The Consumer Price Index & Inflation

Inflation
Inflation is defined as an increase in the overall price level. Please note that inflation does not apply to the
price level of just one good, but rather to how prices are doing overall. A consumer facing inflation that
occurs at the rate of 10% per year will able to buy 10% less goods at the end of the year if his or her
income stays the same. Inflation can also be defined as a decline in the real purchasing power of the
applicable currency.
Consumer Price Index (CPI)
The CPI represents prices paid by consumers (or households). Prices for a basket of goods are compiled for
a certain base period. Price data for the same basket of goods is then collected on a monthly basis. This
data is used to compare the prices for a particular month with the prices from a different time period.
Example:
The inflation rate is computed by subtracting the CPI of last year's prices from the CPI value for this year,
dividing that difference by last year's CPI value and then multiplying by 100.
So if the value of the price index for the current year is equal to 165, and last year's value was 150, the
rate would be calculated as:
Inflation rate = (165 - 150) X100= 10
150
CPI Sources of Bias
The CPI is not a perfect measure of inflation. Sources of bias include:
Quality adjustments - quality of many goods (e.g., cars, computers, and televisions) goes up every year.
Although the Bureau of Labor Statistics is now making adjustments for quality improvements, some price
increases may reflect quality adjustments that are still counted entirely as inflation.
New goods - new goods may be introduced that will be hard to compare to older substitutes.
Substitution - if the price goes up for one good, consumers may substitute another good that provides
similar utility. A common example is beef vs. pork. If the price goes up, and the price of pork stays the
same, consumers might easily switch to pork. Although the CPI will go higher due to the price increase in
beef, many consumers may not be worse off. Also, when prices go up, consumers may effectively not pay
the higher prices by switching to discount stores. The CPI surveys do not check to see if consumers are
substituting discount or outlet stores.
The Aggregate Supply Curve
The aggregate supply curve shows the relationship between a nation's overall price level, and the quantity
of goods and services produces by that nation's suppliers. The curve is upward sloping in the short run and
vertical, or close to vertical, in the long run.
Net investment, technology changes that yield productivity improvements, and positive institutional
changes can increase both short-run and long-run aggregate supply. Institutional changes, such as the
provision of public goods at low cost, increase economic efficiency and cause aggregate supply curves to
shift to the right.

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Some changes can alter short-run aggregate supply (SAS), while long-run aggregate supply (LAS) remains
the same. Examples include:
Supply Shocks - Supply shocks are sudden surprise events that increase or decrease output on a
temporary basis. Examples include unusually bad or good weather or the impact from surprise military
actions.
Resource Price Changes - These, too, can alter SAS. Unless the price changes reflect differences in
long-term supply, the LAS is not affected.
Changes in Expectations for Inflation - If suppliers expect goods to sell at much higher prices in the
future, their willingness to sell in the current time period will be reduced and the SAS will shift to the left.
The Aggregate Demand Curve

The aggregate demand curve shows, at various price levels, the quantity of goods and services produced
domestically that consumers, businesses, governments and foreigners (net exports) are willing to purchase
during the period of concern. The curve slopes downward to the right, indicating that as price levels
decrease (increase), more (less) goods and services are demanded.
Factors that can shift an aggregate demand curve include:
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Real Interest Rate Changes - Such changes will impact capital goods decisions made by individual
consumers and by businesses. Lower real interest rates will lower the costs of major products such as cars,
large appliances and houses; they will increase business capital project spending because long-term costs
of investment projects are reduced. The aggregate demand curve will shift down and to the right. Higher
real interest rates will make capital goods relatively more expensive and cause the aggregate demand
curve to shift up and to the left.
Changes in Expectations - If businesses and households are more optimistic about the future of the
economy, they are more likely to buy large items and make new investments; this will increase aggregate
demand.
The Wealth Effect - If real household wealth increases (decreases), then aggregate demand will
increase (decrease)
Changes in Income of Foreigners - If the income of foreigners increases (decreases), then aggregate
demand for domestically-produced goods and services should increase (decrease).
Changes in Currency Exchange Rates - From the viewpoint of the U.S., if the value of the U.S. dollar
falls (rises), foreign goods will become more (less) expensive, while goods produced in the U.S. will become
cheaper (more expensive) to foreigners. The net result will be an increase (decrease) in aggregate
demand.
Inflation Expectation Changes - If consumers expect inflation to go up in the future, they will tend to
buy now causing aggregate demand to increase. If consumers' expectations shift so that they expect
prices to decline in the future, t aggregate demand will decline and the aggregate demand curve will shift
up and to the left.