Inflation 

PRICE INDICES 

Constructing a Price Index

A price index will allow us to measure inflation and convert nominals to reals. 

To construct a price index: 

1. Select a base year. Price Index for base year = 100 
2. Select a bundle of goods, whose prices will be monitored over time. 
3. Compute the cost of the goods in your bundle in the base year. 
4. Compute the cost of the goods in your bundle in the year you wish to compare to the base year (year i). 
5. Apply the following formula: 

where PI(i) is the price index in year i. 

Example: The following are price data for three years: 

Year	1 Shirt	1 Movie	1 Coke
1990	$20	$7	$.50
1991	$20	$7.50	$.50
1992	$21	$7.50	$.75

1. The Base year is 1990. 
PI(1990) = 100 (since its the base year) 

2. The Bundle is 1 shirt, 1 movie, and 2 Cokes. 3. Cost of bundle in 1991 is $28.50. 

4. Cost of bundle in 1992 is $30. 

5. PI(1991) = (28.50 / 28.00) × 100 = 101.8, 
PI(1992)= (30.00 / 28.00) × 100 = 107.1 

Click here to see the Consumer Price Index.

Using the Price Index to Measure Inflation

inflation rate(t) = [[P(t) - P(t-1)] / P(t-1)] 

This formula calculates the inflation rate in year t by taking the percent change in the price indices of year t (the current year) and year t-1 (i.e. last year). 

Example: 

Inflation rate in 1991 = (101.8 - 100)/100  = 0.018=1.8% 

Inflation rate in 1992 = (107.1 - 101.8)/101.8= 0.0521=5.21% 

Click here to see a chart of inflation rates for the United States. 

Deflating Nominal to Real Values

A real value is corrected for the effects of inflation 

Example: A coat costs $50 in 1991 and $57 in 1992. In real terms, in which year is the coat cheaper? 

Part of the reason that the coat is more expensive in 1992 is because the price level has increased. To make a meaningful comparison, we have to remove this price effect. We must "deflate the nominal values." 

Deflating is the process of deriving the real value of some nominal value by dividing by an appropriate price index. The formula is the following: 

Real Value(i) = Nominal Value(i)/ Price Index(i) x 100 

Example: The coat that cost $50 in 1991 is worth $50/101.8 × 100 = $49.12 in 1990 dollars, and the same coat in 1992 is worth $57/107.1 × 100 = $53.22 in 1990 dollars, so the coat is cheaper in real terms in 1991. 

Costs of Inflation 

The costs of inflation depend on whether inflation is anticipated or unanticipated: 

Costs of anticipated (completely expected) inflation: 

1. shoe-leather costs: costs of financial management 
2. menu costs: physical costs of changing prices (i.e. printing new menus). 
3. tax costs: even if inflation is anticipated, if the tax laws are not adjusted for inflation, inflation may cause the tax bill of an individual to rise. (ex. capital gains taxes, bracket creep) 

1. arbitrary redistribution of income. Example: mortgage borrowing. 
2. inflation uncertainty. It becomes more difficult to enter into transactions when future inflation is uncertain. 
3. Hyperinflation: Hyperinflation is inflation that proceeds at exceptionally high rates. Examples: Germany, Oct. 1923, inflation was 29,586%, in Nicaragua, 1988, inflation was 33,602%, and in Brazil, 1990, inflation was 2,360%. Hyperinflation is ultimately caused by creation of money that gets out of control (often to pay off debts). 

Types of Inflation: 

Cost-Push Inflation: inflation is due to increases in production costs (ex. oil shocks)