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Course: AP®︎/College Macroeconomics > Unit 2
Lesson 4: Price Indices and inflationIntroduction to inflation
Inflation is an increase in the price level over time. In this video we explore inflation and how it is calculated using a measure called the consumer price index (CPI). Created by Sal Khan.
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In this video Sal mentioned price shocks. Now some politicians(and I'm not going to name names or take a political stance)have suggested that the U.S. should place sanctions on China for its currency manipulation.If these sanctions were applied, would the U.S. suffer any price shocks due to the vast number of commodities and goods that we import from China?(38 votes)
Just to illustrate Andrew's point, the Chinese are buying up USDs with Yuan, which their central bank prints in massive quantities. The result is that this vast quantity of printed Yuan is released into the market, increasing the money supply, and driving high inflation (5-15% in China depending on how you estimate it). Inflation decreases the real value of money, which is the VALUE of the money in people's pockets - so in a sense the Chinese government is stealing money from the Chinese and converting that to dollars to keep their currency relatively low. In recent years, however, the Yuan has appreciated considerably against the dollar so some analysts think the two currencies are close to a "fair" market value.(33 votes)
- starting at2:14, why is a little inflation considered good? doesn't this decrease the value of the currency? why is that good albeit a little at a time?(25 votes)
The "good" value of inflation depends upon your philosophy. A little is better than a lot for sure. However, inflation steals from those who save -- as you are stealing from the purchasing power. If I save a $100 and over the next year we have 10% inflation I can only purchase $90 worth of goods. Inflation discourages saving and pushes people into making more risky investments like the stock market. It also encourages spending, which would be fine for a Keynsian (https://en.wikipedia.org/wiki/Keynesian_economics). Can inflation be good? to me is like asking is it okay to steal a little?(20 votes)
I don't understand what the 100 means and why in the video apples and bananas were both equal to 100.(5 votes)
Those are known as index numbers. They make data easier to compare.
To make it slightly more obvious, here are some made up numbers to illustrate what they do:
A pound of apples costs $1 in year 1 and a pound of bananas $2. In year 2 they both got more expensive. This results in the following table:Year 1 Year 2
Apples $1 $1.50
Bananas $2 $3.60
Just by looking at this data, did apples or bananas inflate more in price measured in a percentage?
It's required to do some math to answer that question, so economists invented index numbers. For apples they convert $1 to 100 index points and for bananas they convert $2 to 100 index points. Now the table looks like this:Year 1 Year 2
Apples 100 150
Bananas 100 180
Now it's very easily to see bananas inflated by 80%, which is more than the 50% apples inflated in price.(33 votes)
Can inflation result in the devaluation of a currency ? That is as prices rise the price to buy a foreign currency also rises ?(8 votes)
Yes, all things equal, you would expect a country with a higher inflation rate to see its currency depreciate relative to that of a second country with lower inflation.
This is a result of Purchasing Power Parity--the theory that differences in inflation rates should be reflected in the changes in the exchange rate between two countries. However, I mention that this is a theory because you can't expect the relationship to hold exactly, especially over the short-run (however, over the long-run, it does tend to hold up fairly well).(11 votes)
How do u consider any year as the base year?? I mean what is the criteria?
Its not from the examination point of view..... How is it done for practical purposes...?(6 votes)
In the United States, the base year is set every five years -- 2000, 2005, 2010, etc. The reason the base year is generally a year that's close to the current year -- and moves as time goes on -- is because the market changes so quickly -- it would be impractical to use the year 1960 as a base year considering how there are products that exist now (which might be a significant portion of household expenditures) that didn't even exist back then, eg. consumer electronics like iPods and laptops.
Because of this, you could consider the criteria of a base year to be a balance between closeness to the current year, to account for changing technology, and being further away from the current year, in order to more accurately compare differences in prices. The further away the base year is, the more years you have to be able to compare inflation, so you can better picture it as it moves up or down relative to other years.
In the United States, the base year could be only every five years because technology is assumed to change so quickly, but in a country with slower technology growth, eg. Moldova, the base year might change every 10 years instead, since they don't need to factor changing technology into their analysis of inflation as much.(11 votes)
Can someone please explain why having some positive inflation, real wages decrease even if nominal wages are held constant?
Thanks in advance :)(6 votes)
Nominal wages are the number of dollars given to employees. However, due to inflation, those dollars are now worth less. The formula for this isr = n / (1 + i). So, if i, which is inflation, increases and n, which is nominal wages, remains constant, then that clearly means that r, real wages, must decrease.(7 votes)
- What about asset price inflation? Particularly housing. It seems unusual that the cost of rent, mortgages and accommodation is not mentioned in the video. Are these items excluded from the CPI? If so,mare they captured by the HCIP that the ECB In Europe uses?(4 votes)
- But I am almost sure that the ECB targets the HCIP which excludes asset prices inflation and hence the cost of housing. This is particularly important because it missed the housing boom in Ireland and southern Europe that has since burst leading to a financial cum sovereign debt crisis in the eurozone.(3 votes)
How similar is Inflation rate (CPI) compared between America and other countries that use the CPI (i.e. Australia)? Is there any difference? Are there other influences that may affect it from one country to another?
Thanks :D(3 votes)
CPI itself isn't the inflation rate of a nation, it's more of a measure that allows us to look at inflation.
But anyways! Inflation rate can vary a lot from country to country. And this is because the rate of inflation depends on lots of factors that all depend on the country itself. For example, if in one country there was a sudden increase in the amount that people were paid, all these people would have more money to buy goods and services. They'd probably go out and buy a lot more, right? So aggregate demand would have risen, and the price level would have rose- i.e. we would have seen inflation. The country's inflation rate could be said to have increased. Loads of other factors can affect inflation rates: changes in the costs of production in the country, whether or not consumer confidence is high, etc. Just think about how a factor would affect prices in the economy and that should tell you how it affects the inflation rate!(3 votes)
given the annual inflation of 3.5% how to find the relative rate of inflation?(3 votes)- Oes inflation breed unemployment(2 votes)
- that depends on how big the inflation is. generally, inflation around 2 or 3% is good, but if it is higher than that, it could become dangerous, as it would erode the value of money and make it harder for families and companies to break even. it could breed unemployment in the sense that as the value of money drops, prices for goods and services rise so much that not many consumers can by them any more. since nobody is buying thier products, companies will eventually shut down or cut its workers, resulting in unemployment. however, generally high inflation is related to low unemployment, while low inflation is related to high unemployment(see The Phillips Curve-Inflation and Unemployment)(3 votes)
2:14Video transcript
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, or especially when the
term inflation first came into usage, it actually was
referring to monetary inflation or an increase in
the money supply. So it was referring to 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 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 the sudden. And the most typical
example of a supply shock is especially in the
oil crises in the 1970s. 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-- or the
price of oil 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 was probably the cost of
the gasoline for 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's important to realize
that people are referring to price inflation. And the general consensus
is a little bit of it is a good thing. And I want to stress,
little is good. And we're talking 1, 2. Maybe 3% per year. But anything larger than
that gets a little scary because it can kind
of snowball on itself. And we'll talk about
that in future videos when we talk about
hyperinflation. And economists are also
afraid if inflation 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, inflation is measured with the
Consumer Price Index, CPI. And 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. 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 in the United States, they are urban consumers. So this is the CPI that
affects the largest number of people's pocketbooks. And the way that it's calculated
is, it's like the deflator. It's a price index. And 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
come into agreement or they should be
close to each other if they really are
indices from measuring the general level of prices. But 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 up base year. And let's take a super simple
example, a ridiculously simple example. Let's say in our little
country, the urban consumers-- 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 the two things--
and they spend 60% of their money
on apples, and they spent 40% of their
money on bananas. And in that base year, we just
set that base price of apples at 100, and bananas are 100. Now 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--
so let's say in our current year and we're going to assume
these the same rates, that we're still spending 60%
on apples and 40% on bananas. In our current year,
the apple index-- let's say that it has
grown 50% percent 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. And you could do it either way. So let's do it either way
to get you the same result. So in this year, our base index
is 0.6 times 100 plus 0.4 times 100, and this will
just come out to 100. This is 60 plus 40. This is equal to
100 as it should. That is our base year. 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 would say 0.6 times 150. And then we'll say
plus 0.4 times 180. And that gets us to-- let
me get my calculator out-- so this gets us 0.6 times
150 plus 0.4 times 180. So that gets us to 162. So our general-- if you
look at this basket and this is an overly simplified
basket-- we've increased from 100 to 162. Or you could say
this is plus 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%-- in fact we could 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%. to 30 plus 32
gives us 62% growth for this basket of goods,
which we are assuming is I guess for this
urban consumer, from our base year
to the current year. Now in the next
video, we'll actually look at what the basket
of goods actually looks like in the United States
for an actual urban consumer.