Macroeconomics: Understanding Price Indices, CPI, and PPI

Basic Macro Ideas: Units

Output and Income

Part III: Macroeconomics Basic Macro Ideas: 3 Units Unit 11A: Output and Income

The Price Level

Unit 11B: The Price Level Unit 13: The Labour Market and the Unemployment RateUnit 11B The Price Level (Mankiw & Taylor, Ch 20)

Preview of Unit 11B

1. We have GDP as an aggregate measure of the overall output produced by an economy, which is in a sense a sort "average quantity" "AVERAGE QUANTITY"
2. Here we take up the question of what "average price" we associate to this aggregate quantity.
3. Different answers are possible (and one we already know: the GDP deflator).
4. This is the key to measure inflationPrice indices and inflation

Price Indices and Inflation

Statistical Construct of Price Index

INDICE DI PREZZO REALIZZAZIONE STATISTICA A price index is a statistical construct meant to capture the 'average price' of some quantity aggregate. PRICE INDEX = AVERAGE PRICE OF SOME Q. AGGREGATE IDEATO Various price indices can be devised, depending on what (subset of) relevant commodities one is interested in. VARIOUS DEPENDING ON WHAT RELEVANT COMMODITIES ONE IS INTERESTED IN

Key Indices for the Economy

For the economy as a whole, two indices stand out: cost-of-living indices and the GDP deflator, which are key to measure inflation. • COST-OF-LIVING MEASURE • GOP DEFLATOR INFLATION

Defining Inflation and Inflation Rate

Inflation is the term used to describe a situation in which the economy's overall price level is rising; the inflation rate is the percentage change in the price level rom the previous period. INFLATION = EL. OVERALL PRICE LEVEL IS RISING INFLATION RATE: PERCENTAGE CHANGE IN P. LEVEL FROM THE PREVIOUS PERIOD

The Consumer Price Index (CPI)

Measuring Cost of Living with CPI

The key index to measure the cost of living is the consumer price index (CPI), which estimates the overall cost of the goods and services bought by a typical consumer, CP = OVERALL COST OF GOODS AND SERVICES BOUGHT BY ATYPICAL CONSUMER

CPI Reporting and Impact

National Statistics Agencies (e.g., Istat), and Eurostat for the EU, report the CPI each month, which is used to monitor changes in the cost of living over time. CPI-O REPORTED EVERY MONTH When the CPI rises, the typical family has to spend more money to maintain the same standard of living. CPI RISES - FAMILY SPEND MORE MONEY FOR THE SAME STANDARD OF LIVING

Defining the CPI

Fixing the Relevant Basket of Commodities

Defining the CPI Fix the relevant basket of commodities: Determine what commodities (and hence what prices) are most important to the typical consumer ("representative household") WHAT COMMODITIES ARE MOST IMPORTANT TO THE TYPICAL CONSUMER National Statistics Agencies identify a market basket of goods and services the typical consumer buys (via regular consumer surveys to set the weights for the different prices: the higher the share of one commodity in the budget, the higher the weight of the corresponding price). • HIGHER THE SHARE OF I COMM. IN THE BUDGET LO HIGHER WEIGHT OF THE CORRESPONDING PRICE CONSUMER SURVEYS TO SET WEIGHTS OF THE CORRE SPENDING PRICE

Steps to Calculate CPI

Defining the CPI 1 Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. LO FOR EACH POINT IN TIME 2 Compute the Basket's Cost: Data on prices allow calculating the cost of the commodity basket at different times. BASE YEAR 3 Choose a Base Year and Compute the Index: One year is chosen as the base year, i.e. the benchmark against which other years are compared. The index is given by dividing the price of the basket in one year by the price in the base year and multiplying by 100. P. BASKET ONE YEAR 100 P. BASKET BASE YEAR Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period. % CHANGE FROM THE PRECEDING PERIOD

CPI Calculation Example: Salads and Hamburgers

The consumer price index Fix the Basket: Example: 4 salads and 2 hamburgers Find the Prices: Year Price of Salads Price of Hamburgers 2016 €1 €2 2017 €2 €3 2018 €3 €4 Compute the Basket's Cost: Year Calculation Basket cost 2016 (€1 × 4) + (€2 x 2) = €8 2017 (€2 × 4) + (€3 x 2) = €14 2018 (€3×4) + (€4 x2) = €20. FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017

CPI and Inflation Rate Calculation Example

The consumer price index Choose a base year and compute the index: CPI = cost of basket in current year cost of basket in base year × 100 Year Calculation CPI 2016 (base year) (€8)/(€8) x100 100 2017 (€14)/(€8) ×100 175 2018 (€20)/(€8) x 100 250 Compute the inflation rate: CPI in year 2 - CPI in year 1 Inflation rate in year 2 = CPI in year 1 Inflation Rate for 2017 = (175 - 100)/100 = 0.75 = 75%. Inflation Rate for 2018 = (250 - 175)/175 = 0.43 = 43%. FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017

The Producer Price Index (PPI)

Understanding the PPI

The consumer price Index CALIBRATO The future behaviour of the CPI can sometimes be gauged by looking at the producer price index PRODUCER PRICE INDEX ( PPI) The producer price index is a measure of the cost of a basket of goods and services bought by firms. It is set using the same methodology as the CPI, MEASURE OF THE COST OF A BASKET OF GOODS AND SERVICES BOUGHT BY A FIRM

PPI's Role in Predicting CPI Changes

As firms eventually pass on higher costs to consumers in the form of higher prices on products (at least in part, depending on market conditions), the producer price index is believed to be helpful in predicting changes in the CPI. HELPFUL IN PREDICTING CHANGES IN THE CPI

Distortions in CPI Estimation

Key Problems Overestimating Cost of Living

The consumer price Index TYPICAL BUNDLE The CPI is an estimate based on a typical bundle, some inevitable distortions of which can be INDIVIDUATE singled out( 3 key problems lead to the CPI overestimating the "true" cost of living: DISTORSIONE CHANGE IN RELATIE PRICES Substitution bias: The basket does not reflect the consumer's reaction to changes in relative prices (ideally, only income effects should be considered) CHANGE IN PURCHASING POWER QUE 2New goods: The basket does not reflect the change in purchasing power due to new products (new products result in greater variety, which in turn makes each euro more valuable). NEW PRODUCTS 3Unmeasured quality changes: if the quality rises from one year to the next, the value of one euro rises, even if the price stays the same (and if quality falls from one year to the next, the value of one euro falls). Statistical Agencies try to adjust the price for quality, but such differences are hard to measure. FAMIGLIE RAPPRESENTATIVE Then there is the obvious distortion due to the "representative household" being by definition an approximation.

Importance of Accurate CPI Measurement

The consumer price Index IN TUTTO The same method is used to calculate CPI throughout the EU ('Harmonized" CPI), which allows for direct comparison of inflation rates among EU member states. The issue over accurate measurement is important because many government programs use the CPI to adjust for changes in the overall level of prices. Also, private contracts may include COLA clauses (e.g., wages and salaries).

CPI for Italy (Last 50 Years)

The consumer price Index Here we see the CPI for Italy in the last 50 years or so (source: IMF, 2021) Annual percent change 25 20 15 10 5 .. 0 -5 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025

The CPI and the GDP Deflator

Comparing Price Indices

The CPI and the GDP deflator Economists and policymakers monitor both the GDP deflator and the consumer price VALUTARE index to gauge how quickly prices are rising. There are two important differences between the indexes that may cause them to SEPARARSI diverge. 1 The GDP deflator reflects the prices of all goods and services produced domestically, whereas the CPI reflects the prices of all goods and services bought by consumers. 2. The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year (Statistical Agencies do not usually revise the basket every year), while the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. CPI -. REFLECTS THE P OF ALL GOODS AND SERVICES BOUGHT BY CONSUMERS • COMPARES P OF A FIXED BASKET OF GOODS AND SERV. TO THE P. OF THE BASKET IN THE BASE YEAR GDP DEF. . REFLECTS THE P. OF ALL GOODS. AND SERV. PRODUCED DOMESTICALLY • COMPARES P. OF CURRENTLY PRODUCED GOODS AND SERV. TO THE P. OF THE SAME GOODS AND SERY. IN THE BASE YEAR

Estimating the Effects of Inflation

Correcting for Inflation with Price Indexes

Estimating the effects of inflation Price indexes are used to correct for the effects of inflation when comparing money figures from different times. COMPARING MONEY FIGURES FROM DIFF. TIMES

Example 1: MPs' Earnings Adjustment

Example 1: • In 1947 MPs earned £1000 • In 2015 MPs earned £74,000 but prices have risen since 1947. • CPI index in 1947 = 28.9 • CPI index in 2015 = 1018.6 Salary 2015 = Salary 194 Price Level in 2015 1018.6 Price Level in 1947 = £1000 28.9 = £35,246 FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017

Example 2: Inflation-Adjusted Box Office Receipts

Estimating the effects of inflation Example 2 By box office receipts, Avatar grossed $2.79bn and Titanic some $2.19bn, but things change when data is indexed. Here we see a table of the top 10 films based on inflation- adjusted box office receipts. The winner: 1939's Gone with the Wind. Film Year of release 1. Gone with the Wind 1939 2. Star Wars 1977 3. The Sound of Music 1965 4. E.T. 1982 5. Titanic 1997 6. The Ten Commandments 1956 7. Jaws 1975 8. Doctor Zhivago 1965 9. The Exorcist 1973 10. Snow White and the Seven Dwarfs 1937 FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017

Example 3: Nominal vs. Real Interest Rates

Estimating the effects of inflation Example 3 PAGAMENTO IN FUTURO, PER UN TRASFERIM. MONETA IN PASSATO Interest represents a payment in the future for a transfer of money in the past. NOMINAL INTEREST RATE The nominal interest rate is the interest rate usually reported and not corrected for inflation - e.g., it is the interest rate that a bank pays. The real interest rate is the nominal interest rate that is corrected for the effects of inflation. NOMINAL INTEREST RATE REPORTED AND NOT CORRECTED FOR INFLATION REAL INTEREST : RATE NOMINAL IN. RATE, CORRECTED FOR THE EFFECTS OF INFLATION

Example 3: Loan Repayment with Inflation

Estimating the effects of inflation Example 3 Here is a simple example • You borrowed €1,000 for one year. • Nominal interest rate was 15%. • During the year inflation was 10%. Suppose you buy 500 units of some commodity (coconuts, say) whose price is € 2 At the end of the year your goods sell at € 2(1+0.10) = € 2.2 You sell the coconuts and get (€ 2.2 times 500) = € 1100 You have to pay back € 1,000(1+0.15) = € 1150 So you are actually paying back €(1150 - 1100) = € 50 € 50 are worth (around) 23 coconuts at a price of € 2.2