumed by households in the home economy.

To calculate the rate of inflation, there are three steps:

  1. find the cost of the basket of goods
  2. compute a price index such as the CPI
  3. use the CPI to calculate the inflation rate.

Let’s use a basket with three goods as a simple example. Our simple basket will contain rice, chicken, and carrots, in the quantities given in Figure 4.4a.

2020 2021 2022
Good Quantity Unit price Total cost Unit price Total cost Unit price Total cost
Bags of rice 2 $10 $20 $12 $24 $13 $26
Pieces of chicken 5 $3 $15 $5 $25 $8 $40
Carrots 20 $0.50 $10 $0.75 $15 $1 $20
Cost of basket $45 $64 $86

Figure 4.4a Calculating the CPI: a basket of goods.

Let’s set 2020 as our base year. Note that the quantity is held fixed while the prices of the goods vary year by year. The cost of the basket is displayed in the table. The next step is to calculate the CPI (see Figure 4.4b). To do this, we use the following formula:

\[\text{price index (e.g. the CPI)} = \frac{\text{basket price}}{\text{basket price in base year}} \times 100\]
2020 2021 2022
Basket price $45 $64 $86
Basket price in base year (2020) $45 $45 $45
CPI 100 142.22 191.11

Figure 4.4b Calculating the CPI using the basket prices.

Finally, since inflation is defined as the change in the general level of prices over time, we use the following formula to calculate the rate of inflation:

\[\text{inflation} = \frac{\text{CPI}_\text{this year}-\text{CPI}_\text{last year}}{\text{CPI}_\text{last year}} \times 100\]

For 2021, the inflation rate is equal to \((142.22 − 100)/100 \times 100 = 42.2%\).

For 2022, the inflation rate is equal to \((191.11 − 142.22)/142.22 \times 100 = 34.4%\).

GDP deflator
A measure of the change in the level of prices for domestically produced output, based on price changes of consumption, investment, government expenditure, and exports.

The GDP deflator is a price index like the CPI, but it tracks the change in prices of all domestically produced final goods and services. Instead of a basket of goods and services that a consumer buys, the GDP deflator tracks the price changes of the components of domestic GDP, that is, of \(C + I + G + X − M\). It includes exports, which are produced by the home economy, but excludes imports, which are produced abroad.

The GDP deflator can also be expressed as the ratio of nominal (or current price) GDP to real (or constant price) GDP. The GDP deflator series is most commonly used to transform a nominal GDP series into a real GDP series. The real GDP series shows how the size of the home economy changes over time, taking into account changes in the price of domestically produced goods and services.

In Section 3.4, when discussing the challenges of measuring GDP in real terms, we raised the problem of interpreting changes in prices that may reflect changes in quality. The same issues arise when using a price index to calculate changes in the standard of living, where changes in the price of a good may reflect genuine quality improvements such as new features, rather than economy-wide inflation. Take smartphones: compared to when they were first released, they have bigger screens, better cameras, and faster processors—and unlike earlier mobile phones they are able to act as a GPS, access the internet, and more. Smartphones may have become more expensive over time, but economists calculating CPI want to disentangle the effect of quality improvements on prices from that of inflation.

Issues in measuring inflation

Substitution bias. When prices are rising across the economy, the price of certain goods may nonetheless be rising faster than the price of other goods. In this case, consumers are likely to change their consumption patterns, shifting away from goods with more rapidly rising prices. For example, if the price of beef is rising faster than the price of chicken, consumers may choose to reduce their consumption of beef and eat more chicken instead. The CPI uses a fixed basket and doesn’t account for changes like this (or ‘substitution’), so it tends to overestimate inflation. By allowing the basket to change over time to account for changes in purchasing patterns, a price deflator called the PCE (personal consumption expenditures price index) avoids this bias. You can read more about the PCE at the US Bureau of Economic Analysis website.

Quality changes. Dealing with quality changes when constructing a price index like the CPI is referred to by economists as ‘hedonic quality adjustment’ (using ‘hedonism’ or ‘pleasure seeking’ in the philosophical rather than the everyday sense of the word). To dig deeper into how this is done, read the Q and A page on the US Bureau of Labor Statistics website.

Describing a change in price level

We used three terms to describe what was happening to the UK price level in Figure 4.1.

Changes in price level

  • Inflation: The price level is rising (positive CPI change).
  • Deflation: The price level is falling (negative CPI change).
  • Disinflation: The inflation rate is falling (scale of positive CPI change reducing).

The change in the general price level can be positive (inflation) or negative (deflation), and even where there is a positive change it can be smaller than in the previous period (disinflation).

Question 4.1 Choose the correct answer(s)

The table below shows the CPI for Japan from 2003 to 2022, using 2003 as the base year. Based on this information, read the following statements and choose the correct option(s).

Year CPI
2003 100
2004 100
2005 99.7
2006 100
2007 100
2008 101.4
2009 100
2010 99.3
2011 99
2012 99
2013 99.3
2014 102.1
2015 102.9
2016 102.7
2017 103.2
2018 104.3
2019 104.7
2020 104.7
2021 104.5
2022 107.1
  • Japan experienced disinflation from 2004 to 2005.
  • Japan experienced disinflation from 2013 to 2015.
  • Japan experienced rising inflation from 2016 to 2018.
  • Japan did not experience inflation four times in a row over the period shown.
  • The price level fell from 2004 to 2005, which corresponds to deflation. (With disinflation, the price level is still rising but at a slower rate.)
  • The CPI rose by 2.8% from 2013 to 2014, but only by 0.8% from 2014 to 2015. Since the price level rose but at a slower rate, Japan was experiencing disinflation.
  • The CPI rose by a larger amount in 2017 to 2018 (1.1%) than 2016 to 2017 (0.5%).
  • In the period shown, inflation was positive for at most three years in a row (twice, from 2012 to 2015 and from 2016 to 2019).

Exercise 4.1 Measuring inflation

Go to the Office for National Statistics (ONS) website, scroll to ‘Overview of basket update’ in Section 2, and answer these questions:

  1. How does a national statistical authority such as the ONS in the UK construct a giant representative shopping basket for the whole population?
  2. If inflation this year is 6.7%, then what is the current price of the representative shopping basket that cost £100 last year?

The official national inflation rate does not necessarily reflect your own personal inflation rate. If you want to calculate your own personal inflation rate and find out how it deviates from the national one, some national statistics agencies offer a personal inflation calculator, such as Statistics Netherlands or Statistics South Africa. Your own office of national statistics may also have a personal inflation calculator.

  1. Using a personal inflation calculator, calculate your personal inflation rate and comment on how and why it differs from the official inflation rate for your country.

Exercise 4.2 The CPI and the GDP deflator

Follow these instructions to construct data charts for Germany:

  • Go to the FRED website.
  • Find the following data series for Germany: annual real GDP growth (NGDPRXDCDEA), the unemployment rate (LMUNRRTTDEM156S), the German GDP deflator (NGDPDIXDEA), and the inflation rate (DEUCPIALLAINMEI). (Hint: use the consumer price index to calculate the inflation rate.)
  • Using the ‘Edit graph’ options (the button above the top-right corner of your graph), select the series’ maximum range and make sure your series are all in annual frequency. You can watch this short tutorial to understand how FRED works.
  • Select the ‘Download’ button and choose the Excel format.

Use the data you downloaded to answer the following questions. (Remember that the CPI is calculated from the price of goods consumed in the home country, while the GDP deflator is calculated from the price of the goods produced in the home country.)

  1. There is a positive difference in the growth rates for CPI and the GDP deflator in 1981 and 2022. What could explain this pattern? (Hint: think about the likely impact of an oil crisis on the price of imported goods and, in particular, on your own transport and fuel bills.)
  2. How have unemployment and inflation evolved in the early 1980s?
  3. Now construct the same charts for your own country. How have inflation, unemployment, and the real GDP growth rate evolved over the same period? Write a brief report summarising your findings.

Exercise 4.3 Using the CPI to measure inflation

Listen to this podcast from the Financial Times where economist Emi Nakamura is interviewed about how inflation is measured, the costs of inflation, and the relationship between inflation and unemployment. Use it to answer the following questions:

  1. What are some of the main flaws of the use of CPI to measure inflation that Emi Nakamura mentions in the podcast? Provide an example.
  2. What is Emi Nakamura’s main finding from her work on understanding the costs of inflation?
  3. What was interesting about the way she collected data?