Compiling a basket of goods and services

The main measure of inflation in the U.S. (and also many other countries, including the U.K.) is calculated by the BLS and called the Consumer Price Index (CPI). The CPI measures the average price of goods and services bought by consumers (as opposed to those bought by firms or the government).

The rate of inflation affects so many things, such as state benefits, pensions, contracts, income tax brackets, and salaries, that calculating it accurately is vitally important. We want a good estimate of how much it costs today to buy some standard basket of goods relative to what it cost say at this time last year, or maybe ten years ago. So, the first task is to create a large “representative basket” of goods and services on which people spend their money. This basket contains all sorts of items: food (milk, eggs, bakery items), clothing (men’s suits, women’s outerwear, shoes), transportation (new cars, tires, motor oil), medical products (prescription drugs, over-the-counter drugs, medical equipment), and so on over approximately 200 different goods that consumers typically purchase.

When the total cost of the basket increases, this change is reflected as an increase in the CPI. So, if the cost of purchasing the basket’s contents goes up by 5 percent, say it rises from $1,000 to $1,050, the CPI also increases by 5 percent.

Of course, consumers’ tastes change over time, so the composition of the basket also changes. The BLS regularly updates its basket in two-year cycles to reflect the current spending patterns of the population. Equally important is the fact that some items make up a larger proportion of expenditure than others. So, for example, energy bills represent a large fraction of expenditure for most people, but postage stamps don’t. Accordingly, different goods are given different weights, so an increase in energy prices has a bigger impact on the CPI than an increase in the price of stamps.

Once statisticians have decided on the basket and the weights, someone needs to collect data about prices. This job is a huge undertaking: Every month around 80,000 prices covering the 200 or so goods and service categories in the basket are recorded. Much of this data is now compiled electronically, but a substantial amount is still collected by an army of price collectors who physically visit local shops to record the prices.

Adjusting for quality and size

One of the principles for calculating inflation is that comparisons over time must be “like-for-like.” As with measuring per capita GDP (see Chapter 4), there is a problem when the quality of goods changes over time. For example, a family car you purchase today is likely to be more fuel efficient, more stylish, and have more safety features than one bought ten years ago.

Cars aren’t the only good with increased quality. Refrigerators, laptops, cellphones, and many other goods have also improved. Simply comparing the prices over time tends to overstate inflation, because part of any price increase is due to the rise in quality (see also the later section “Understanding why inflation is usually overestimated”). Statisticians at the BLS attempt to adjust for quality improvements, but doing so is incredibly difficult.

On the other side of the coin, product package size can shrink while the price remains unchanged. Chocolate bars can grow a bit smaller; or a bag of firewood can become a bit less hefty. Companies may choose to reduce the size of their products instead of increasing the price for many reasons. But that doesn’t change the fact that the price per unit is rising. Here again, the statisticians at the BLS have to be careful to make the right adjustments for quality, size, and other features to measure price changes accurately.

Assessing different measures

As we’ve said, measuring inflation is basically a matter of choosing some basket of goods and seeing how the price to buy that basket is changing over time. Sounds simple enough. There are different ways of doing this, though. Depending on what we think is important, you and I might choose different goods or weight them differently. You might ask how much it costs to buy a collection of goods from 2010 in 2016. I might ask how much it costs to buy a collection of goods from 2016 relative to what it would have cost to buy that basket earlier in 2010. These different ways won’t always give the same answer. Luckily, they come pretty close — especially these days when inflation is low no matter how it is calculated.

The CPI and similar measures are indices. In each case, they are what economists call a “pure number.” This means they don’t have any dollar signs attached. For example, suppose we find that our standard basket of goods cost $1000 in 2005, but now costs $1100, that is, its cost has increased by $100. An index is a normalized concept that looks at the basket’s cost each year relative to some base year. Continuing with our example, let’s assume that the base year is 2005. Then the index for 2016 is computed by dividing the cost in that year by the cost in the base year. That is:

CPI₂₀₁₆ =

By the same formula:

CPI₂₀₁₅ =

Note three things. First, as mentioned, the price index is a pure number — 100 in 2015 and 110 in 2016. It measures the dollar cost of the basket of goods relative to some base year. In that calculation, the dollar signs cancel out. Second, the index is equal to 100 in the base year. Third, comparing any later year index value with its base year value tells you the amount of inflation there has been since the base year.

In our example, the basket cost or price has increased by a total of $100 since 2005. That’s a 10 percent rise over the base year cost of $1000. In turn, that 10 percent increase is captured by the fact that the index in 2016 is 10 points higher relative to the base year value — 110 versus 100. An extension of this is that the percentage change in the index between any two points in time, say, from one year to the next, tells you the rate of inflation over that interval.

The following sections cover the three most commonly used price indices.

GDP deflator

Another widely used measure of inflation is the GDP deflator (check out Chapter 4 for more on GDP). The GDP deflator is calculated in a quite different way from the CPI and PPI, because it uses the already available data on nominal GDP and real GDP to infer the rate of inflation.

As described in Chapter 4, nominal GDP is the total value of goods produced in a year using current prices, and real GDP is the total value of goods produced in a year using constant prices. That is, real GDP is calculated by correcting the current prices for the inflation that has occurred since a base year. But as explained earlier, that amount of inflation is indicated by whatever index we’re using divided by its base year level of 100. So, if we call our index in any year Def, it’s Def × 100. Real GDP is then just nominal GDP divided or, as economists say, deflated by the price index. That is:

Real GDP =

The Bureau of Economic Analysis reverses this logic to find the value of the GDP deflator. They first measure nominal GDP. Then they construct real output levels for the different sectors of the economy using individual industry price indices that look a lot like the CPI or PPI and add the real outputs of each different sector together to get total real GDP. Now that they have an estimate of both nominal and real GDP, they use these to solve for the implied deflator value. That is, they solve the following:

The result is the GDP deflator, Def.

The BEA could construct nominal GDP and then, much like BLS, construct a price index like the CPI and use this to translate that nominal GDP into its real counterpart. Instead, they measure nominal GDP and real GDP first and then use the ratio of these two to back out the price index value. That is, given nominal income, the GDP deflator value that the BEA calculates is implicit in how it calculates real GDP. For this reason, it’s often referred to as the implicit GDP deflator.

The GDP deflator is a broader inflation measure than the CPI because it captures price pressures for both consumer and producer goods. Most macroeconomists prefer the GDP deflator to the CPI because of this breadth. In practice, though, the two move very closely together and each gives pretty much the same picture of inflation.

Understanding why inflation is usually overestimated

Many economists think that the measures of inflation just described tend to overestimate the true increase in the cost of living. That is, if the inflation rate is quoted as being 3 percent, economists think that the true cost of living has actually increased by less than 3 percent.

Here are some of the reasons why:

• The substitution effect: Inflation at 3 percent means that on average prices have increased by 3 percent. But some prices will have increased by more and some prices will have increased by less (or even decreased). In response to these changes, people alter their behavior by buying relatively more of the goods that haven’t increased in price by much and relatively less of the goods that have increased in price by a lot: hence the name the substitution effect. This means that inflation overestimates the true increase in the cost of living as people switch to relatively cheaper goods.
• Unobservable quality improvements: As we mention in the earlier section “Adjusting for quality and size” section, inflation needs to be calculated like-for-like. Although statisticians try to adjust for quality improvements, doing so fully is impossible. Thus, some unobserved quality improvements remain unaccounted for. This means that inflation overestimates the true increase in the cost of living. An example helps make this clear: Suppose you had $100,000 to spend from either the 2015 Amazon website or the really cheap 1963 Sears Catalog your Grannie told you about. Which would you choose? Prices were much lower in 1963, so you could buy lots more stuff, but it would be lots of low-quality stuff you would not want. So, even though the 2015 selection is much more expensive, part of that problem is compensated by the higher quality.
• Introduction of new goods: As time passes, new goods or services are created that didn’t exist in the past. When this happens, consumers are better off because they now have a new option to spend their money on. Although these new goods may eventually be included in the “basket of goods” (see “Compiling a basket of goods and services” earlier in this chapter), the value of the new option isn’t accounted for in the inflation statistics. This means that inflation overestimates the true increase in the cost of living because it doesn’t take into account that consumers are better off due to the introduction of new goods.

Connecting inflation to interest rates

There is an intimate link between inflation and interest rates in an economy, which you can read about in detail in Chapter 6. Here, we simply recall two different interest rates from Chapter 2, the real interest rate and the nominal interest rate, and show the relationship between the two and inflation.

As discussed in Chapter 2, interest rates measure the price of credit — both giving it (lending) and using it (borrowing). They are therefore very important in an economy because they influence all sorts of things: how much it costs to get a loan, the incentives firms face to invest in new capital, and the exchange rate, among others. In turn, inflation affects interest rates. So, we need to understand this link if we want to understand consumer borrowing, firm investment spending, and so on.

Imagine that you’re thinking about where to put $10,000 in savings. You find a bank willing to pay you 5 percent interest ($500) if you deposit your money there for one year. That’s a pretty good deal these days, so you make the deposit, thinking all the while how well you’ve done.

A year passes, and you withdraw your promised money, namely, $10,500. Unfortunately, when you take the $10,500 to the store to buy stuff, you find it doesn’t buy any more than the $10,000 you started with a year earlier because the price of everything went up by 5 percent — in other words, there was 5 percent inflation. You waited a whole year to spend your money and for what? A few dollars more, but no extra goods and services.

As we state repeatedly throughout this book, economists believe that it is the real things in life that count. You’re not interested in how many dollars you have — those are just pieces of paper or numbers in cyberspace. What you care about is how many goods you can get with your money. When it comes to interest rates, this means macroeconomists have to talk about two different ones:

• Nominal interest rate: Percentage return in terms of dollars. In the example, it’s the bank interest rate of 5 percent. You deposited $10,000 at the start and received $10,500 a year later.
• Real interest rate: Percentage return in terms of goods (units of GDP). In the example, it’s equal to zero. You gave up $10,000 worth of goods at the start and ended up able to buy the same amount of goods a year later thanks to prices rising by 5 percent. That inflation has completely wiped out your nominal 5 percent gains.

Economists express the relationship of the real interest rate, nominal interest rate, and inflation with the following equation, called the Fisher equation after early 20th century economist Irving Fisher. Note that by convention, and confusingly, economists call inflation π:

Don’t be confused — this has nothing to do with π from math class, which is roughly equal to 3.14159.

The Fisher equation says that the nominal interest rate (i) is equal to the real interest rate (r) plus inflation (π). For example, if inflation is 3 percent (π = 3), the bank will have to pay a nominal rate of 4 percent (i = 4) if you are to earn a real rate of 1 percent (r = 1) and be able to purchase 1 percent more goods after a year relative to when you started.

For short periods, the real interest rate can even be negative. If your bank offers you a rate of 3 percent (i = 3), and inflation is 4 percent π = 4), your real interest rate is (r = –1%). That is, you’re able to purchase 1 percent fewer goods after a year.

Moving money: Velocity and the quantity equation

Macroeconomists use Y to denote real GDP and P to denote the price index. So, PY is nominal GDP. Whether nominal or real, though, GDP is a flow measured per unit of time, for example, right now we are producing at about $18 trillion per year.

Money on the other hand is a stock. At any point in time, including the present, there is a certain amount of cash and funds in checking accounts plus other “money” assets in circulation. Macroeconomists usually denote this total amount of money as M.

Of course, every nominal GDP transaction involves money. The buyer gives dollars to the seller whether it’s for champagne or for root canal surgery. In other words, to make all the transactions that comprise GDP, the dollars in the money stock have to move around as someone buys things from you and you use the money to buy stuff from somebody else.

Economists define the velocity of circulation of money as follows:

For example, if nominal GDP is $18 trillion per year and the money stock is $3 trillion, then velocity is 6 per year. This means that the average dollar changes hands about once every two months.

The definition of velocity can be rewritten in a way known as the quantity equation, namely:

The quantity equation is an important framework for thinking about inflation. It’s not actually an equation, however. It’s what economists call an identity — a relation that’s true by definition. The quantity equation should really be called the quantity identity.

Here’s the difference between an equation and an identity:

• An equation: Is true for some values of the variables (for example, x + 5 = 7 is an equation because it’s only true for x = 2).
• An identity: Is always true whatever values the variables take. For example, the relationship between the temperature in Fahrenheit (F) and in Celsius (C): F = (9/5)C + 32 is always true by definition.

Because it’s an identity, the quantity equation holds constantly, 24/7, 52 weeks per year.

One drawback to the quantity equation as shown is that it is written in levels. That is, for given values of M, V, and Y, the equation tells us what the price level P has to be. Usually, we want to know about the growth rate of prices (inflation), not their level. Fortunately, a simple trick allows you to go from levels to growth rates, which if applied to the quantity equation, yields the following:

where g_X is the growth rate of variable X, so g_P is the growth rate of prices (that is, inflation). Although velocity (V) may vary from year to year, it’s unlikely to move wildly in the long run. Indeed, we can think of long-run increases in velocity as the result of technical change in the financial sector. Credit cards and electronic banking make it easier to move money around today than it was 100 years ago. For the most part, however, such changes happen gradually over many years, so that velocity grows slowly over the long run. If you plug in g_P = π and rearrange, you have this:

This expression says that the rate of inflation π is equal to the rate of growth of money plus the growth rate of velocity minus the growth rate of output. Like its level form, this growth form of the quantity equation always holds true as well.

The intuition linking money growth and inflation is clear. The price level tells you the rate at which you can convert money into goods. If the price level is high, you need a lot of money in order to buy goods, and vice versa. So, if the amount of money in the economy (M) increases and the amount of goods (Y) stays unchanged, goods become relatively scarce and money is relatively abundant. This situation causes the prices of things to increase, because the rate at which you can turn money into goods worsens.

Again, that’s what inflation really is — a fall in the purchasing power of money.

Inflating the economy: Money and other factors in the long run

The quantity equation is useful, especially in its growth form, because it makes clear where inflation comes from. Basically, inflation happens for one of three reasons:

• Faster growth in the money supply, g_M
• Faster growth in velocity, g_V
• Slower growth in real GDP, g_Y

Now think about the long run, where the economy is on trend and producing its potential GDP by fully employing its resources. What does the Quantity Equation say about inflation in this context?

• As discussed in Chapter 3, potential or trend real GDP rises steadily through time as we get more labor input and it has more capital and better technology to work with. In the long run, actual GDP is on the trend. So, it’s growing steadily, too — at 2 to 3 percent per year in the U.S. But remember, this is all part of the market economy’s natural workings. It’s not really under the control of policy-makers. That is, the economy’s long-run growth will be steady and mainly reflect the positive forces of Adam Smith’s “invisible hand.”
• As already suggested, velocity also grows rather steadily (and quite slowly) in the long run. Financial innovations that make it easier to move money around faster obviously do happen. But these take time before they affect everyday practice. Over a long horizon of many years, the best guess is that velocity will be pretty close to where it is right now.

What we are saying is that of the three factors that can cause inflation, policy-makers have little control over two of them — velocity and real GDP growth — in the long run. Instead, those two follow their own steady course.

However, policy-makers do control the third factor: the rate of money growth. The Federal Reserve (working with the Treasury) has a legal monopoly over the creation of money. If anyone else does it, it’s called counterfeiting. That’s why your answer to the question “How much money do you make?” should always be “zero.” You don’t make money. You earn income (and you’re free to talk about that).

Putting it all together, we now have a long-run story that says: a) inflation is the sum of money growth and velocity growth less the growth in real GDP, and b) velocity growth and output growth are essentially given in the long run, so that c) the principal determinant of whether long-run inflation is high or low is the Fed’s choice of how fast to grow the money supply. (The full story is slightly more complicated, because the financial system has the ability to “multiply” the amount of money through fractional reserve banking — see Chapter 14 for details.)

This is the deeper meaning of the Friedman quote. In the long run, inflation is a monetary phenomenon in that excessive money growth is the root cause. Whether it’s Germany in the interwar period, Bolivia in the 1980s, or Zimbabwe more recently, the explosive inflation in these and other cases is rooted in very rapid money growth. What Friedman is really saying to policy-makers is this: If your country is experiencing persistent high levels of inflation, it’s your fault. It must be because you’re letting the money supply grow too fast. Furthermore, if you want to reduce the amount of inflation, you have to do one simple thing: stop printing so much money.

Although economists agree that in the long run growth in the money supply causes inflation, in the short run other things can cause inflation (see Chapters 14 and 16 for details).

Counting the costs of inflation

The reason laypeople typically give for not liking inflation is that it makes them poorer. They worry that their wage or salary won’t keep up with the price increases.

Economists, though, look at inflation slightly differently, because over time nominal wages (the wage in money terms) do tend to at least keep up with inflation. In fact, most of the time, nominal wages tend to rise faster than inflation — which is the same as saying that the real wage (the wage in terms of goods) tends to rise over time.

Appreciating two benefits of inflation

Even bad things have an upside. For example, getting lost on a trip can lead to discovery of a charming off-the-beaten path village; losing Internet service gives an excuse for not returning e-mail; your kids getting a driver’s license means they can now chauffeur themselves.

Economists identify at least two benefits of inflation: allowing otherwise “sticky” prices to adjust and giving policy-makers more flexibility by allowing them to set negative real interest rates.

Understanding negative real interest rates

One of the main tools policy-makers have at their disposal to boost the economy is lowering the real interest rate. (For a detailed look at monetary policy, see Chapter 14.) We can rearrange the Fisher equation like this:

In other words, the real interest rate (r) is equal to the nominal interest rate (i) minus inflation π. Sometimes policy-makers want to super-boost the economy by having a negative real interest rate. Among other things, this would encourage households to spend now, because the real returns on saving are negative.

If inflation is positive, achieving a negative real interest rate is easy: Just set the nominal interest rate to be less than inflation. But with no inflation (π = 0), having a negative real interest rate is impossible. Policy-makers can’t choose a nominal interest rate of less than zero, because it would mean putting $100 into your bank account and getting back, say, $95. People would prefer to keep cash under their mattresses.

Seigniorage: Financing the government by printing money

When governments generally behave themselves, they fund their economies from the tax revenue they collect. If they give in to a little temptation, they fund themselves by borrowing money from whoever will lend it to them.

If they’re feeling very naughty (or if perhaps no one is willing to lend to them, because they’re seen as a bad risk), governments fund themselves by printing more money — known as seigniorage (which by the way does not mean senior age and does not get you discount drug prescriptions). Again, the government can do this because it has the legal monopoly to produce the thing we all need to conduct our daily affairs, namely money.

Closely related to seigniorage is the idea that inflation is a tax on money. If you start Monday morning with $10,000 in your wallet and the inflation rate is 5 percent per day, Tuesday morning will feel a lot like someone just took $500 from you. That someone is the government because it’s the government that’s ultimately responsible for inflation. We talk more about this in Chapter 13, but for now we’ll just note that every government faces the temptation of raising some funds by creating a little inflation.

Of course, not every government gives in to temptation. A government usually turns to seigniorage and inflation only if two conditions both apply:

• It’s running a budget deficit: Government spending is greater than tax revenue.
• No one is willing to lend it funds on reasonable terms: Potential lenders don’t believe they’re likely to be paid back.

In other words, if the government weren’t running a budget deficit, it wouldn’t have to borrow money, and if someone were willing to lend to it at a reasonable rate, it wouldn’t have to print money to cover its budget deficit. As you can guess, governments tend not to use seigniorage unless it’s the only remaining option, for the simple reason that replying heavily on seigniorage never ends well.

Hyperinflating and inflationary psychology

You may have heard about inflationary psychology (no, it has nothing to do with macroeconomists and their egos). In general, inflationary psychology refers to the fact that when inflation becomes persistent, and especially when it becomes large, people start acting differently and in ways that perpetuate the inflation and possibly make it worse. This is the major potential problem with “a little inflation.” It can grow into more and more inflation over time and ultimately explode into hyperinflation. How this can happen is a bit related to seigniorage and a bit related to velocity.

Seigniorage and money printing can be a way for governments to raise funds, as we’ve seen. However, it’s not a very efficient tax-collection device. Rough estimates suggest that it would take money growth and inflation on the order of 15 percent just to cover 5 percent or so of the U.S. federal budget. So, though it may be tempting, this sort of revenue source becomes prohibitively expensive very fast.

That doesn’t mean that governments won’t try, however. Faced with a chronic need for funds, the government may well turn to seigniorage and money growth to secure its finances. Some governments certainly have done so.

Even then, things might be okay if this were the end of the story. Sadly, it’s not for two reasons. First, high inflation makes collecting taxes difficult, owing to a time lag in collection. For example, you may work all year but only pay your income tax at the end of December. Or a business may not pay its sales tax bill until a few months have passed. Normally, these delays have little impact. But in an economy with high inflation, even short delays mean that by the time the tax money comes in it doesn’t cover the bills racked up.

Now the government’s problem is ten times worse. It has to make payments for defense, law enforcement, transportation, and other public expenditures every day, from 1 January through 31 December. But it doesn’t get any tax revenue until, say, 15 April. By the time those tax dollars come in, they’ve lost so much purchasing power that they fall even farther short of what’s needed, and the government’s real deficit is worse than when it started. This leads to more money growth to cover the difference, leading to more inflation, and an even bigger budget shortfall. A vicious cycle is now in motion.

The second problem has to do with the expectations mechanism discussed briefly in Chapter 3. There is a strong element of social psychology in financial markets. A bank can have a perfectly healthy balance sheet, yet if investors suddenly decide it looks sick and start pulling their funds out, it can indeed become ill very quickly. So it is with money. A large part of a dollar’s value to someone is their belief that they can use that money to buy stuff. But if everyone starts worrying that the money will lose value, it can in fact lose value very quickly even without super-fast money growth. And, as you know, inflation is another name for money losing value.

The velocity term is the key here. Suppose each household initially expects zero inflation and keeps $5,000 in cash on hand to conduct their daily business. Then, perhaps purely for psychological reasons, each begins to expect that inflation will be 10 percent. That means that each household’s cash will lose $500 in purchasing power. Bummer! But each can avoid this loss by getting rid of the money today and rushing out to buy real goods before prices rise. Then they’ll have real stuff and won’t care about its dollar value. The only problem is that everyone can’t do this simultaneously. If you buy stuff from your neighbor, then your neighbor has the money that’s losing value. So, the neighbor quickly buys stuff from someone else, and of course, they do the same thing. We all move our money around faster trying to buy more goods. But that means velocity rises, and with it, inflation.

Thus, the expectation of inflation can create inflation. Moreover, the psychology can feed on itself. People begin to expect a rise in inflation. As a result, they try to spend their money faster, increasing velocity and leading to the inflation they feared. Now they may get even more nervous and expect more inflation, leading to a further rise in velocity and to even more inflation, setting another vicious cycle in motion.

Stopping hyperinflation after it starts

There is then a self-fulfilling aspect to inflationary psychology. Once people have a psychological expectation of inflation, they start to act in ways that actually create inflation. As a result, it’s very difficult to get the inflation genie back into the bottle once it’s been let out. To do that requires that the government make a firm and credible commitment to slow money growth.

The government has to do more though than just say that, from now on, money growth will be slow. Such a statement is not believable unless the government also addresses its fundamental problems. If it has serious fiscal problems spending more than it earns in taxes and is unable to borrow, then it has to attack these directly at their source. Either government spending has to be cut or taxes have to be raised, or both. Usually, it’s hard to raise taxes, so ending the hyperinflation typically requires massive cuts in government expenditure. Only when the deficit is under control and fiscal credibility has been restored can the government credibly promise to turn away from printing money to fund itself. And it has to do that. No hyperinflation can end without a serious reduction in money growth.