Inflation measurement

Table of Contents

Executive Summary

List of Abbreviations

List of Figures

1 Introduction

2 Problem Definition

3 Objectives

4 Methodology

5 Main Part – Inflation Measurement
5.1 The basket of goods
5.2 The calculation of price indices
5.2.1 Calculation of the price of the basket
5.2.2 Some information about Laspeyres and Paasche indices
5.2.3 Calculation of the inflation rate
5.3 Overview about different problems of inflation measurement
5.4 Why is information on inflation important to businesses?
5.4.1 Consumer behaviour and its consequences for businesses
5.4.2 Slightly positive inflation rate
5.4.3 Inflation rate above 4%
5.4.4 Deflation
5.4.5 Costs of inflation

6 Results

7 Conclusion

Appendices

ITM Checklist

List of Abbreviations

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List of Figures

Figure 1 – Distribution of the goods and services in the basket

Figure 2 – Prices of the Goods

Figure 3 – Calculation of the price of the basket

Figure 4 – Laspeyres Price Index

Figure 5 – Paasche Price Index

Figure 6 – Consumer Price Index

Figure 7 – Calculation of the inflation rate

Executive Summary

A dominating topic in recent times, not only in special interest media with a financial or economic background, but in daily regional newspapers as well, is inflation and its causes and effects. Therefore within this group assignment a classical approach to inflation measurements and relating economic issues is done, starting with the description of the function and the content of the basket of goods and services and explaining the weighting-scheme. With regard to the fact, that the whole basket contains 750 items, it is a logical consequence that for the calculation of the prices of the basket of goods a simplified example with only three different items in the basket, in this case three alcoholic beverages, was choosen. In the next paragraph the formula of the calculation of two most common used price index methods “the Laspeyres” and “the Paasche” index are shown and both indices are compared. The core essence of the main part is of course the calculation of the inflation rate, which is based on the calculation of the CPI, and followed by the development of the CPI values within a three years time period. In the following paragraphs the critical argument with the current problems which are influencing or even impeding an accurate inflation measurement are discussed: price, product and consumer. The authors are describing wrong assumptions and forecasts, resulting from the “purchase of substitute goods”, the late or even missing quality adjustment of goods in the basket and of course the overwhelming influence of aggressive and intimidating media reporting on inflation scenarios for the economy of a country. In the last sub chapter an even more practical approach is made, by demonstrating the importance of inflation and inflation measurement for business. Especially the percentage of an inflation rate which is mostly between one up to four percent and its various interpretation attempts are described. Moreover the different types of costs of inflation for example menu costs, occurring from price adjustments, or shoeleather costs which contain all the efforts a company has to reduce money holdings are explained in detail. The last part summarizes the most important facts, with combining historical aspects and current relevance of inflation measurement for a modern economy of today.

1 Introduction

In economics, inflation is a rise in the general level of prices of goods within an economy over a period of time. That means the real value of money will decline and generate a loss of purchasing power.⁴ “A dollar today doesn’t buy as much as it did twenty years ago.”⁵ In 1931, for example, it was possible to go to the cinema for 25 cents. Today we have to pay between five and nine Euros. In Germany the fear of inflation is based on some experiences the Germans already have made with it. During the period of hyperinflation in 1923 for instance, the customers had to take their money in huge bags to the supermarket. The dealers started to weight the money, because counting the incredible amount of bank notes would take the whole day. In the 70ies the extremely high cost for oil was the crucial factor for increasing prices. Especially the general customer, Joe Sixpack, is concerned about a high inflation rate because in most cases the annual pay rise does not keep up with the increase of the rate of inflation. Therefore Joe Sixpack does not get the same amount of goods and services for his money in the current year compared to the years before. To avoid that people loose their standard of living inflation is always one of the most discussed topics world wide. The following assignment deals with the measurement of inflation and tries to provide a better understanding for the general issue and the impact of increasing prices to people and businesses.

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2 Problem Definition

At the moment you can read in almost each newspaper something about inflation. In most cases this topic is written in a negative context. “Everything gets more expensive!”⁸ or “This is the only way to defend from inflation”⁹ are just two of the most common headlines. But it is not only the written context people get afraid of, it is also the fact that a general consumer has no idea what inflation actually is. The only thing people are able to connect with inflation, is the heavily increased price of goods compared to ten years before. It is a different kind of threat for instance compared to a gun, where you can precisely understand what happens if you squeeze the trigger.

After the crisis the inflation rate will play an important role to all people and organisations all over the world. Unfortunately do business economists in general not learn very much about inflation and its impact on businesses in their studies.¹⁰ Therefore it is necessary to develop a better understanding for the “cryptic phenomenon” of inflation and make it worth to have a closer look behind the curtain.

3 Objectives

The following assignment should provide an overview to the reader regarding the questions how the inflation rate is calculated, the problems with the measurement of inflation and a summary of problems of the inflation measurement. But nevertheless we have to clean up with some expectations referring to this assignment in advance. Due to the recommended scope it is unfortunately not possible to cover all areas of this interesting topic. There are specific sub areas which had to be left out and other parts are only touched and approached slightly. But in the end the core essence and the most important facts have will be covered and a better understanding of the “black box” called inflation should be provided to the reader.

4 Methodology

This assignment is mainly based on literary research (library, technical magazines, company documents, etc.).

Another source the authors have taken into account, is the essence and knowledge exchange within some intensive group discussions to find out which experiences and economic skills each group member already has and in how far these points could be implemented into the assignment.

After the group had defined a table of content and the tasks for each group member were allocated a short conversation with the professor took place to be sure to do not miss the point.¹¹

During the whole process of writing – and hopefully in future as well – the authors were observing the daily press regarding some important facts which could help to develop a better understanding for the whole topic of “inflation”.

5 Main Part – Inflation Measurement

The main part of this assignment will show how to measure and calculate inflation, followed by an overview of different problems of inflation measurement and the impact of inflation on business and organizations.

5.1 The basket of goods

This paragraph describes the first step in the process of measuring the inflation rate: it begins by collecting the prices of goods and services a typical private household consumes regularly and frequently. For this collection of goods, like in the supermarket, we need some kind of basket – a so called basket of goods. For example, a typical consumer buys five eggs and three tomatoes every month – then the basket of goods consists of five eggs and three tomatoes.

Nevertheless, it is neither possible nor necessary to take into consideration all prices of goods and services purchased by consumers. It is perfectly adequate to choose a number of selected goods, representing the overall consumption. For instance, in the year 2000 the basket of goods contained approximately 750 items and services.¹⁸

The so called weighting-scheme dictates the „weight“, meaning the importance of these different goods. In other words: it should reflect the structure of consuming of the private households. It quantifies the importance of, e.g., rental fees in the overall expenses of private households. Figure Number 1 gives a rough overview of the weighting-scheme. The main expenses of the private households are rental fees, water and energy, representing over 30% of the total of all expenses. These expenses are followed by transportation with more than 16% and food, drinks and tobacco with 14.5%. An equally important position is occupied by education and entertainment with almost 12%.

[...]

⁴ compare Mankiw (2000): p. 29

⁵ compare Mankiw (2000): p. 29

⁸ Wirtschaftswoche, 11.04.2009: p. 20

⁹ Focus, 04.05.2009: front page

¹⁰ compare Bofinger (2004): p. 15

¹¹ conversation to Professor Wilhelm (25.04.09)

¹⁸ compare Bofinger (2004): p. 238