Inflation
- Why Should I Care?
Everyone cares about prices. When things are cheap, we are richer. And when things are expensive, we are poorer. Enough said?
CASE - PERSONAL CPI INDEX https://www150.statcan.gc.ca/n1/pub/71-607-x/71-607-x2020015-eng.htm
- This Lecture Has 4 Parts
- Why Inflation?
- Types of Inflation
- Winners and Losers of Inflation
- Consumer Price Index
- What is Inflation?
To inflate. To make something bigger. In this case, to inflate prices. No one really wants this. But it happens. Everything costs more today than it did a decade ago.
Example. You can buy a bottle of Molson beer for seven dollars in a bar today. That same pint was sold for 5 cents in 1786. We asked MolsonCoors. The information is from their archives.
Which beer was more expensive?
The price of that pint of beer has increased by an average of 2.06 percent every year, over 226 years. If the average wage has increased by the same amount, the relative price has not changed. But if wages have increased at a quicker pace than beer, then you could say that beer is cheaper today.
$7.00 today could be a lower price than 5 cents in 1786. Who knows? We don't have wage data going back to 1786, so it's hard to tell.
- Why Inflation?
Two reasons:
- There may be shortages:
- on product markets, due to high demand or a sudden drop in supply.
- on factor markets, due to increases in the wages, or the price of natural resources, (copper, iron, aluminum, etc.). The higher prices trickle down to production lines and increase prices of final products.
- The central bank may be printing too much money, which then loses its value. Storekeepers hike prices to keep up with the decreased value of paper money.
The term “inflation” can be used to discuss one market, but it is also used in a much broader meaning. In macroeconomics, “inflation” refers to a sustained and generalized increase in prices over the whole economy. As a general rule, inflation usually slows down economic activity. People become poorer when prices rise, because their spending ends up buying less stuff. If the economy is over-heating, and producing more than potential, inflation can be a good thing, to slow the economy down.
- Types of Inflation
Whatever the reason for inflation, the consequences can be disastrous. When people expect prices to be higher, they change their behaviour. Stores hike prices, anticipating higher costs, which accelerates the process. The problem is that inflation can easily snowball out of control.
Economists have categorized the speeds with which prices increase. This refers to the rate of inflation as percentage change of the level of prices. For example,
- 2 % inflation is called “creeping inflation”.
- 15 % inflation is called “galloping inflation”.
- 200 % inflation is called “hyperinflation”.
- Also, a decrease in prices (rare) is called a “deflation”.
- Winners and Losers of Inflation
Everyone loses from inflation because it increases prices on all markets. Even if workers obtain wage increases, these are usually negotiated late and workers never recoup their losses. However, some people do stand to win in the face of inflation. A young family that owns a heavily mortgaged home, for example, may be better off. They may find themselves with a higher priced home, while their debt is fixed.
On the losing side, older folks whose income is fixed (retirees), and whose expenses are increasing (car, fuel, food, etc.), will become poorer. Also, banks stand to lose because they won’t be able to keep up with rising house prices unless they increase their interest rates. But higher rates will slow their business as well.
Interview with Julien Brault - on Inflation and Housing
- Consumer Price Index
Statistics Canada uses the Consumer Price Index (CPI) to measure the level of prices in the country. This statistic compares prices for exact goods over time, while keeping quantities constant. CPI includes a list of almost 700 goods and services sold in Canada. The measurement is an index, because each good may have different list prices, and might be weighted differently according to the type of good. For example, milk is inexpensive, but you need to include it once a week. Rent is more expensive, but you only count it once a month. The list of goods is called a basket.
The formula is:
CPI = (This Year Value of Basket / Base Year Value of Basket) * 100
CPI for the base year is always 100, which means nothing, really. An index always has a base year, used as a reference to compare the next years. The useful thing is that if the CPI for the next year is 102, we know prices have increased by 2 %. This is the rate of inflation.
How to calculate CPI
If 2002 is the base year, you start by calculating the sum of products in the basket. This example has 7 products, but the methodology is the same for a longer list. You then apply the CPI formula which gives 100 for the base year. This is expected.
For 2003, you calculate the Value in Basket, and apply the CPI formula. This time the value is 102, which means prices increased by 2 percent on average. It is important to average using the weights for each product. If you did the simple average of the percent change for each product, you would not get 2 percent. Some products increased 12.5 percent (wood), and others decreased 5.3 percent (tv). The weights make a difference because changes in the price of the daily consumption items would be drowned out by a few big changes in big-ticket items.
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2002 = Base Year |
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Goods |
Price |
Quantity in Basket |
Value in Basket |
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32 inch TV |
$600 |
2 |
$1,200 |
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Milk 4l |
$4.50 |
50 |
$225 |
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Bread |
$2.80 |
50 |
$140 |
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Plywood 4X8 half in |
$16 |
20 |
$320 |
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Alpine skis |
$300 |
1 |
$300 |
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Leather sofa |
$1,800 |
1 |
$1,800 |
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Minivan |
$15,000 |
1 |
$15,000 |
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Total |
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125 |
$18,985 |
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Consumer Price Index |
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($18,985 / $18,985) * 100 = 100 |
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2003 = Following Year |
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Goods |
Price |
Quantity in Basket |
Value in Basket |
Percent change |
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32 inch TV |
$570 |
2 |
$1,140 |
-5.3 % |
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Milk 4l |
$4.60 |
50 |
$230 |
2.2 % |
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Bread |
$2.90 |
50 |
$145 |
3.5 % |
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Plywood 4X8 half in. |
$18 |
20 |
$360 |
12.5 % |
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Alpine skis |
$320 |
1 |
$320 |
6.7 % |
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Leather sofa |
$1,900 |
1 |
$1,900 |
5.6 % |
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Minivan |
$15,270 |
1 |
$15,270 |
1.8 % |
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Total |
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125 |
$19,365 |
2 % |
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Consumer Price Index |
($19,365 / $18,985) * 100 = 102 |
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Once you know how CPI is built, you can understand how to use it. The CPI value can be used to deflate aggregate measurements, in order to see if inflation is playing too much of a role in their variation.
A very useful calculation is to deflate a raw measurement, such as wages, or GDP.
Real measurement = (Nominal measurement / CPI ) * 100
You can also deflate a percentage, such as a rate of return on investment, or an interest rate, using the following Fisher formula.
Real rate = Nominal rate - Inflation Rate
Table - Deflating Nominal Measurements and Rates
|
Year |
CPI |
Average Wage ($/h) |
Return on Stock Market Investment (%) |
Nominal GDP (Trillion$) |
Real wage ($/h) |
Real Return (%) |
Real GDP (Trillion$) |
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2001 |
100 |
30.00 |
7.5 % |
1.80 |
30.00 |
7.5 % |
1.80 |
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2002 |
105 |
31.00 |
3.6 % |
1.90 |
29.52 |
-1.4 % |
1.81 |
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2003 |
107 |
32.00 |
9.1 % |
2.10 |
29.91 |
2.1 % |
1.96 |
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2004 |
108 |
35.00 |
2.1 % |
2.80 |
32.41 |
-5.9 % |
2.59 |
As you can see on the table (the data is fictional), sometimes a nominal increase is misleading. Your paycheck might be bigger than last year, like say in 2002, but the inflation of prices took a piece out of your purchasing power. Your real income has actually decreased.
Same goes for your investment statement. You get a letter from your financial advisor that your investments are up 3.6 percent in 2002. But inflation has brought your real return down to negative 1.4 percent.
In the case of the GDP, national output, the transactions across the country were up 2.1 percent in 2004. But most of that extra output was just higher prices, inflating cashier's receipts. Using CPI to deflate GDP, you realize that real production is actually 2.59 trillion dollars. Sounds like alot, but its a negative 7.5 percent change. A really big recession.
- Green Policy
Inflation can be a good thing for the environment. Prices are a form of feedback that we can use to steer economic behaviour. In the case of pollution, if we can price the pollution, then the higher the price, the better. It becomes an incentive to reduce polluting activities.
The key to using inflation for green policies is to have alternatives ready for producers and for consumers. When the price of gas increases, those who depend on the fuel for transportation will feel the hit. Those who can pivot and use transit, or other means, won’t be hit the same way. Having alternatives ready will ease the pain of inflation.
- Climate Change Solution
It should be obvious that green house gases should be more expensive to produce, and to consume, than at present. Inflation is then a good thing.
However, many people object that carbon taxes, which make GHGs more expensive, are inflationary. And it’s true that petrol is such a widely used input, that it can trigger inflation in many, many, sectors of the economy, turning a micro-economic issue, into generalized macro-economic inflation.
However, there is more and more research pointing to the fact that carbon taxes don’t have to be inflationary. Konradt & Weder di Mauro (2021) compared carbon tax regimes in Canada and Europe and found that most cases were not inflationary. It may be that the higher prices encourage innovation, and substitution. It may also be that the money generated by carbon taxes can be reinjected in the economy in money-saving programs for consumers.
For example, in Canada, the federal government is using carbon tax revenue to subsidize efficient heating and cooling systems such as heat pumps. Consumers get a large rebate on the installation of the unit, and they save on their monthly bill, because these units cost much less to heat.
There is now an argument to say that carbon taxes are not inflationary. Of course, carbon fuels become more expensive, but there is reason to believe that that effect will be constrained, and not generalized to other goods and assets in the economy, such as heating and housing.
- Democracy Booster
Inflation is one of the most hated economic phenomena because it makes people poor. Whenever you see a major social upheaval on the news, such as widespread demonstrations, strikes, and revolts, there is almost always an underlying problem with prices for basic foods and amenities.
Mismanaging inflation is therefore the best way to lose public support. For this reason, it is important that a transition towards a low-carbon economy is done correctly. It is really important that the transition be done with careful planning, which provides incentives and alternatives for people to maintain their quality of life, while fuel prices increase.
- Wrap-Up
Inflation is a sustained increase in prices. It hurts everyone, but some more than others, especially retirees.
Inflation is measured by Statistics Canada, which produces the Consumer Price Index (CPI). Percent change of CPI is called the inflation rate.
Even a small rate of inflation (2 %) will cause prices to double in less than a generation (35 years), according to the Rule of 70.
- Cheat Sheet
Inflation:
A sustained and generalized increase in prices.
Inflation Rate:
Percent change of the level of prices.
Hyperinflation:
An extreme increase in the level of prices. Money will eventually completely lose its value. New money will have to be issued with a much higher numerical value.
Consumer Price Index:
A statistic produced by Statistics Canada to measure the rate of inflation.
- References and Further Reading
Konradt, M., & Weder di Mauro, B. (2021). Carbon Taxation and Inflation: Evidence from the European and Canadian Experience. https://cepr.org/sites/default/files/CEPR-DP16396_free_download.pdf
Statistics Canada. (2022). CPI Portal. https://www.statcan.gc.ca/en/subjects-start/prices_and_price_indexes/consumer_price_indexes