You might notice inflation on a routine shopping trip or
especially when you see a reference to prices in an old
book or movie.
For example, in the 1960 movie Psycho, a hotel room for
one night was priced at just $10.
Recall that inflation is defined as the growth in the
overall level of prices in an economy—so inflation occurs
when prices rise throughout the economy.
When overall prices rise, our budget is affected; we can
buy less with our income.
When overall prices fall, our income goes farther and we
can buy more goods and services.
Imagine an annual inflation rate of 100%.
At this rate, prices would double every year.
How would this inflation affect your life?
Would it change what you buy?
Would it change your savings plans?
Would it change the salary you negotiate with your employer?
Yes, it would change your life on a daily basis.
Now imagine that prices double every day.This is the situation currently
TheVenezuela situation is an example of hyperinflation, an extremely
high rate of inflation that completely stymies economic activity.
Inflation and deflation
Figure 11.8 shows inflation in the United States from 1960 to 2013.
The long- run average over this period was 4%, meaning that prices as a whole
rose 4% per year on average.
In some years, the rate was much higher than 4%.
At one point in 1980, the inflation rate was almost 15%.
But since the early 1980s, inflation seems well controlled in the United States.
Looking again at Figure 11.8, you might notice a brief spell of deflation in 2009.
Deflation occurs when overall prices fall; it is negative inflation. Notice, too, that
periods of recessions— the blue- shaded vertical bars in Figure 11.8—often (but
not always) coincide with falling inflation rates. See, for example, 1982, 1991, and
Stagflation occurs when inflation rises during times of recession.
(The term is a combination of the words “stagnation” and
Stagflation occurred during the recession of the mid-1970s.This
unexpected outcome caused economists to re- evaluate the deficit
spending suggestions of Keynesian economists .
The result was the supply- side revolution of the 1980s, when
policy focused on promoting business activity.
Whenever unusual macroeconomic events take place, new
thinking about the macroeconomy often comes to the forefront.
Measuring inflation accurately requires great care.
1. First, prices don’t all move together; some prices fall even when most others rise.
2. Second, some prices affect consumers more than others. For example, a 10%
increase in the cost of housing is significantly more painful than a 10% increase in
the cost of hot dogs.
Before we arrive at a useful measure of inflation, we have to agree on what prices to
monitor and how much weight we’ll give to each price.
In the United States, the Bureau of Labor Statistics (BLS) measures and reports
In this section, we describe how the BLS estimates the overall price level.
The price level (P) is a measure of the average prices of goods and services
throughout an economy.
The Consumer Price Index (CPI)
Let’s look at the most common price level used to compute inflation.
The consumer price index (CPI) is a measure of the price level based on
the consumption patterns of a typical consumer.
When you read or hear about inflation in the media, the report almost
certainly focuses on this measure.
The CPI is essentially the price of a typical “basket” of goods purchased
by a representative consumer in the United States.
Think about this situation as if you were going to the planet’s hugest
SuperWalmart.You get an enormous shopping cart and start buying
things to include in the basket. But what exactly goes in the basket?
In addition to groceries, you would buy clothing,
transportation, housing, medical care, education, and many
other goods and services.
The goal of the CPI is to include everything a typical consumer
buys, thereby giving a realistic measure of a typical
consumer’s cost of living.
Figure 11.9 displays how the CPI was allocated among major
spending categories in December 2014.
Prices for very specific goods are included in each of these
For example, “Food and beverages” includes prices for
everything from potato chips to oranges (bothValencia and
navel) to flour (both white and all- purpose).
These are the goods in the “basket” purchased by typical
Of course, none of us is exactly typical in our spending.
College students allocate significantly more than 3.3% of their
spending on education,
senior citizens spend a lot more than average on medical care,
a fashionista spends more than average on clothing, and
those with lengthy commutes spend more than average on
The CPI reflects the overall rise in prices for consumers on
Computing the CPI
Each month, the BLS conducts surveys by sending employees
into stores in 38 different geographic locations to gather and
input price information on over 8,000 goods.
The BLS estimates prices on everything from apples in
Chicago, Illinois, to electricity in Scranton, Pennsylvania, to
gasoline in San Diego, California.
In addition to inputting price information, the BLS surveyors
estimate how each good and service affects a typical
Once they do this, they attach a weight to the price of each good
in the consumer’s “basket” so that the things people spend more
money on are counted more heavily.
For example, Figure 11.9 indicates that the typical consumer
spends 15.3% of his or her budget on transportation. Therefore,
transportation prices receive 15.3% of the total weight in the
typical consumer’s basket of goods.
Once the BLS has compiled the prices and budget- allocation
weights, it can construct the CPI.
Economics in the Real World
Follow the ‘Price Chaser’
Tracking the prices in the CPI requires a great deal of
effort and precision.
In September 2007, Nancy Luna of the Orange
County Register followed one of the 350 employees
of the Bureau of Labor Statistics who is charged
with finding current prices of the goods included in
The BLS employee, Frank Dubich, traveled 800
miles per month tracking prices.
CPI in real world Cont.
The items to be priced were very specific.
For example, Dubich was asked to visit a grocery store to find
the price of “an 18.5-ounce can of Progresso Rich & Hearty
creamy chicken soup with wild rice,” which turned out to be
Dubich also had to note that this was a sale price.
In another instance, Dubich was embarrassed to be seen pricing
because the item was a prom dress.
He noticed several clerks staring at him as he hunted for the price
tag, so he quickly recorded the price and left.
In macroeconomics, we generally see one single number that
indicates how much prices have changed.
But it’s important to remember that there are thousands of prices
tracked each month by government workers like Frank Dubich.
Measuring Inflation Rates
Once the CPI is computed, economists use it to measure
the inflation rate.
The inflation rate (i) is calculated as the percentage change
in the price level (P).
Using the CPI as the price level, the inflation rate from
period 1 to period 2 is:
Measuring inflation Cont.
Note that this is a growth rate, computed just like the
growth rate of GDP we computed earlier.
Assume the CPI rises from 100 to 125 in one year.
The inflation for that year would be 25%, computed as:
The US Bureau of Labor Statisitcs releases CPI estimates every
however, inflation rates are officially measured over the course
of a year, showing how much the price level grows in a 12-
Over time, we see significant changes in the overall price level.
The CPI was just 30 in 1961 and rose to 233 by 2013.
This means that the typical basket of consumer goods rose in
price nearly eightfold between 1961 and 2013.
Sum: CPI measured every month, inflation every year
Real World Case: Prices don’t all move
While it’s clear that prices generally rise, not all prices go up.
An increase in the CPI indicates that the price of the overall
consumer basket rises.
However, some individual prices stay the same or even fall.
For example, consumer electronic prices almost always fall.
When flat- panel plasmaTVs were introduced in the late
1990s, a 40-inch model cost more than $7,000. Fifteen years
later, 50-inch flat- panelTVs are available for less than $500.
This drop in price is the result of technological
advancements: as time passes, it often takes fewer resources
to produce the same item or something better.
Computers are another example. In 1984, Apple introduced the
Macintosh computer at a price of $2,495.The CPU for the
Macintosh ran at 7.83 MHz, and the 9-inch monitor was black and
Today, you can buy an Apple iMac for less than $1,800.This new
Apple computer has a quad- core processor that runs at a total of
The new computer is better by any measure, yet it costs less than
the early model.These kinds of changes in quality make it difficult
to measure the CPI over time.
The Accuracy of the CPI
Computing the CPI isn’t simple.
Yet for economists to understand what’s happening in the
macroeconomy, it’s important that the CPI be accurate.
For example, sometimes a rapid fall in inflation signals a
recession, as it did in 1982 and 2008.
Like real GDP and the unemployment rate, inflation is an
indicator of national economic conditions.
The Accuracy of the CPI cont.
How accurate is the CPI?
If consumers always bought the same goods from the same suppliers, it
would be extremely accurate,
and economists would be able to compare the changes in price from one
year to the next very easily.
But this isn’t a realistic scenario. Consumers buy different goods from
different stores at different locations, and the quality of goods changes over
Because the typical basket of consumer goods keeps changing, it’s difficult
to measure its price.
The most common concern is that the CPI overstates true inflation.
There are three reasons for this concern:
(1) the substitution of different goods and services,
(2) changes in quality, and
(3) the availability of new goods, services, and locations.
When the price of a good rises, consumers instinctively look
to substitute less expensive alternatives.
This substitution makes CPI calculations difficult because the
typical consumer basket changes.
If you go to the store looking for potato chips but find that
pretzels are on sale, you’re substituting away from a more
expensive good if you buy the pretzels instead of the potato
This substitution alters the weights of all the goods in the
typical consumption basket.
If the CPI didn’t acknowledge the substitution of less-
expensive items, it would exaggerate the effects of the
price increase, leading to upward bias (that is, an
estimate of inflation that is too high).
Since 1999, the BLS has attempted to deal with this
problem by using a formula that accounts for both the
price increase and the shift in goods consumption;
however, keeping track of changing consumer behavior
is very difficult.
2. Changes in Quality
Over time, the quality of goods generally increases.
For example, the movies that you watch at home are
probably on Blu-ray Discs.You can still get DVDs, but Blu-ray
Discs are a higher quality and thus more expensive: the price
of movies has risen from about $15 to about $25.
This price increase might seem like inflation, since movie
prices on disc have gone up.
Yet consumers are getting “more” movie for their buck,
because the quality has improved.
If the CPI did not account for quality changes, it would have
an upward bias, but the BLS also uses an adjustment method
to try to account for quality changes.
3. New Products and Locations
In a dynamic, growing economy, new goods are
introduced and new buying options become available.
For example, tablet computers, iTunes downloads, and
even cell phones weren’t in the typical consumer’s basket
20 years ago.
In addition, Amazon.com ,Taobao, JD weren’t options for
consumers to make purchases before the 1990s.
New Products and Locations cont.
Traditionally, the BLS updated the CPI goods basket only
after long time delays.
This strategy biased the CPI in an upward direction for two
First, the prices of new products typically drop in the first
few years after their introduction. If the CPI basket doesn’t
include the latest prices, this price drop is lost.
Second, new retail outlets such as Internet stores typically
offer lower prices than traditional retail stores do.
If the BLS continued to check prices only at traditional retail
stores, it would overstate the price that consumers actually
pay for goods and services.
What Problems Does Inflation Bring?
We intuitively understand that something is wrong when
a country doesn’t grow or when unemployment rates
But inflation is a problem too,
and most people understand that if prices rise and their
incomes don’t, they are worse off as a result.
But inflation also brings other problems that directly
impact you. Let’s look at the most important ones.
Uncertainty about Future Price Levels
Imagine you decide to open a new coffee shop in your college town.
You want to produce espressos, tea, and cappuccinos.
Of course, you hope to sell these for a profit.
You have to buy (that is, invest in) capital goods like an espresso bar,
tables, chairs, and a cash register.
You also have to hire workers and promise to pay them.
Before any revenue arrives from the sales of output, firms have to
spend on resources.
The same is true of the overall macroeconomy:
to increase GDP in the future, firms must invest today.
The funds required to make these investments are typically borrowed
Uncertainty about Future Price Levels
The timeline of production shown in Figure 11.10 illustrates
how this process works.
At the end, the firm sells its output.
The important point is that in a normal production process,
funds must be spent today and then be repaid in the future—
after the output sells.
But for this sequence of events to occur, businesses must
make promises to deliver payments in the future, including
payments to workers and lenders.
Thus, two types of long- term agreements form the
foundation for production: wage and loan contracts.
Both of these involve agreements for dollars to be delivered in
Uncertainty about Future Price Levels
But inflation affects the real value of these future dollars.
When inflation confuses workers and lenders, these essential
long- term agreements seem risky and people are less likely to
enter into them.
Inflation can cripple loan markets because people don’t know
what future price levels will be.
When firms cannot borrow money or hire long- term workers,
future production is limited. PPF is limited!!
Thus, inflation risk can lead to lower economic output (that is,
lower GDP). curb efficiency !
Inflation can also redistribute wealth between borrowers
If you borrow $20,000 to finance your college education,
you’re doing so with the promise to pay back more than
what you borrowed because you’ll be paying interest on
Let’s say you agree to a 5% interest rate.This means you
will pay back $21,000.
The catch is that you have time to repay the loan.
Assume you have 10 years to pay it back.
If inflation unexpectedly rises during those years, the inflation
will devalue your future payment to the lender.
As a result, you’ll be better off because the money you’re
repaying has less purchasing power than what you borrowed,
but the lender will be worse off.
Thus, inflation redistributes wealth from lenders to borrowers.
If both you and the lender fully expect the inflation to occur,
the lender will require more in return for the loan.
In the United States, inflation has been low and steady since
the mid- 1980s.Therefore, surprises are rare.
But nations with higher inflation rates also have a higher
variability of inflation, which makes it difficult to predict the
This is one more reason why high inflation increases the risk of
making the loans that are an important source of funding for
Impact on Savings
You may have heard the phrase “saving is a virtue.”
When you were younger, perhaps you saved money to
buy a new bike or video game.
Later in life, it’s important that you save in order to put
a down payment on a house and provide for your
However, inflation can erode your savings.
Impact on Savings cont.
One way to think about the effect of inflation on future
dollars is to ask what amount of future dollars it will take to
match the real value of $1.00 today.
Figure 11.11 answers this question based on a retirement date
of 40 years in the future.
The different inflation rates are specified at the bottom of
If the inflation rate averages 4% over the next four decades,
you’ll need $4.80 in savings just to buy the same goods and
services you can buy today for $1.00.
Impact on Savings cont.
What does this mean for your overall retirement plans?
Let’s say that you decide you could live on $50,000 per year if
you retired today.
If the inflation rate is 4% between now and your actual future
retirement date, though, you would need enough savings to
supply yourself with $50,000 * $4.80,
$240,000 per year, just to keep pace with inflation.
How Much Does the bank have to PayYou to Make saving
Suppose you’re hoping to save money to buy your first house.
You look around to find the best place to put your money and
find that banks are paying interest rates of 1%.
This means that they’ll pay you 1% of whatever amount you
have in your account at the end of each year just for keeping
your money in the bank.
Now 1% isn’t a lot, and when you compare it to inflation, it
may mean that saving is actually a bad idea. For example, if
the inflation rate is 3% per year, then you need a 3% interest
rate just to keep pace with inflation.
If the inflation rate is greater than the 1% interest rate,
then keeping your money in the bank would actually cause a
decline in your purchasing power since prices rise faster than
the interest you earn.
Case Study New York Times
Economic reports in the media are often misleading.
Now that you have perspective on economic statistics, you
can determine for yourself whether economic news is
positive or negative.
For example, a NewYorkTimes article from July 2014
offers the following description of economic growth in
the United States for the second quarter:
(Source: Dionne Searcey, “EconomyGrew 4% for Quarter,” NewYorkTimes, July 30,
“The United States economy rebounded strongly in the
second quarter of the year, shaking off the negative
effects of an unusually harsh winter and stirring hopes
that it might finally be establishing a solid enough
footing to put the lingering effects of the recession
squarely in the past.
The Commerce Department . . . reported on
Wednesday that the economy grew at a seasonally
adjusted annual rate of 4 percent, surpassing
Evaluation of the Article
Good economists are very careful with language,
because certain terms have very specific meanings.
For example, we know that “economic growth” always
refers to changes in per capita real GDP, not simply GDP
or real GDP.
But economic reports in mainstream media outlets
often blur this distinction.That is exactly the case with
the report in the NewYorkTimes article excerpted
Even though the author of the article uses the term
“seasonally adjusted annual rate,” additional research
reveals that she’s talking about real GDP growth, but
not adjusting the data for population changes.
This is a fairly common mistake, so you should watch
out for it when you read economic growth reports.
It turns out that the population growth rate in the
United States was about 0.7% in 2013.
Assuming the same rate for 2014, this means that the
growth rate of per capita real GDP in the second quarter
was closer to 3.3%.
This chapter began with the misconception that measuring
the macroeconomy is a straightforward process.
While we have ways of calculating the three primary data
points of macroeconomics— unemployment, output, and
inflation—each of them has its own challenges.
Nevertheless, economists stick to the processes that they
have been using for some time, making changes when new
measurement techniques allow them to do so.
Economists typically compute GDP by adding four types of
expenditures in the economy:
Government spending (G), and
net exports (NX).
For many applications, it is necessary to compute real GDP,
which is nominal GDP adjusted for changes in prices.
The unemployment rate reflects the portion of the labor force
that is not working and is unsuccessfully searching for a job.
The natural rate of unemployment is the typical rate of
unemployment that occurs when the economy is growing
Most economists feel that the natural rate of unemployment
in the United States is between 4% and 6%.
The labor- force participation rate reflects the portion of the
population that is working or searching for work.
Unemployment rates differ among groups based on age, race,
The inflation rate is calculated as the percentage change in
the price level.
Economists most commonly use the CPI to determine the
general level of prices in the economy.
Determining which prices to include in the CPI can be
challenging for several reasons: consumers change what they
buy over time, the quality of goods changes, and new
products and sales locations are introduced.
Inflation causes uncertainty about future price levels and can
lead to a redistribution of wealth.
Inflation can also impact how much people save.
Inflation erodes purchasing power over time, so you need to
save more to meet savings targets.
consumer price index (CPI)
durable consumption goods
government spending (G)
price level (P)
labor-force participation rate
natural rate of unemployment (u*)
net exports (NX)
non-durable consumption goods
unemployment rate (u)
Review Questions (p.341)
1.What is the most important component (C, I, G, or NX) of
GDP? Give an example of each component.
2. Is a larger GDP always better than a smaller GDP? Explain
your answer with an example.
3. If Max receives an unemployment check, would we include
that transfer payment from the government in this year’s
GDP?Why or why not?
Review Questions cont.
4. Phil owns an old set of golf clubs that he purchased for
$1,000 seven years ago. He decides to post them on Craigslist
and quickly sells the clubs for $250. How does this sale affect
5.What groups does the Bureau of Labor Statistics count in
the labor force? Explain why the official unemployment rate
tends to underestimate the level of labor market problems.
Review Questions cont.
6. Does the duration of unemployment matter? Explain your
7.What are three issues regarding the accuracy of the CPI? Give an
example of each issue.
8. If the prices of houses go up by 5% and the prices of concert
tickets rise by 10%, which will have the larger impact on the CPI?
9.What are some problems caused by inflation, other than a
decrease in purchasing power? Briefly explain each one.
1. In the following situations, explain what is counted in this year’s GDP and what
a. You bought a new PS4 at GameStop last year and resold it on eBay this year.
b. You purchase a new copy of an Investing for Dummies book at Barnes & Noble.
c.You purchase a historic home using the services of a real estate agent.
d.You detail your car so that it is spotless inside and out.
e.You purchase a new hard drive for your old laptop.
f. Apple buys 1,000 motherboards for use in making new computers.
2.To which component of GDP expenditure (C, I, G, or NX)
does each of the following belong?
a. Swiss chocolates imported from Europe
b. the salary of a new employee at the Department of Justice
c. a candle you buy at a local store
d. a new house
e. the sale of a U.S.-made Ford F-150 truck to a man in Mexico
f. a new watch that you bought from Amazon .com
A country with a civilian population of 90,000 (all over age 16)
has 70,000 employed and 10,000 unemployed persons. Of the
unemployed, 5,000 are frictionally unemployed and another
3,000 are structurally unemployed.
On the basis of this data, answer the following questions:
a.What is the size of the labor force?
b.What is the unemployment rate?
c.What is the natural rate of unemployment for this country?
d. Is this economy doing well or poorly? Explain.
Consider a country with 300 million residents, a labor force of
150 million, and 10 million unemployed.
Answer the following questions:
a.What is the labor- force participation rate?
b.What is the unemployment rate?
c. If 5 million of the unemployed become discouraged and
stop looking for work, what is the new unemployment rate?
Suppose that you also take out a $1,000 loan at the Colonial
Credit Union.The loan agreement stipulates that you must pay it
back with 4% interest in one year, and again, the inflation rate is
expected to be 2%.
a. If the inflation rate turns out to be 3% rather than 2%, who
will be hurt?Why?
b. If the inflation rate turns out to be 3% rather than 2%, who
will be helped?Why?