Measuring cost of living --inflation and the consumer price index
Introduction to inflation Basics of price inflation and the CPI (consumer price index)
Introduction to inflation
- When economists refer to inflation today,
- they are referring to a general increase in the level of prices of goods and services.
- So they're really talking about price inflation.
- The reason why I stress that is because sometimes,
- especially when the term "inflation" first came into usage,
- it actually was referring to monetary inflation, or an increase in the money supply.
- These two ideas are closely related.
- But it's important to realize that people really are measuring inflation.
- When they're talking about inflation today, they're talking about price inflation.
- Because although these two things are related, they aren't always exactly the same thing.
- It is generally true that if the money supply - and the money supply is more than just the amount of dollars that are printed.
- It's affected by the amount of lending that's occurring,
- it's affected by the number of transactions that are occurring in the economy.
- And if that money supply that's affected by all of those things grows faster
- than the total real productivity of the economy, then it will generally increase the level of prices.
- But especially in the short-term, there could be other causes of price inflation.
- You could have things like "supply shocks."
- And a supply shock is the supply of something becomes scarce all of a sudden.
- And the most typical example of a "supply shock" is the oil crisis in the 1970's.
- If for whatever reason oil becomes scarce in a country like the United States,
- then the price of oil and gas would go up. But then, these are inputs into a whole set of things.
- Even that banana that you buy at the grocery store. If the price of oil or gas or both of them, frankly,
- were to shoot up, even the price of your banana would shoot up.
- Because to get that banana to your store, you need to use some gasoline.
- In fact a significant fraction of that banana in that store would probably
- include the cost of the gasoline to operate that ship to take that banana
- from wherever it was grown to your grocery store, and then on a railroad, and then on a truck or whatever.
- So this would affect the general prices, not just the prices of oil or gas.
- So these two things are related, but it is important to realize that people
- are referring to price inflation.
- And the general consensus is, a little bit of it is a good thing.
- So, a little is good.
- And I want to stress little is good. And we're talking 1, 2, maybe 3 per cent per year.
- But anything larger than that gets a little scary because it can kind of snowball on itself.
- But we'll talk about that in future videos when we talk about hyperinflation.
- And economists are also afraid of inflation if it were to ever get negative.
- That leads to "deflation" and we'll talk in future videos
- why in many circles that is viewed as a scary thing.
- Now, in the United States, the inflation is measured with the "consumer price index." CPI
- You'll always hear this reported in the news especially if you watch some of the business programming.
- And there are actually multiple consumer price indices.
- And the one that people report whenever they say
- the "CPI" went up 2%", they are actually referring to the CPI-U.
- And the U here stands for urban consumers. And the reason why this is the headline CPI,
- or the one that people actually report, is because most of the country
- the United States, are urban consumers.
- So this is the CPI that affects the largest number of peoples' pocketbooks.
- And the way that it's calculated is, it's like the deflator, it's a price index,
- and like the deflator it's measuring a general increase
- or a general change in the level of prices.
- But they actually are calculated in slightly different ways.
- Although they should be close to each other
- if they really are indices for measuring the general level of prices.
- So the way that the CPI works is that they take a basket of goods
- for this type of consumer in a base year.
- So they'll pick a base year.
- And let's take a super simple example, a ridiculously simple example.
- Let's say, in our little country, the urban consumer - so we'll focus on CPI-U -
- only consumes two things.
- In the next video we'll see that in reality we consume many more than two things
- but two things, and they spend 60% of their money on apples
- and they spend 40% of their money on bananas.
- And in that base year we just set the base price of apples at a 100 and of bananas at a 100.
- We're not saying that apples and bananas cost the same thing.
- We're saying that we're spending 60% of our money on apples, 40% on bananas in that base year
- and that this is just that base year level of prices.
- What will matter is how much this grew,
- what will this index change as we go to whatever year we want to calculate the inflation in,
- relative to this base year.
- So let's say in our current year, could be the very next year,
- and we're going to assume the same ways, that we're spending 60% on apples and 40% on bananas,
- in our current year, the apple index has grown 50% to 150,
- so it is plus 50%,
- and let's say that the banana index has grown to 180,
- so bananas have gotten even more expensive.
- Plus 80%.
- So how would we measure, how much would we say the CPI-U has grown?
- Well, we would take a weighted average of these indices,
- or you could say a weighted average of the growth,
- you could do it either way,
- so let's do this either way to give you the same result.
- So, in this year, our base index is 0.6 times a hundred,
- plus 0.4 times a hundred,
- and this will just come out to a hundred, this is 60 plus 40, this is equal to 100, as it should.
- That is our base for our index.
- Now over here, in our current year, so this is what we're transitioning to,
- there's a couple of ways to do it,
- you could say "Look, we're spending 60% on something that has gone up to 150 now".
- So we'd say 0.6 times 150 and then we'd say plus 0.4 times 180,
- and that gets us to, let me get my calculator out,
- so that gets us 0.6 times 150 plus 0.4 times 180.
- So that gets us to 162.
- So if we look at this basket,
- and this is an overly simplified basket,
- we have increased from 100 to 162.
- Or you could say this is +62%.
- And you would have gotten the same result if you took the weighted average of the percentages,
- if you took 0.6 times 50% plus 0.4 times 80%,
- we can do that in our head,
- 0.6 times 50% is going to be 30%
- and then 0.4 times 80% is going to be 32%.
- 30 plus 32 gives us 62% growth.
- If for this basket of goods, which we're assuming is I guess for this urban consumer,
- from our base year to the current year.
- In the next video we will look at what the basket of goods actually looks like
- In the United States for an actual urban consumer.
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