Chapter 12 - Notes

12.1 - Measuring Inflation

Key Definitions

• Inflation: a generalized rise in the overall level of prices / a rise in the cost of living / a decline in the purchasing power of money
• Consumer Price Index (CPI): an index that tracks the average price consumers pay over time for a representative basket of goods and services
• Inflation rate: the annual percentage increase in the average price level, calculated as the percentage change in the price of a fixed basket of goods and services
• Deflation: a generalized decrease in the overall price level

How the CPI is Constructed (4 Steps)

1. Find out what people typically buy
   • Statistics Canada surveys thousands of people on their spending habits
   • Most money goes to housing, transportation, and food
2. Collect prices from stores where people shop
   • Government surveyors visit thousands of retailers, check online stores, call offices, etc.
3. Tally up the price of the basket
   • Not a simple average — items you buy more of get more weight (e.g., coffee weighted more than tea if people buy more coffee)
   • Set so the basket costs $100 in a base year, then tracked over time
4. Calculate the inflation rate

Important Distinction

• Inflation (macro) = generalized rise in prices across the economy
• Relative price adjustment (micro) = price of individual goods rising or falling due to their own supply and demand

CPI Biases — Why CPI Overstates the True Cost of Living

1. Quality improvements can hide price decreases
   • Products get better over time but it's hard to fully adjust for that, so measured price increases partly reflect better quality, not true inflation
2. New products make people better off
   • CPI doesn't capture that a new invention (e.g., iPhone) replaced many expensive things — it only tracks price changes of existing goods, not the gains from new ones being invented
3. Substitution bias: the overstating of inflation that occurs because people substitute toward goods and services whose prices rise by less
   • CPI assumes a fixed basket, but in reality people swap expensive items for cheaper alternatives to maintain quality of life

• Together, these three biases overstate the cost of living by roughly 1% per year
• Statistics Canada tries to reduce this by updating the basket every ~2 years

12.2 - Different Measures of Inflation

Consumer Price Measures

• CPI — used for cost of living adjustments
  • Workers use indexation clauses in contracts to automatically adjust wages in line with CPI
  • Government indexes GST tax credits, payment amounts, and income cut-offs for programs based on CPI
• All-items CPI — what the Bank of Canada targets for monetary policy
  • Target is to keep year-over-year CPI change close to 2%
• Core inflation — strips out temporary fluctuations to reveal the underlying inflation trend
  • Private sector version excludes food and energy (not because they're unimportant, but because their prices are volatile and don't track broader trends)
    • Yeah food and energy changes in price are not a good reflection because there are many other factors that affect those types of prices
    • Bank of Canada uses its own core measures, like CPI-Median which tracks the 50th percentile of price changes in the CPI basket (it The median CPI is a measure of core inflation that calculates the price change of the item in the exact middle (50th percentile) of all component price changes, ranked from lowest to highest.)

Business Price Measures

• Producer Price Index (PPI): measures the price of inputs into the production process
  • Useful for businesses to see how their costs are changing and to track competitors' costs
  • Rising input prices eventually cause businesses to raise their prices for consumers
• GDP deflator: a price index based on a basket representing everything the Canadian economy produces
  • Unlike CPI, it includes capital goods but excludes imported goods
  • Used to convert nominal GDP into real GDP

- If the deflator is above 100 it means prices have risen since the base year, and nominal GDP will be greater than real GDP.
- If you're in the base year, the deflator is exactly 100 and nominal = real.

12.3 - Adjusting for the Effects of Inflation

Comparing Dollars Over Time

• You can't directly compare dollar amounts from different time periods because inflation changes the value of a dollar
• Inflation adjustment formula:

- Can also adjust to any base year, not just "today" — just swap the numerator CPI to whatever year you want to convert into

Real vs Nominal Variables

• Nominal variable: measured in dollars whose values fluctuate over time — can change because of actual quantity changes OR because of inflation
• Real variable: adjusted to account for inflation — changes only in response to changes in physical quantities
• You should always focus on real variables when making comparisons over time
  • Real wage > nominal wage for judging if you're better paid
  • Real revenue > nominal revenue for judging business performance
• Shortcut: Real growth ≈ Nominal growth − Inflation rate (works for small percentage changes under ~10%)

Real and Nominal Interest Rates

• Nominal interest rate: the stated interest rate, no correction for inflation
• Real interest rate: adjusts for inflation, measures actual change in purchasing power
  • Real interest rate ≈ Nominal interest rate − Inflation rate
  • e.g., 5% nominal interest − 3% inflation = 2% real interest rate

Money illusion: the mistaken tendency to focus on nominal dollar amounts instead of real values

• Can distort decisions — e.g., if all prices AND your income rise by 25%, the real cost of everything is unchanged, but people still feel like things are more expensive
• Can lead to mis-pricing — e.g., selling a house based on what you paid years ago without adjusting for inflation
• Creates nominal wage rigidity — employers avoid cutting nominal wages because workers resent it, but with 2% inflation and 0% nominal raise, your real wage is actually falling by 2%
• In wage negotiations, always set your real wage as the baseline, not your nominal wage

12.4 - The Role of Money and the Costs of Inflation

The Functions of Money

• Money: any asset that's regularly used in transactions

Criteria:

1. Medium of exchange — you use money to buy stuff and get paid for work
   • Without money you'd need barter, which requires a double coincidence of wants (you need to find someone who has what you want AND wants what you have)
   • Only works if people have faith that money will hold its value
2. Unit of account — a common unit to measure economic value, compare prices, record debts, write contracts
   • Needs to be stable to be useful (like how a measuring tape needs to stay the same length)
3. Store of value — you can save money now and use it to buy stuff later
   • Works when money is easy to store and holds its value over time

Inflation undermines all three functions — less reliable store of value, less stable unit of account, and in extreme cases people stop accepting it as a medium of exchange

Hyperinflation: an extremely high rate of inflation, think prices at least doubling every few months

• Venezuela example — café con leche went from 450 bolivars (2016) to 600 billion bolivars (2021)
• People resorted to barter, using US dollars, weighing cash instead of counting it
• Erodes all three functions of money completely

Costs of Expected Inflation

1. Menu costs — costs businesses incur from having to update prices more frequently (reprinting menus, reprogramming vending machines, updating websites)
   • Arises because inflation undermines money as a stable unit of account
2. Shoe-leather costs — the time and effort people spend trying not to hold cash that's losing value (more trips to the bank, rushing to spend money quickly)
   • Arises because inflation undermines money as a store of value

Costs of Unexpected Inflation

3. Inflation confuses price signals

• Hard to tell if a price increase is real demand for that product or just general inflation
• Leads to mistakes — businesses might expand production unnecessarily or miss real demand increases

4. Inflation redistributes between borrowers and lenders
   • Higher than expected inflation = good for borrowers, bad for lenders (you repay in dollars that are worth less)
   • Lower than expected inflation = good for lenders, bad for borrowers (you repay in dollars worth more than expected)
   • Real interest rate = nominal rate − actual inflation, so if actual inflation differs from what was expected, one side wins and the other loses

The Inflation Fallacy: the mistaken belief that inflation destroys purchasing power

• Only tells half the story — yes prices go up, but wages and incomes typically rise in lockstep with inflation
• People blame inflation for higher prices but take personal credit for their higher wages
• Thought experiment: if every price AND every wage AND every bank balance all got an extra zero, nothing real changes — same purchasing power, same opportunity costs
• The costs of inflation aren't from the price level being higher, they're from the process of changing prices (menu costs, shoe-leather costs, confusion, redistribution)

NOTE: BITCOIN IS NOT A FORM OF MONEY IN CANADA

iClicker Questions:

• Unanticipated inflation is a gift to borrowers with fixed-rate debt
• Unemployment and output move in opposite directions:
  • Unemployment below natural rate → output above potential → inflationary gap
  • Unemployment above natural rate → output below potential → recessionary gap
  • Unemployment equal to natural rate → output equal to potential → no gap