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[music playing]
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In October of 1978, President Jimmy Carter addressed the American public on television. He began his speech by saying: Good evening. I want to have a frank talk with you tonight about our most serious domestic problem. That problem is inflation. Inflation can threaten all the economic gains we've made, and it can stand in the way of what we want to achieve in the future. This has been a long-time threat. For the last 10 years, the annual inflation rate in the
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United States has averaged six and a half percent. And during the three years before my inauguration, it had increased to an average of eight percent. Inflation has, therefore, been a serious problem for me ever since I became president. But the problem of inflation continued to get worse before it got better, rising to 14.8 percent in March 1980, the highest level reached since just after World War II. In contrast, a generation later, in November of 2008, the problem had entirely changed.
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Here's how a front-page story in the Wall Street Journal began: US consumer prices in October registered their largest single-month decline since before World War II, a broad-based drop that creates a new challenge for policy makers: avoiding a bout of deflation, a prolonged period of falling prices throughout the economy. Interesting juxtaposition, isn't it? One generation's worries that prices were rising too fast had been replaced by a new generation's worries that prices were falling.
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These two stories illustrate the importance of knowing more about inflation, the macroeconomic variable we will take a closer look at in this lecture. If everything you know about inflation came from the news, then you could be forgiven for thinking about inflation as a mysterious virus that occasionally bedevils the economy. President Carter's speech echoes that framing. But inflation is simply the rate at which prices are rising in the economy.
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If we were to continue with the health analogy, inflation is more a symptom than it is a disease. Think of it like your blood pressure: Too high is not good, too low is not good, but an abnormal reading is usually a sign of some other underlying imbalance or disequilibrium in the system. If inflation is a measure of how fast prices in the economy are rising, then in order to calculate inflation, we first need an accurate measure of the price level of an economy.
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Only when the level of prices is accurately measured can we accurately measure how fast that level is rising. In our previous lecture, we learned about how to summarize all the production of new goods and services in the economy using a single number in the form of GDP. In this lecture, we will first learn how to summarize the prices of all the goods and services in the economy into a single number that we call the price level of the economy; we
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can then calculate inflation using the price level. The most commonly used measure of the price level is the consumer price index (or CPI). In the United States, the CPI is calculated every month by the Bureau of Labor Statistics. As the name suggests, the CPI is a measure of the prices faced by a typical consumer for a basket of goods and services. The word index in the consumer price index tells us that the CPI gives us the price of the basket compared to its price in
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the base year, rather than the actual price of the basket or the average price of an item in the basket. So the CPI for the current period is just the cost of the CPI basket of goods for the current period divided by the cost of that same basket for a base year. The result is multiplied by 100, so that the CPI is calibrated to always be 100 in the base year. Currently, the base year for the CPI is 1983, so a value for the CPI of 150 in 1994 and 200 in 2006 would tell us that the
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price level in 1994 was 50 percent higher than in 1983 and that the price level in 2006 was twice as high as in 1983. How is the CPI basket derived? The Bureau of Labor Statistics carries out an extensive study of consumer purchases something they've been doing since 1913! In every quarter of a two-year reference period, they survey a large sample of 24,000 consumers about their spending habits. This is accompanied by an even more detailed data collection
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exercise in which they ask another 12,000 consumers to keep a detailed track of their purchases over two-week intervals in a spending diary. The spending habits gleaned from the diaries and the interviews are used to construct a collection of goods and services that form the reference CPI basket. Each item's relative importance, or weight, in the basket reflects consumer purchasing habits so, for example, both salt and chicken will be in the CPI basket, but chicken will be
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weighted more heavily in the basket since consumers buy more pounds of chicken than they buy pounds of salt. Once the reference-year basket is formed, it stays the same until the next revision occurs, which can be more than a decade. After the CPI was set up in 1919, revisions were done in 1940, 1953, 1964, 1978, 1987, 1998, and 2018.
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The BLS then collects data on the prices of the individual goods and services in the CPI basket from stores, and updates the index every month. The stores themselves are chosen to be representative of the places where consumers actually shop for goods and services; the BLS uses telephone surveys to identify the establishments. For administrative ease, the stores are located in urban and metropolitan areas that cover about 93 percent of the US population, so the CPI is sometimes labeled more
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specifically as the CPI-U (the CPI for all urban consumers).
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What exactly is in the CPI basket? Now, you may have an idea of what would be in your personal basket, but the CPI has to be representative of all consumers, not just you. The list of individual goods and services in the CPI basket includes thousands of items, so the BLS groups them into eight broad categories. Housing and utilities take up the largest share, followed by transportation and fuel, and then food and beverages. When all three of these categories show a sharp rise in
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prices, as happened in 2021 and 2022, the overall CPI increases sharply as well. The CPI is a stepping stone to calculating inflation, but CPI also has other uses as well. In particular, I want to show you how we can use the CPI to make more accurate comparisons of monetary amounts over time. Here's an example I often use with my students: I have a student whose parents graduated from college in 1985. The parents tell her that their tuition was 10,000 a year,
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compared to the 50,000 a year they have to pay for her tuition in 2020. Is it five times more expensive for my student to go to college than it was for her parents? Well, yes, but a more meaningful answer requires that we need to account for the fact that a dollar in 2020 does not buy as much as a dollar did in 1985. Here's another example: The federal minimum wage was 1.60 per hour in 1970, whereas in 2020, it was 7.25 an hour. Is a minimum wage worker in 2020 getting paid between four and
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five times more than a minimum wage worker was in 1970? Again, while the prima facie answer is yes, a more meaningful answer requires that we need to account for the fact that a dollar in 2020 does not buy as much as a dollar did in 1970. Economists describe this type of transformation as doing a real comparison rather than a nominal comparison. The CPI helps us make this adjustment, allowing us to correct for inflation in the economy. Let's go back to our college tuition example: We can look up
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data that the CPI for 1985 was 106.3 and that the CPI for 2020 was 255.1. We can then find the 2020 equivalent of 10,000 in 1985 as being 10,000 divided by the CPI in 1985 and multiplied by the CPI in 2020. This is approximately 24,000. So the real cost of college tuition has basically doubled (from 24,000 to 50,000) instead of the fivefold increase (from 10,000 to 50,000) that the nominal cost comparison revealed. In the minimum wage example, we can look up the CPI value for
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1970 as being 38.6, and the CPI for 2020 was 255.1. We can then find the 2020 equivalent of 1.60 in 1970 by dividing by the CPI in 1970 and multiplying by the CPI in 2020. This is around 10.60. This shows that a minimum wage worker in 1970 actually earned a higher real wage than did a minimum wage worker earning 7.25 in 2020. The real minimum wage declined, even though it looked in nominal terms that the latter made four times as much.
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My students are especially quick to put these two facts together: The real price of college doubled, while the real value of the minimum wage jobs available to typical students working their way through college declined by more than 30 percent. Sometimes firms and governments can do the CPI calculation in reverse and use the CPI to adjust a stream of payments over time, so as to keep the real value of the payments constant. For example, a police officer or a teacher may retire at the age
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of 60 and be entitled to a pension of 50,000 a year in retirement. Suppose that the government wants to make sure that the purchasing power of this pension does not erode over time. If the CPI in the year of retirement was 220 and the CPI five years after retirement was 250, then the pension in that year should be scaled up to be 50,000 divided by the retirement year CPI and multiplied by the CPI in five years. That number would be 56,800. The CPI is used in this manner to index Social Security
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payments, public-sector pensions, and payments on treasury inflation-protected securities (or TIPS). So it is useful for you to know how to do this kind of calculation. Now let's use the CPI to calculate the rate of inflation. Suppose we have new CPI data that was just released for, say,
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July of 2022. Inflation over the past 12 months is given by the price level change over the last 12 months divided by the price level at the start of the 12 months. (Note that economists like to use the Greek letter pi to denote inflation. Since pi is the coolest of all Greek letters, perhaps this reflects how important a macroeconomic variable inflation is.) Sometimes we want to know how much inflation we had in just the most recent month.
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Then we simply take the price level change over the last month and divide it by the price level in the previous month. It is important to realize that this is a monthly change rather than an annual change, so the magnitudes are different. To avoid confusion (or maybe to unwittingly create confusion), sometimes news stories will express the monthly change as an annualized rate, which is a fancy way of saying, By how much would prices rise over a year if they increased for the
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next 11 months at the rate that they increased over the last month? This is roughly similar to multiplying the monthly number by 12 for low inflation rates, but not exactly, since we have to take into account the effect of compounding. The multiplying by 12 works less and less well as the monthly inflation rate increases. Even though the CPI is the most widely discussed measure of prices that you will see in the process, there are several other
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measures of prices that economists construct and use. There are a couple of these measures you should know about, since they will sometimes appear in the news. The first of these alternative measures is something called the personal consumption expenditures deflator (or PCE), sometimes also called the PCE index. This has become the Federal Reserve's preferred method of measuring the price level. The PCE deflator is defined as the consumption portion of
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nominal GDP divided by the consumption portion of real GDP. Remember from the previous lecture that nominal GDP values goods and services produced in the current period at current prices, while real GDP values those same goods and services at base-year prices. The idea behind the PCE is similar to the CPI: We compare the cost of a basket that includes all the goods and services consumed in the domestic economy in the current period to the cost of that basket in the base year.
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But the PCE deflator has one important (and quite subtle) advantage over the CPI. In calculating the CPI, the BLS uses a basket of goods and services that captures what the typical consumer would purchase in the reference year. This is a very time-consuming task, involving tens of thousands of interviews and consumption diaries, as we learned about earlier. Once the basket is constructed, however, its contents are fixed, and the BLS only needs to see how the cost of that basket is
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changing over time, relative to its base year cost. In contrast, when the BEA constructs the PCE deflator, they construct the basket for the current period (that is, what did consumers purchase this period), and then compare what that new basket would cost today to its cost in the base year. This continual updating of the PCE basket means that the PCE is a better reflection of what consumers are buying now, whereas the CPI basket was a better reflection of what
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consumers bought in the reference year. This helps the PCE overcome a common criticism that the CPI overestimates the true level of inflation in the economy because it ignores the fact that consumers can change what they consume when prices rise. A simple example can shed light on this criticism: Suppose consumers in the reference year bought 50 pounds of chicken and 25 pounds of pork. So the CPI basket will contain twice as much chicken as it does pork.
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Suppose that the price of chicken rises in some subsequent year, but the price of pork doesn't change. Consumers will switch some of their chicken consumption to pork consumption let's say 40 pounds of chicken and 40 pounds of pork. The CPI basket (which reflects the reference year spending patterns) will not capture that change; it will still think that consumers buy twice as much chicken as they do pork. The PCE, on the other hand, will accurately capture that chicken
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and pork consumption were equal and should be weighted the same in the current basket. Hence, the CPI will indicate a higher price level than the economy is actually experiencing because it does not capture how higher prices for a good can reduce consumption of that good. This is why the PCE is considered to be the Fed's favorite price index. So why, then, do we not use the PCE for all purposes? Because it takes more time to get accurate data on what people bought in the current period.
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For instance, GDP data for the first quarter, covering January through March, is not released until the end of April, then revised again in May and June. These quarterly numbers are also subject to an annual revision in the middle of the next year. So, at best, if we used the PCE, we would not know how much prices rose in January until three to six months later. By contrast, the CPI is available every month, and that's why the CPI remains the overall favored measure of prices.
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Let's look at some data on yearly inflation rates between 1971 and 2021, using the CPI and the PCE deflator. As you can see, the data series track each other reasonably closely, so we do not lose much by focusing on a particular indicator as a general description of what is happening in the economy. You can also see that the relationship is by no means exact, so you can see why a more serious (as opposed to a casual or curious) observer of the economy would want to dig deeper
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and look at both series. A third measure that you may run across is called the producer price index (or PPI). The PPI (as the name suggests) is similar to the CPI, except that instead of using a basket of goods and services that a typical consumer would purchase, the PPI uses a basket of goods and services that a typical producer would purchase in constructing the index. This means that warehouse costs, shipping costs, and the cost of raw materials like textiles, lumber, iron, steel, industrial
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chemicals, packaging supplies are likely to feature much more prominently in determining the value of the PPI. The PPI is useful because it provides an overview into the pressures that producers face. It can often serve as a harbinger for changes to come in the CPI. When trade barriers or supply shocks affect the cost of raw materials, the PPI will rise much earlier than the CPI and provide a signal to economists about potential price increases
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that arise if firms have to pass on higher costs to consumers. Last but not least, you will also see references to something called the core CPI, which is basically a CPI that omits the cost of food and energy. In other words, the core CPI basket leaves out the food and energy-related items from the CPI basket. The core CPI is used because the prices of food and energy tend to be much more volatile than other components of the CPI. The volatility means that if prices of food or fuel rise
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sharply in, say, March, we may even see a decline in those prices in April. By taking out these unpredictable fluctuations, the core CPI may have a higher signal-to-noise ratio than the CPI does in a given month. For the first two decades of the 2000s, notice how much smoother the core CPI is than the overall CPI. On the other hand, food and energy costs represent about a third of the CPI, so ignoring them and focusing on the core CPI will not give us a full picture of the experience of
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consumers in that month. The big picture in all this is that economists use a price index to measure the price level in the economy. The price index is constructed by taking a basket of goods and services, and comparing how the cost of that basket in the current period compares to the cost of the basket in the base year. The choice of basket leads to different price indices that vary in terms of coverage and frequency of updates, but the
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basic idea is always the same millions of prices of goods and services in the economy are synthesized into a single number. Now that we've learned how to calculate inflation, let's take a look at why policy makers pay such close attention to the inflation rate. Why, for example, was Jimmy Carter so alarmed by the high inflation rates in 1978? And why was The Wall Street Journal concerned about the negative inflation rates in 2008/09? There are three broad reasons why inflation is a cause for
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macroeconomic concern. The first and most obvious one is that inflation erodes the purchasing power of money. Consider a retiree who receives a fixed pension of 25,000, and compare what happens to the purchasing power of that pension under different inflation rates ranging from 2 percent to 10 percent over a 15-year period. As you can see, even a 2-percentage-point change in inflation can have a dramatic impact. At 2 percent inflation, which has been the Fed's inflation
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target for many years, the real value of 25,000 in 15 years' time is around 19,000. But at 4 percent inflation, it falls to 14,000, and at the 6 percent rate of inflation that President Carter mentioned, 25,000 falls to just 10,500 in 15 years. In addition to pensioners who live on fixed retirement incomes, very often it's disadvantaged groups who bear the brunt of inflation. The poor do not have access to financial assets that protect
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them from inflation, and minimum wage workers receive wages that are fixed until politicians change them. Second, inflation creates winners and losers in the economy. Note that even in the previous example, when inflation hurt the retirees receiving a fixed income, it would help the groups paying the fixed incomes. Taxpayers, corporations, and pension funds all benefit from the lower real value of the payments they make. Similarly, unexpected inflation helps borrowers on a
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fixed-interest-rate loan while hurting lenders: If you took out a fixed-rate loan to buy a house at an interest rate of 5 percent when inflation was around 2 percent, all else equal, you would benefit if the inflation rate went to 4 percent. Intuitively, this is because the money you pay back has less purchasing power than the money you borrowed. Also, keep in mind that a 3 percent inflation rate in the economy does not mean that each individual price rose by 3 percent.
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The price of some goods would increase by more than others. So, for example, in the late 2000s, the price of housing fell while the price of gasoline and food rose sharply. This would benefit some groups (home buyers, farmers, and oil companies) at the expense of others (consumers, homeowners, and people with long commutes). The third broad reason why inflation is harmful is that it creates uncertainty and shortens planning horizons. Inflation creates a lot of uncertainty because people have
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to be on guard against the possibility of being on the losing side. For example, an airline company and the pilot's union have to worry about the impact of inflation on their wage contract because the real cost of the wages and pensions they agree upon in their contract will be impacted by inflation that is higher or lower than what they expected. In countries with unpredictable inflation, people are very reluctant to enter into long-term relationships.
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This makes it hard to borrow money over a long period of time to buy a house or to build a factory. People prefer to buy and hold gold or land instead of putting money into a bank or lending it out to entrepreneurs. The lack of long-term investments, as we will see in a later lecture, reduces the growth rate of an economy. Uncertainty also means that, in theory, an economy where inflation was always 15 percent a year may lend itself better to
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long-term planning than an economy where inflation was sometimes 1 percent and at other times 6 percent. Empirically, however, higher inflation and more variable inflation are strongly correlated, so it's okay to say that we are, in general, concerned about high inflation. Finally, recall that I started this lecture by stating that inflation, like your blood pressure, can be too high or too low. Economists consider a negative rate of inflation, known as deflation, to be too low.
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The problems caused by too much inflation can help us think about problems posed by deflation. Deflation will help people on fixed incomes but hurt those who have to pay fixed incomes. Deflation will help creditors who make fixed-rate loans but hurt the debtors who take out those loans. Deflation creates uncertainty and leads people to hold back spending until prices fall even further. The beauty of macroeconomics is that even something that seems
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so technical as How do I construct a price index for the whole economy? is a stepping stone to access and unlock doors of greater understanding. In this lecture, we learned about how a price index is constructed and about the different price indices that economists use to calculate the rate of inflation. We also looked at why economists worry about the inflation rate being too high or too low in an economy. Just as with GDP, understanding exactly how inflation is
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measured gives us insight into the limitations of the existing measures. When you listened to me describe how the BLS painstakingly surveys consumer purchases using diaries and follows up with store visits to gather prices, you must have thought there must be a better way to do this with online price information. In fact, in 2008, two researchers at Harvard and MIT started an initiative called the Billion Prices Project to do just that. In 2010, Google announced its intention to create a Google
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Price Index that would provide a real-time index of inflation. However, neither of these projects have been able to come up with a measure that replaced the price indexes that we discussed in this lecture. In later lectures, we will dig deeper into the causes of inflation, ranging from the supply of money to supply shocks to excessive government spending. But for the next lecture, we will stay with the theme of learning more about key macroeconomic variables and
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focus on understanding what the unemployment rate is.
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