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9 | Inflation

Figure 9.1 Big Bucks in Zimbabwe This bill was worth 100 billion Zimbabwean dollars when issued in 2008. There
were even bills issued with a face value of 100 trillion Zimbabwean dollars. The bills had $100,000,000,000,000
written on them. Unfortunately, they were almost worthless. At one point, 621,984,228 Zimbabwean dollars were
equal to one U.S. dollar. Eventually, the country abandoned its own currency and allowed people to use foreign
currency for purchases. (Credit: modification of work by Samantha Marx/Flickr Creative Commons)

A $550 Million Loaf of Bread?

If you were born within the last three decades in the United States, Canada, or many other countries in the
developed world, you probably have no real experience with a high rate of inflation. Inflation is when most
prices in an entire economy are rising. However, there is an extreme form of inflation called hyperinflation.
This occurred in Germany between 1921 and 1928, and more recently in Zimbabwe between 2008 and 2009.
In November 2008, Zimbabwe had an inflation rate of 79.6 billion percent. In contrast, in 2014, the United
States had an average annual rate of inflation of 1.6%.

Zimbabwe’s inflation rate was so high it is difficult to comprehend, so let’s put it into context. It is equivalent to
price increases of 98% per day. This means that, from one day to the next, prices essentially double. What is
life like in an economy afflicted with hyperinflation? Most of you reading this will have never experienced this
phenomenon. The government adjusted prices for commodities in Zimbabwean dollars several times each
day. There was no desire to hold on to currency since it lost value by the minute. The people there spent a
great deal of time getting rid of any cash they acquired by purchasing whatever food or other commodities they
could find. At one point, a loaf of bread cost 550 million Zimbabwean dollars. Teachers’ salaries were in the
trillions a month; however, this was equivalent to only one U.S. dollar a day. At its height, it took 621,984,228
Zimbabwean dollars to purchase one U.S. dollar.

Government agencies had no money to pay their workers so they started printing money to pay their bills
rather than raising taxes. Rising prices caused the government to enact price controls on private businesses,
which led to shortages and the emergence of black markets. In 2009, the country abandoned its currency and
allowed people to use foreign currencies for purchases.

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How does this happen? How can both government and the economy fail to function at the most basic level?
Before we consider these extreme cases of hyperinflation, let’s first look at inflation itself.

Introduction to Inflation
In this chapter, you will learn about:

• Tracking Inflation

• How to Measure Changes in the Cost of Living

• How the U.S. and Other Countries Experience Inflation

• The Confusion Over Inflation

• Indexing and Its Limitations

Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change
in relative prices. A relative price change occurs when you see that the price of tuition has risen, but the price of
laptops has fallen. Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the
economy. In addition, price increases in the supply-and-demand model were one-time events, representing a shift
from a previous equilibrium to a new one. Inflation implies an ongoing rise in prices. If inflation happened for one
year and then stopped, then it would not be inflation any more.

This chapter begins by showing how to combine prices of individual goods and services to create a measure of overall
inflation. It discusses the historical and recent experience of inflation, both in the United States and in other countries
around the world. Other chapters have sometimes included a note under an exhibit or a parenthetical reminder in the
text saying that the numbers have been adjusted for inflation. In this chapter, it is time to show how to use inflation
statistics to adjust other economic variables, so that you can tell how much of, for example, we can attribute the rise
in GDP over different periods of time to an actual increase in the production of goods and services and how much we
should attribute to the fact that prices for most items have risen.

Inflation has consequences for people and firms throughout the economy, in their roles as lenders and borrowers,
wage-earners, taxpayers, and consumers. The chapter concludes with a discussion of some imperfections and biases
in the inflation statistics, and a preview of policies for fighting inflation that we will discuss in other chapters.

9.1 | Tracking Inflation

By the end of this section, you will be able to:

• Calculate the annual rate of inflation

• Explain and use index numbers and base years when simplifying the total quantity spent over a year

for products

• Calculate inflation rates using index numbers

Dinner table conversations where you might have heard about inflation usually entail reminiscing about when
“everything seemed to cost so much less. You used to be able to buy three gallons of gasoline for a dollar and then go
see an afternoon movie for another dollar.” Table 9.1 compares some prices of common goods in 1970 and 2017. Of
course, the average prices in this table may not reflect the prices where you live. The cost of living in New York City
is much higher than in Houston, Texas, for example. In addition, certain products have evolved over recent decades.
A new car in 2017, loaded with antipollution equipment, safety gear, computerized engine controls, and many other
technological advances, is a more advanced machine (and more fuel efficient) than your typical 1970s car. However,
put details like these to one side for the moment, and look at the overall pattern. The primary reason behind the price
rises in Table 9.1—and all the price increases for the other products in the economy—is not specific to the market
for housing or cars or gasoline or movie tickets. Instead, it is part of a general rise in the level of all prices. At the
beginning of 2017, $1 had about the same purchasing power in overall terms of goods and services as 18 cents did in

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219 Chapter 9 | Inflation

1972, because of the amount of inflation that has occurred over that time period.

Items 1970 2017

Pound of ground beef $0.66 $3.62

Pound of butter $0.87 $2.03

Movie ticket $1.55 $8.65

Sales price of new home (median) $22,000 $312,900

New car $3,000 $4,077

Gallon of gasoline $0.36 $2.35

Average hourly wage for a manufacturing worker $3.23 $20.65

Per capita GDP $5,069 $57,294

Table 9.1 Price Comparisons, 1970 and 2017 (Sources: See chapter References at end of book.)

Moreover, the power of inflation does not affect just goods and services, but wages and income levels, too. The
second-to-last row of Table 9.1 shows that the average hourly wage for a manufacturing worker increased nearly
six-fold from 1970 to 2017. The average worker in 2017 is better educated and more productive than the average
worker in 1970—but not six times more productive. Per capita GDP increased substantially from 1970 to 2017, but
is the average person in the U.S. economy really more than eleven times better off in just 47 years? Not likely.

A modern economy has millions of goods and services whose prices are continually quivering in the breezes of
supply and demand. How can all of these shifts in price attribute to a single inflation rate? As with many problems in
economic measurement, the conceptual answer is reasonably straightforward: Economists combine prices of a variety
of goods and services into a single price level. The inflation rate is simply the percentage change in the price level.
Applying the concept, however, involves some practical difficulties.

The Price of a Basket of Goods
To calculate the price level, economists begin with the concept of a basket of goods and services, consisting of the
different items individuals, businesses, or organizations typically buy. The next step is to look at how the prices of
those items change over time. In thinking about how to combine individual prices into an overall price level, many
people find that their first impulse is to calculate the average of the prices. Such a calculation, however, could easily
be misleading because some products matter more than others.

Changes in the prices of goods for which people spend a larger share of their incomes will matter more than changes
in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in
the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct
an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket,
where the weights are based on the actual quantities of goods and services people buy. The following Work It Out
feature walks you through the steps of calculating the annual rate of inflation based on a few products.

Calculating an Annual Rate of Inflation

Consider the simple basket of goods with only three items, represented in Table 9.2. Say that in any given
month, a college student spends money on 20 hamburgers, one bottle of aspirin, and five movies. The table
provides prices for these items over four years through each time period (Pd). Prices of some goods in the
basket may rise while others fall. In this example, the price of aspirin does not change over the four years,
while movies increase in price and hamburgers bounce up and down. The table shows the cost of buying the

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given basket of goods at the prices prevailing at that time.

Items Hamburger Aspirin Movies Total Inflation Rate

Qty 20 1 bottle 5 – –

(Pd 1) Price $3.00 $10.00 $6.00 – –

(Pd 1) Amount Spent $60.00 $10.00 $30.00 $100.00 –

(Pd 2) Price $3.20 $10.00 $6.50 – –

(Pd 2) Amount Spent $64.00 $10.00 $32.50 $106.50 6.5%

(Pd 3) Price $3.10 $10.00 $7.00 – –

(Pd 3) Amount Spent $62.00 $10.00 $35.00 $107.00 0.5%

(Pd 4) Price $3.50 $10.00 $7.50 – –

(Pd 4) Amount Spent $70.00 $10.00 $37.50 $117.50 9.8%

Table 9.2 A College Student’s Basket of Goods

To calculate the annual rate of inflation in this example:

Step 1. Find the percentage change in the cost of purchasing the overall basket of goods between the time
periods. The general equation for percentage changes between two years, whether in the context of inflation
or in any other calculation, is:

⎞
⎠Level in new year – Level in previous year⎛⎝

Level in previous year x 100 = Percentage change

Step 2. From period 1 to period 2, the total cost of purchasing the basket of goods in Table 9.2 rises from
$100 to $106.50. Therefore, the percentage change over this time—the inflation rate—is:

(106.50 – 100) = 0.065 = 6.5%100.0

Step 3. From period 2 to period 3, the overall change in the cost of purchasing the basket rises from $106.50
to $107. Thus, the inflation rate over this time, again calculated by the percentage change, is approximately:

(107 – 106.50) = 0.0047 = 0.47%106.50

Step 4. From period 3 to period 4, the overall cost rises from $107 to $117.50. The inflation rate is thus:

(117.50 – 107) = 0.098 = 9.8%107

This calculation of the change in the total cost of purchasing a basket of goods accounts for how much a
student spends on each good. Hamburgers are the lowest-priced good in this example, and aspirin is the
highest-priced. If an individual buys a greater quantity of a low-price good, then it makes sense that changes
in the price of that good should have a larger impact on the buying power of that person’s money. The larger
impact of hamburgers shows up in the “amount spent” row, where, in all time periods, hamburgers are the
largest item within the amount spent row.

Index Numbers
The numerical results of a calculation based on a basket of goods can get a little messy. The simplified example in
Table 9.2 has only three goods and the prices are in even dollars, not numbers like 79 cents or $124.99. If the list
of products were much longer, and we used more realistic prices, the total quantity spent over a year might be some

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221 Chapter 9 | Inflation

messy-looking number like $17,147.51 or $27,654.92.

To simplify the task of interpreting the price levels for more realistic and complex baskets of goods, economists
typically report the price level in each period as an index number, rather than as the dollar amount for buying the
basket of goods. Economists create price indices to calculate an overall average change in relative prices over time.
To convert the money spent on the basket to an index number, economists arbitrarily choose one year to be the base
year, or starting point from which we measure changes in prices. The base year, by definition, has an index number
equal to 100. This sounds complicated, but it is really a simple math trick. In the example above, say that we choose
time period 3 as the base year. Since the total amount of spending in that year is $107, we divide that amount by itself
($107) and multiply by 100. Again, this is because the index number in the base year always has to have a value of
100. Then, to figure out the values of the index number for the other years, we divide the dollar amounts for the other
years by 1.07 as well. Note also that the dollar signs cancel out so that index numbers have no units.

Table 9.3 shows calculations for the other values of the index number, based on the example in Table 9.2. Because
we calculate the index numbers so that they are in exactly the same proportion as the total dollar cost of purchasing
the basket of goods, we can calculate the inflation rate based on the index numbers, using the percentage change
formula. Thus, the inflation rate from period 1 to period 2 would be

(99.5 – 93.4) = 0.065 = 6.5%93.4

This is the same answer that we derived when measuring inflation based on the dollar cost of the basket of goods for
the same time period.

Total Spending Index Number Inflation Rate Since Previous Period

Period 1 $100 100
1.07 = 93.4

Period 2 $106.50 106.50
1.07 = 99.5

(99.5 – 93.4)
93.4 = 0.065 = 6.5%

Period 3 $107 107
1.07 = 100.0

100 – 99.5
99.5 = 0.005 = 0.5%

Period 4 $117.50 117.50
1.07 = 109.8

109.8 – 100
100 = 0.098 = 9.8%

Table 9.3 Calculating Index Numbers When Period 3 is the Base Year

If the inflation rate is the same whether it is based on dollar values or index numbers, then why bother with the index
numbers? The advantage is that indexing allows easier eyeballing of the inflation numbers. If you glance at two index
numbers like 107 and 110, you know automatically that the rate of inflation between the two years is about, but not
quite exactly equal to, 3%. By contrast, imagine that we express the price levels in absolute dollars of a large basket of
goods, so that when you looked at the data, the numbers were $19,493.62 and $20,040.17. Most people find it difficult
to eyeball those kinds of numbers and say that it is a change of about 3%. However, the two numbers expressed in
absolute dollars are exactly in the same proportion of 107 to 110 as the previous example. If you’re wondering why
simple subtraction of the index numbers wouldn’t work, read the following Clear It Up feature.

Why do you not just subtract index numbers?

A word of warning: When a price index moves from, say, 107 to 110, the rate of inflation is not exactly
3%. Remember, the inflation rate is not derived by subtracting the index numbers, but rather through the
percentage-change calculation. We calculate the precise inflation rate as the price index moves from 107 to

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110 as 100 x (110 – 107) / 107 = 100 x 0.028 = 2.8%. When the base year is fairly close to 100, a quick
subtraction is not a terrible shortcut to calculating the inflation rate—but when precision matters down to tenths
of a percent, subtracting will not give the right answer.

Two final points about index numbers are worth remembering. First, index numbers have no dollar signs or other
units attached to them. Although we can use index numbers to calculate a percentage inflation rate, the index numbers
themselves do not have percentage signs. Index numbers just mirror the proportions that we find in other data. They
transform the other data so that it is easier to work with the data.

Second, the choice of a base year for the index number—that is, the year that is automatically set equal to 100—is
arbitrary. We choose it as a starting point from which we can track changes in prices. In the official inflation statistics,
it is common to use one base year for a few years, and then to update it, so that the base year of 100 is relatively close
to the present. However, any base year that we choose for the index numbers will result in exactly the same inflation
rate. To see this in the previous example, imagine that period 1 is the base year when total spending was $100, and
we assign it an index number of 100. At a glance, you can see that the index numbers would now exactly match the
dollar figures, and the inflation rate in the first period would be 6.5%.

Now that we see how indexes work to track inflation, the next module will show us how economists measure the cost
of living.

Watch this video (http://openstaxcollege.org/l/Duck_Tales) from the cartoon Duck Tales to view a mini-lesson
on inflation.

9.2 | How to Measure Changes in the Cost of Living

By the end of this section, you will be able to:

• Use the Consumer Price Index (CPI) to calculate U.S. inflation rates

• Identify several ways the Bureau of Labor Statistics avoids biases in the Consumer Price Index (CPI)

• Differentiate among the Consumer Price Index (CPI), the Producer Price Index (PPI), the

International Price Index, the Employment Cost Index, and the GDP deflator.

The most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI). Government
statisticians at the U.S. Bureau of Labor Statistics calculate the CPI based on the prices in a fixed basket of goods
and services that represents the purchases of the average family of four. In recent years, the statisticians have paid
considerable attention to a subtle problem: that the change in the total cost of buying a fixed basket of goods and
services over time is conceptually not quite the same as the change in the cost of living, because the cost of living
represents how much it costs for a person to feel that his or her consumption provides an equal level of satisfaction or
utility.

To understand the distinction, imagine that over the past 10 years, the cost of purchasing a fixed basket of goods
increased by 25% and your salary also increased by 25%. Has your personal standard of living held constant? If you

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223 Chapter 9 | Inflation

do not necessarily purchase an identical fixed basket of goods every year, then an inflation calculation based on the
cost of a fixed basket of goods may be a misleading measure of how your cost of living has changed. Two problems
arise here: substitution bias and quality/new goods bias.

When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely,
as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally
rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation,
while goods with falling prices should tend to become more important. Consider, as an example, a rise in the
price of peaches by $100 per pound. If consumers were utterly inflexible in their demand for peaches, this would
lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to
whether they have peaches or other types of fruit. Now, if peach prices rise, people completely switch to other fruit
choices and the average price of food does not change at all. A fixed and unchanging basket of goods assumes that
consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption.
Thus, substitution bias—the rise in the price of a fixed basket of goods over time—tends to overstate the rise in a
consumer’s true cost of living, because it does not take into account that the person can substitute away from goods
whose relative prices have risen.

The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with
the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal
is improved by adding 12 essential vitamins and minerals—and also if a box of the cereal costs 5% more. It would
clearly be misleading to count the entire resulting higher price as inflation, because the new price reflects a higher
quality (or at least different) product. Ideally, one would like to know how much of the higher price is due to the
quality change, and how much of it is just a higher price. The Bureau of Labor Statistics, which is responsible for
computing the Consumer Price Index, must deal with these difficulties in adjusting for quality changes.

Visit this website (http://openstax.org/l/Fords) to view a list of Ford car prices between 1909 and 1927.
Consider how these prices compare to today’s models. Is the product today of a different quality?

We can think of a new product as an extreme improvement in quality—from something that did not exist to something
that does. However, the basket of goods that was fixed in the past obviously does not include new goods created since
then. The basket of goods and services in the Consumer Price Index (CPI) is revised and updated over time, and so
new products are gradually included. However, the process takes some time. For example, room air conditioners were
widely sold in the early 1950s, but were not introduced into the basket of goods behind the Consumer Price Index
until 1964. The VCR and personal computer were available in the late 1970s and widely sold by the early 1980s, but
did not enter the CPI basket of goods until 1987. By 1996, there were more than 40 million cellular phone subscribers
in the United States—but cell phones were not yet part of the CPI basket of goods. The parade of inventions has
continued, with the CPI inevitably lagging a few years behind.

The arrival of new goods creates problems with respect to the accuracy of measuring inflation. The reason people
buy new goods, presumably, is that the new goods offer better value for money than existing goods. Thus, if the price
index leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the
price of a new good is often higher when it is first introduced and then declines over time. If the new good is not
included in the CPI for some years, until its price is already lower, the CPI may miss counting this price decline
altogether. Taking these arguments together, the quality/new goods bias means that the rise in the price of a fixed
basket of goods over time tends to overstate the rise in a consumer’s true cost of living, because it does not account

http://openstax.org/l/Fords

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224 Chapter 9 | Inflation

for how improvements in the quality of existing goods or the invention of new goods improves the standard of living.
The following Clear It Up feature is a must-read on how statisticians comprise and calculate the CPI.

How do U.S. government statisticians measure the Consumer
Price Index?

When the U.S. Bureau of Labor Statistics (BLS) calculates the Consumer Price Index, the first task is to
decide on a basket of goods that is representative of the purchases of the average household. We do this
by using the Consumer Expenditure Survey, a national survey of about 7,000 households, which provides
detailed information on spending habits. Statisticians divide consumer expenditures into eight major groups
(seen below), which in turn they divide into more than 200 individual item categories. The BLS currently uses
1982–1984 as the base period.

For each of the 200 individual expenditure items, the BLS chooses several hundred very specific examples
of that item and looks at the prices of those examples. In figuring out the “breakfast cereal” item under the
overall category of “foods and beverages,” the BLS picks several hundred examples of breakfast cereal. One
example might be the price of a 24-oz. box of a particular brand of cereal sold at a particular store. The BLS
statistically selects specific products and sizes and stores to reflect what people buy and where they shop.
The basket of goods in the Consumer Price Index thus consists of about 80,000 products; that is, several
hundred specific products in over 200 broad-item categories. Statisticians rotate about one-quarter of these
80,000 specific products of the sample each year, and replace them with a different set of products.

The next step is to collect data on prices. Data collectors visit or call about 23,000 stores in 87 urban areas all
over the United States every month to collect prices on these 80,000 specific products. The BLS also conducts
a survey of 50,000 landlords or tenants to collect information about rents.

Statisticians then calculate the Consumer Price Index by taking the 80,000 prices of individual products and
combining them, using weights (see Figure 9.2) determined by the quantities of these products that people
buy and allowing for factors like substitution between goods and quality improvements, into price indices for
the 200 or so overall items. Then, the statisticians combine the price indices for the 200 items into an overall
Consumer Price Index. According the Consumer Price Index website, there are eight categories that data
collectors use:

The Eight Major Categories in the Consumer Price Index

1. Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks)

2. Housing (renter’s cost of housing, homeowner’s cost of housing, fuel oil, bedroom furniture)

3. Apparel (men’s shirts and sweaters, women’s dresses, jewelry)

4. Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)

5. Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care,
hospital services)

6. Recreation (televisions, cable television, pets and pet products, sports equipment, admissions)

7. Education and communication (college tuition, postage, telephone services, computer software and
accessories)

8. Other goods and services (tobacco and smoking products, haircuts and other personal services,
funeral expenses)

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225 Chapter 9 | Inflation

Figure 9.2 The Weighting of CPI Components Of the eight categories used to generate the Consumer
Price Index, housing is the highest at 42.7%. The next highest category, food and beverage at 15.3%, is less
than half the size of housing. Other goods and services, and apparel, are the lowest at 3.4% and 3.3%,
respectively. (Source: www.bls.gov/cpi)

The CPI and Core Inflation Index
Imagine if you were driving a company truck across the country- you probably would care about things like the prices
of available roadside food and motel rooms as well as the truck’s operating condition. However, the manager of the
firm might have different priorities. He would care mostly about the truck’s on-time performance and much less so
about the food you were eating and the places you were staying. In other words, the company manager would be
paying attention to the firm’s production, while ignoring transitory elements that impacted you, but did not affect the
company’s bottom line.

In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned, CPI measures prices as
they affect everyday household spending. Economists typically calculate a core inflation index by taking the CPI and
excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices
that affect the cost of living.

Examples of excluded variables include energy and food prices, which can jump around from month to month because
of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for
the nation’s gasoline was nearly knocked out. …