Inflation and the Price Level
Michael Kuehlwein,
Prices have risen steadily in the
The Completeness of the Consumer Price Index
Robert J. Thompson,
In pointing out to students the tremendous variety of goods and services covered by the CPI, I distribute lists (or display them via an overhead projector) of the 400‑plus items in the "typical" consumer's budget along with corresponding expenditure weights. The complete list runs about 6 pages and is available from the U. S. Department of Labor. As I browse down the list, noting examples of salami and socks, jewelry and pet supplies, toilet tissue and parking fees, etc., the fine detail and thorough nature of the CPI is emphasized. More than one student has suggested that it reflects "everything but the kitchen sink." (To this remark the instructor can reply, "You're only partially correct. Until the 1978 revisions, even the cost of replacing the kitchen sink was included!"). In addition to emphasizing the completeness of the CPI, the list of items and their expenditure weights also impresses on students the possible differences in the changes in the general cost‑of‑living as measured by the CPI and in students' own cost‑of‑ living. Interesting discussion can be generated by discovering items that are dominant in students' own consumption patterns but which are either excluded or not weighted very heavily in the CPI. College tuition is one of the best examples of the former in this regard.
D.
To start students thinking about inflation, blow up a balloon, explaining that it represents the price level. As you inflate it, inflation is occurring. Now let the balloon go, and ask what happened‑‑deflation. Now blow it up again until it finally explodes, and ask what happened. The inflation was so pervasive (hyperinflation) that the balloon (price level) burst, leading to an economic breakdown.
(NOTE: One could now use the balloon to explain nominal and real GDP as suggested by Jose Alberro in the second edition of Great Ideas, p. 48.)
Textbooks, Yardsticks, and Inflation
James Neal, Lake‑Sumter Community College
In discussing the negative effects of unanticipated inflation, I have incorporated the use of a yardstick for a simple demonstration. The demonstration is prefaced by the statement that inflation is, of course, only a change in the length of the financial measuring rod so why be concerned about any real effects. I then ask the students to consider the effects of an unanticipated change in the calibration of a slide rule (for the benefit of older students) or the basic statistical functions in an electronic calculator. Would these changes alter the ability of an engineer to construct a building, a bridge, a highway? Next, I ask about the consequences on a textile manufacturer if its basic measure, the yard, was arbitrarily altered in an unexpected fashion. How would this affect its orders, machinery settings, and potential revenues? This question is accompanied by the dramatic breaking of the yardstick into as many pieces as strength permits. Now discussion of the specific financial difficulties in planning caused by unanticipated inflation can easily begin.
Common Sense and the Measurement of Inflation
Most students have a vague idea about the relationship between price indices and the value of the dollar. Their common sense tells them that as prices rise, a dollar buys less and therefore is worth less. After a brief reminder of what they already know about indices, a student is asked, "If a dollar is worth one dollar when the price index is 100, what is its value when the price index increases to 178?" The following dialogue typically ensues between the (S)tudent and the (T)eacher.
S: "I guess the dollar will be worth less, since prices have gone up."
T: "That's right. But what's the numeric value?"
S: "I'm not sure. Maybe about 22 cents."
T: "That's not the right answer. But I'm sure you know how to work the problem. Want me to prove it?" ("Yes.") "OK, suppose the price index goes from 100 to 200. Prices double. What's the value of the dollar?"
S: "Fifty cents?"
T: "Good! Just common sense, isn't it? Now suppose the index goes from 100 to 300. What's the value of the dollar?"
S: "Thirty‑three cents?"
T: "Excellent! Just common sense, isn't it? How about 100 to 400?"
S: "Twenty‑five cents."
T: "You're three for four. You've demonstrated you know how to work the problem. Now, suppose the index increases from 100 to 178. What's the value of the dollar?"
S: "I'm still not quite sure."
T: "Your intuition or common sense helped you solve the easy problems, but still fails in the more complex situation. You apparently have a method for working the problem, but you haven't formalized it. The value of the dollar equals 100 divided by the price index. V=100/P. The answer is 100/178 or approximately 56 cents. What can we learn from this? The economic theory in this class merely formalizes and extends your common sense so that you can go beyond simple problems and analyze more complex situations."
Daniel Levy,
To check how well students understand the uses of the CPI, ask them these questions:
a. Compute the inflation rate for the two‑year period if you know that the annual inflation rate in the first year was 3% and in the second 5%. (It is greater than 8%.)
b. If the nominal income rises by 30% and at the same period the inflation rate is also 30%, does this imply that the real income is unchanged? (No!)
c. "The government announced today that last month, the annual inflation rate was 6%." What was the actual monthly inflation rate last month? (This is important because every month when these figures are published, the media often uses this type of terminology in explaining their meaning.)
Political Economy and the Index Number Problem
Frederick S. Weaver,
You are the Minister of Economics in Stagnacia, a small country in which bread and ale are the only two goods produced and consumed. During your five year term in office, ale production and prices have slightly but steadily increased while the output of bread has slowly and consistently fallen, although the price of bread has not changed. Now that you are running for reelection, you want to show the maximum increase (or minimum decrease) in aggregate production and to minimize the apparent inflation that has occurred while the economy has been under your guidance. While this goal (and outright falsification not feasible), which year's prices would you choose to calculate the published "real GDP" and which year's output to calculate the published price index?
A Price Index ‑ An Intuitive Interpretation
David
I find it helpful to relate the logic behind price indices as measures of changes in economic activity to the question of determining which college football teams should be rated #1, #2, and so on. The different schedules played by the teams and the different conditions under which they played makes such judgments difficult. Similarly, it is difficult to determine the extent to which economic activity, measured by the level of final goods and services produced, changes over time. Because of the difficulty of making such comparisons when production is measured in terms of physical output, there is an obvious advantage to measuring all final outputs in a common denominator such as dollars. But the disadvantage of doing so is that an element of "distortion" is introduced because per unit prices of different goods and services, the bases for conversion to dollar values, are unlikely to remain unchanged over time.
Now, a reasonable way to determine the best college football team (at least conceptually) would be to standardize the opposition (as well as the playing conditions) confronted by each team being compared so that performance differences among them may be related to quality differences among them. Similarly, standardizing prices is the objective and achievement of incorporating a price index into the measurement of economic activity. Because changes in the dollar value of final outputs will reflect, at lease in part, changing price levels and not changing production only, a "distortion" is introduced which can be overcome with the help of an appropriate price index. In effect, the use of price index puts the production levels of different years on the same footing, valuing them by the same set of prices so that the "distortion" created by changing prices over time is eliminated. Without pursuing the technicalities of the "index number problem" and related matters, it may be argued that the use of a price index achieves a kind of standardization in terms of which changing levels of economic activity may be compared more accurately.
The Differences Between CPI and the GDP Price Deflator
Paul G. Coldagelli,
This exercise teaches students the differences between the CPI and the implicit GDP price deflator, revealing how the CPI over‑states inflation by failing to account for consumer's substitution of goods, and shows the important distinction between real and nominal GDP.
Consider a small island economy which produces (and consumes only 3 goods: Apples (A), Bananas (B), and Coconuts (C). You have the following price and production information for the last 3 years.
1991 1992 1993
P Q P Q P Q
A $.30 200 $.40 250 $.50 200
B .25 400 .30 500 .35 500
C .50 100 .50 160 .50 200
Let 1991 be the "base year" for the CPI and the implicit GDP price deflator (IPD). For calculating the CPI, use the following market basket for an average family: A: 20 B: 40 C: 10
a. calculate nominal GDP for each year.
b. indicate the percent increase in nominal GDP from
i. 1991 to 1992 ii. 1992 to 1993
c. calculate real GDP (in 1991 dollars) for each year.
d. calculate the IPD for 1992 and 1993. Hint: the nominal GDP, when deflated by the IPD, yields real GDP.
e. redo problem (b) using real GDP and compare your answers.
f. calculate the CPI for 1992 and 1993. Explain differences in your calculations from those in problem (d).
Ralph T. Byrns
The problems associated with inflation and hyperinflation can be graphically illustrated to students by obtaining and passing around the classroom actual pieces of currency from the German (1921‑1923), Hungarian (1945‑1946), Chinese (1946‑1949), Russian (1922‑1924), or various South American hyperinflations (1910s‑ present). Postage stamps from such periods have a similar effect.
Actually seeing the large denomination notes contrasted to earlier and smaller notes makes quite an impact on students. You might, for example, show a German one mark note from 1919, indicate that a loaf of bread cost roughly one mark at the end of World War I, and then show a 5 million mark note from 1923, a 2" stack of which was needed to buy a loaf of bread by that time. Currency and stamps can be obtained from coin and stamp dealers. Many large denomination notes have become somewhat expensive, but the effects of such demonstrations on students and their appreciation of the problems surrounding hyperinflation make them worthwhile. (NOTE: The Hyperinflation Collection provided to instructors who adopt our texts contains 29 such artifacts from six major hyperinflations.)
Figure 7-1
Ralph T. Byrns
Assert that government has the power to eliminate inflation. If students challenge this, offer the possibility that the Federal Reserve System could cut the money supply in half (prove that the FED is the relevant agency by having them peruse bills from their purses or wallets). Most students recognize intuitively that halving the money supply would precipitate an enormous drop in spending. Their familiarity with demand and supply analysis will lead them to conclude that downward pressures on prices would be irresistible. Ask why we have inflation if the government could eliminate it. Some students may come up with the acceptable answer that inflation may be more acceptable than the alternatives. Now assert that we have inflation because we demand it (politically). Why? Cite the traditional reasons: that debtors and government gain from inflation, etc. Point to the late 19th century (1868‑95) and the Great Depression (1929‑39) as eras when political pressure for inflationary policies were rampant (the Greenback Party, the Free Silverites, the New Deal, etc. You might also cite the pressures for inflationary policies from, e.g., realtors and such White House insiders as Secretary of the Treasury Donald Regan prior to the 1984 presidential election.) Suggest that, at a minimum, this establishes that some people gain from inflation.
Now treat inflation as a zero‑sum game and examine the possible winners and losers from income redistribution caused by inflation. Use the following table as a starting point.
Losers Gainers
Creditors Debtors
Taxpayers Government (Bracket Creep and Seignorage)
Those whose prices paid rise Those whose incomes rise faster
faster than their incomes than prices paid
Sellers of futures contracts Buyers of futures contracts
People who fail to anticipate Correct forecasters of inflation
inflation
Ralph T. Byrns
Here is a suggestion for instructors who enjoy counterintuitive lectures to stimulate student thought and discussion. It depends on a view that some people might perceive as outrageous to rationalize the concept that people demand inflationary policies. Specifically, it is the possibility that some (many?) people equate success with achieving numerical goals, and that nominal goals move upwards (or if the desire is for smaller numbers, down) gradually as monetary targets are achieved. That is, we have inflation (or deflation, where appropriate) in many scoring systems because people like big (small) numbers, and policy makers are prone to accommodate these desires. The following evidence can be cited:
a. Grade Inflation. Students want higher grades. Professors (rule makers) have complied with this want by gradually (all A's would be too flagrant, and people would realize that the game had changed) lowering standards and raising grade averages. In 1965, the median GPAs of graduating seniors were approximately 2.2 on a 4.0 scale; by 1982, median GPAs had reached 2.9+ on a 4.0 scale.
b. Basketball. The fans' desires for higher scores have led pro basketball to outlaw the zone defense, adopt a 24 second clock, and award 3 points (instead of 2) for baskets scored from over 22' away. Result: even losing teams typically score over 100 points per game. In the college game, a shot clock and a 3‑point shot from 20' were introduced during 1986‑87 to favor offensive scoring and speed up the game.
c. Football. Similar desires by fans resulted in numerous rules changes favoring the offense over the defense. Offensive linemen can `hold' on passing downs; defensive backs are allowed only limited contact with potential pass receivers, etc. Result: offensive statistical records (yardage, passing, etc.) are shattered regularly, and average points scored in professional football games have soared over the decades.
d. Track and Field Events. Indoor tracks are now `tuned' with steel springs so that sprinters run faster and faster. (If the boards are too stiff, runners `cushion' their strides and speeds fall; if the boards are too limber, the `mushy' feel slows runners down.) Pole vaulting: the poles permissibly used have evolved from bamboo and aluminum to extremely flexible fiber glass, with the permissible amount of flexibility being increased over time. Result: record heights have risen by 5' or so over the past 40 years.
e. Pinball and Electronic Games. In the early 1950s, winning a bonus pinball game required a score of roughly 100 points on a typical machine. Pinball addicts kept track of record scores. The manufacturers recognized that players wanted higher scores, so the values of bumpers and bonus rollovers were raised, increasing the number of points required to win games, but with little or no change in the difficulty encountered in doing so. Result: winning scores went from 100 to 400 to 1,000 to 10,000 to 100,000 to 1,000,000 to 10 million to 100 million points, in roughly three year increments. The same phenomenon occurred, but even faster, with computerized arcade games; each generation of games has easier scoring possibilities.
f. Dress Sizes. This is a slightly perverse example. Many women want to wear lower dress sizes, and dressmakers have accommodated them. What was a size 16 in the mid‑1950s is now a size 10. More expensive clothes lead the trend towards lower numbers, being `roomier' for a given nominal size than cheaper clothes. This might seem to be a counterexample, but conforms to the general idea exposited here that numbers do matter, and people's desires for `better' numbers are accommodated by those who govern what the numbers are.
g. Income. People commonly measure their success by their incomes. Many want `to do better' than their parents, or feel cheated and unappreciated if they don't get raises each year. The regulators of this `income game' (the FED, politicians, etc.) accommodate these desires through inflationary policies. (This motive may help explain why wages appear to be relatively sticky downward and flexible upward.)