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Research Paper (undergraduate), 2010
25 Pages, Grade: 1,7
Executive Summary
List of Abbreviations
List of Figures
List of Tables
1. Introduction
1.1 Problem Definition
1.2 Objectives
1.3 Methodology
2. Inflation Measurement
2.1 Measures for changes in the price level
2.1.1 Consumer Price Index
2.1.2 Gross Domestic Product Deflator
2.2 Problems with measuring the overall price changes
2.2.1 Accuracy of Consumer Price Index
2.2.2 GDP deflator versus CPI
2.3 Inflation rate as an important measure for businesses
3. Results and Conclusion
Appendices
Bibliography
illustration not visible in this excerpt
Fig. 1: Typical basket of goods and services
Fig. 2: Annual Inflation Rates of 2008 across the EU [in %]
Tab. 1: Calculation of CPI and inflation rate in five steps
Tab. 2: Calculation of nominal GDP, real GDP and GDP deflator
This assignment is dealing with the topic inflation measurement. In the assignment a multi step approach is used to discuss this theme.
In the first part the most common indices and the calculation of these indices are introduced.
In the second part it is discussed how precise these indices are in the measurement of overall price changes and in comparison.
Finally it is discussed why the inflation rate is an important measure for businesses.
The rate of inflation measures the annual percentage change in prices. This therefore has an impact on the cost of living for the people. How is this change in cost of living measured?
This assignment deals with the above mentioned question and try’s to present an answer.
The prices for services and goods are changing annually and as everyone knows for the most part the prices are increasing. To compare the purchasing power from different periods economist are using different indexes.
This paper is focused on presenting therefore an answer for the following questions:
1. What role do price indices play in the calculation of inflation?
2. What exactly are they and how they are calculated?
3. How precise are they in the measurement of overall price changes?
4. Why is the inflation rate an important measure for businesses?
In the assignment a multi step approach will be used to address the questions stated in chapter 1.2.
First the most common indices and the calculation of these indices will be introduced. Second it will be discussed how precise these indices are in the measurement of overall price changes and in comparison. Finally it will be discussed why the inflation rate is an important measure for businesses.
For the term inflation there are a lot of definitions available. A common accepted definition for inflation in economy would be the rise in the overall price level.
Until 1914 in Germany the paper money was fully backed up by gold. Back at this time inflation was a temporarily phenomenon.
But since the middle of the 20th century the overall price level in the western industrial countries with a view exception (especially Japan 1998-2006) are just moving in one direction - to the top (Letzgus, O. (2008), p. 26-27).
The value of money is determined by the quantity of goods that can be purchased by a certain amount of money. The purchasing power of money is therefore opposing to the prices of goods.
Money is not only used as a counting unit and to simplify trading, it is also used as a store of value and for saving purposes.
A central roll for the saving purpose is the expectation of the future purchasing power of money. With a higher inflation (higher goods prices) the saving tendency will drop as long as there is no compensation by the interest rate. All the functions of money therefore depend on the price level (Letzgus, O. (2008), p. 19-20). Therefore the price level needs to be measured.
The most common measure for the development of the purchasing power of money is the changing in consumer prices. For private households the consumer price index (CPI) and for firms the Producer Price Index (PPI) is used to measure this change. Each month, a government bureau (e.g. in UK the Office of National Statistics (ONS) or in U.S. the Bureau of Labour and Statistics, which is part of the department of labour) computes and reports the consumer price index (Mankiw, N.G. and Taylor M.P. (2003), p. 512 and Mankiw, N.G. and Taylor M.P. (2008), p. 486).
This measure is based on a basket of goods and services, which represents the consumption behaviour of the consumers. The ingredients are updated in regular intervals depending on the consumer behaviour. Figure 1 shows how for example the typical UK consumer basket is assumed (the percentage shows the relative importance of the category).
Fig. 1: Typical basket of goods and services
illustration not visible in this excerpt
Source: Mankiw, N.G. and Taylor M.P. (2003), p. 514, fig. 23-1
The inflation is measured by comparing the price for the ingredients of the basket of the current period with the preceding period (e.g. month, year).
When the government bureaus calculate the CPI and the inflation rate, they consider thousand of prices for different goods and services. In the following example it is described which steps for example the ONS follows to calculate the CPI and the inflation rate. To simplify the calculation it is assumed that the consumers buy only two goods - hot dogs and hamburgers. Table 1 shows the five steps in a brief form.
1. Fix the basket. The first step is to determine which prices are most important for the consumers. If the typical consumer buys more hot dogs than hamburgers, than the price of hot dogs is more important and should be get a greater weight in measuring the cost of living. The ONS sets these weights by surveying consumers and finding the basket of goods and services that the typical consumer buys (Mankiw, N.G. and Taylor M.P. (2006); p. 512 and Mankiw, N.G. and Taylor M.P. (2008), p. 486).
2. Find the prices. The second step is to find the prices of each good and service in the basket. Table 1 shows for the example the prices of hot dogs and burgers in three different years (Mankiw, N.G. and Taylor M.P. (2003); p. 513 and Mankiw, N.G. and Taylor M.P. (2008), p. 486).
3. Compute the basket’s cost. In the third step the data are used to calculate the cost oft the basket of goods and services at different times. Table 1 shows this calculation for each year (only the prices changes). For the calculation the basket is kept the same to isolate the effect of price changes from the effect of quantity change that could occur at the same time (Mankiw, N.G. and Taylor M.P. (2003); p. 513 and Mankiw, N.G. and Taylor M.P. (2008), p. 486).
4. Choose a base year and compute the index. In the fourth step a base year is chosen. This year is the benchmark against which other years are compared. In the calculation the price of basket of goods and services in each year is divided by the price of the basket in the base year. This ratio is then multiplied by 100. The result is the consumer price index.
In the example the year 2001 is the base. In this year the basket is $8. As a result, the basket price in all years are divided by $8 and multiplied by 100. The CPI in 2002 is therefore 175. That means that the price of the basket in 2002 is 175 percent of its price in the base year. Similarly the CPI in 2003 is 2003, which means that the price level in 2003 is 250 percent of the level in the base year (Mankiw, N.G. and Taylor M.P. (2003); p. 512 - 513).
5. Compute the inflation rate. In the last step the CPI is used to calculate the inflation rate. The inflation rate change in percentage related to the preceding period. The inflation rate between two following years is computed as follows:
Inflation rate in year 2 = 100 x (CPI in year 2 - CPI in year 1)/CPI in year 1 In the example the inflation rate is 75 percent in 2002 and in 43 percent in 2003 (Mankiw, N.G. and Taylor M.P. (2003); p. 514 - 515).
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