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Big Bucks in Zimbabwe
This bill was worth 100 billion Zimbabwean dollars when issued in 2008. There were even bills issued with a face value of 100 trillion Zimbabwean dollars. The bills had $100,000,000,000,000 written on them. Unfortunately, they were almost worthless. At one point, 621,984,228 Zimbabwean dollars were equal to one U.S. dollar. Eventually, the country abandoned its own currency and allowed foreign currency to be used for purchases. (Credit: modification of work by Samantha Marx/Flickr Creative Commons)
If you were born within the last three decades in the United States, Canada, or many other countries in the developed world, you probably have no real experience with a high rate of inflation. Inflation is when most prices in an entire economy are rising. But there is an extreme form of inflation called hyperinflation. This occurred in Germany between 1921 and 1928, and more recently in Zimbabwe between 2008 and 2009. In November of 2008, Zimbabwe had an inflation rate of 79.6 billion percent. In contrast, in 2014, the United States had an average annual rate of inflation of 1.6%.
Zimbabwe’s inflation rate was so high it is difficult to comprehend. So, let’s put it into context. It is equivalent to price increases of 98% per day. This means that, from one day to the next, prices essentially double. What is life like in an economy afflicted with hyperinflation? Not like anything you are familiar with. Prices for commodities in Zimbabwean dollars were adjusted several times each day. There was no desire to hold on to currency since it lost value by the minute. The people there spent a great deal of time getting rid of any cash they acquired by purchasing whatever food or other commodities they could find. At one point, a loaf of bread cost 550 million Zimbabwean dollars. Teachers were paid in the trillions a month; however this was equivalent to only one U.S. dollar a day. At its height, it took 621,984,228 Zimbabwean dollars to purchase one U.S. dollar.
Government agencies had no money to pay their workers so they started printing money to pay their bills rather than raising taxes. Rising prices caused the government to enact price controls on private businesses, which led to shortages and the emergence of black markets. In 2009, the country abandoned its currency and allowed foreign currencies to be used for purchases.
How does this happen? How can both government and the economy fail to function at the most basic level? Before we consider these extreme cases of hyperinflation, let’s first look at inflation itself.
INFLATION
Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change in relative prices. A relative price change occurs when you see that the price of tuition has risen, but the price of laptops has fallen. Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the economy. In addition, price increases in the supply-and-demand model were one-time events, representing a shift from a previous equilibrium to a new one. Inflation implies an ongoing rise in prices. If inflation happened for one year and then stopped—well, then it would not be inflation any more.
Dinner table conversations where you might have heard about inflation usually entail reminiscing about when “everything seemed to cost so much less. You used to be able to buy three gallons of gasoline for a dollar and then go see an afternoon movie for another dollar.” The table below compares some prices of common goods in 1970 and 2014. The primary reason behind the price rises in Table—and all the price increases for the other products in the economy—is not specific to the market for housing or cars or gasoline or movie tickets. Instead, it is part of a general rise in the level of all prices. In 2014, $1 had about the same purchasing power in overall terms of goods and services as 18 cents did in 1972, because of the amount of inflation that has occurred over that time period.
| Items | 1970 | 2014 |
|---|---|---|
| Pound of ground beef | $0.66 | $4.16 |
| Pound of butter | $0.87 | $2.93 |
| Movie ticket | $1.55 | $8.17 |
| Sales price of new home (median) | $22,000 | $280,000 |
| New car | $3,000 | $32,531 |
| Gallon of gasoline | $0.36 | $3.36 |
| Average hourly wage for a manufacturing worker | $3.23 | $19.55 |
| Per capita GDP | $5,069 | $53,041.98 |
Moreover, the power of inflation does not affect just goods and services, but wages and income levels, too. The second-to-last row of Table shows that the average hourly wage for a manufacturing worker increased nearly six-fold from 1970 to 2014.
A modern economy has millions of goods and services whose prices are continually quivering in the breezes of supply and demand. How can all of these shifts in price be boiled down to a single inflation rate? Use a price index.
Price Index – The Consumer Price Index
Price Index
A price index tracks the prices of a groups of goods and services over time. The price index most often used to estimate the inflation is the Consumer Price Index (CPI) that measures the changes in the prices of goods and services purchased by typical households such as Housing, Food and Beverages, Transportation etc.
How to build the Consumer Price Index:
Choose the prices that you want to track: Consumer goods and services: Housing, Transportation, Medical Care etc… This is what we call the ‘market basket.’ The CPI contains 8 main categories and about 400 sub categories.- Assign weights to each category in the index to reflect their importance in our spending patterns. Housing will carry a greater weight than Apparel because a change in the price of housing will have a greater impact in our cost of living than the same change in the price of clothing items
- Choose a base year. The price index will start at 100 at the base year.
- Compute the index: Price index (2016) = [ Price of the market basket (2016) / Price of market basket (base year) ] x 100
- Calculate the inflation as the rate of change or percentage change in the Consumer Price Index
Click here for more details about price indexes
How to calculate the Consumer Price Index and inflation
Below is a simplified market basket with 3 items and its price for 3 years. From this information we can calculate the price index for each year and then the yearly inflation rate:
| Weight | Price-Base year-2014 | Price-2015 | Inflation/category | Price -2016 | Formulas | ||
| Food | 30% | $300 | $310 | 1% = % price increase x weight = [($310-300)/300] x 30% = 3.33% x 30% = 1% | 340 | ||
| Housing | 50% | $500 | $550 | 5% | 600 | CPI = (Price of market basket in Year n / Price of market basket in base year) x 100 | |
| Transport | 20% | $200 | $230 | 3% | 210 | ||
| Total | 100% | $1000 | $1090 | $1150 | |||
| Price Index | 100 | ($1090/1000)x100= 109 | ($1150/1000)x100= 115 | Yearly Inflation = [(CPI year 2 – CPI year 1) / CPI year 1 ] x 100 | |||
| Yearly inflation | [(109-100)x100]/100 = 9% | 9% | [(115-109)x100]/109 = 5.5% |
A word of warning: When a price index moves from, say, 107 to 110, the rate of inflation is not exactly 3%. Remember, the inflation rate is not derived by subtracting the index numbers, but rather through the percentage-change calculation. The precise inflation rate as the price index moves from 107 to 110 is calculated as (110 – 107) / 107 = 0.028 = 2.8%. When the base year is fairly close to 100, a quick subtraction is not a terrible shortcut to calculating the inflation rate—but when precision matters down to tenths of a percent, subtracting will not give the right answer.
The red line represents the Consumer Price Index while the green line represent the percentage change in the CPI i.e. the inflation rate.
You can observe that the CPI increases most years i.e. there is inflation most years. The CPI does not increase as fast each year and so the inflation can be more or less severe. The inflation has been rather mild since the 1990’s with an average of about 2%.
More details about how the CPI is calculated and some shortcomings
The most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI). The CPI is calculated by government statisticians at the U.S. Bureau of Labor Statistics based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four.
When the U.S. Bureau of Labor Statistics (BLS) calculates the Consumer Price Index, the first task is to decide on a basket of goods that is representative of the purchases of the average household. This is done by using the Consumer Expenditure Survey, a national survey of about 7,000 households, which provides detailed information on spending habits. Consumer expenditures are broken up into eight major groups, shown below, which in turn are broken up into more than 200 individual item categories. The BLS currently uses 1982–1984 as the base period.
For each of the 200 individual expenditure items, the BLS chooses several hundred very specific examples of that item and looks at the prices of those examples. So, in figuring out the “breakfast cereal” item under the overall category of “foods and beverages,” the BLS picks several hundred examples of breakfast cereal. One example might be the price of a 24-oz. box of a particular brand of cereal sold at a particular store. The specific products and sizes and stores chosen are statistically selected to reflect what people buy and where they shop. The basket of goods in the Consumer Price Index thus consists of about 80,000 products; that is, several hundred specific products in over 200 broad-item categories. About one-quarter of these 80,000 specific products are rotated out of the sample each year, and replaced with a different set of products.
The next step is to collect data on prices. Data collectors visit or call about 23,000 stores in 87 urban areas all over the United States every month to collect prices on these 80,000 specific products. A survey of 50,000 landlords or tenants is also carried out to collect information about rents.
The Consumer Price Index is then calculated by taking the 80,000 prices of individual products and combining them, using weights determined by the quantities of these products that people buy and allowing for factors like substitution between goods and quality improvements, into price indices for the 200 or so overall items. Then, the price indices for the 200 items are combined into an overall Consumer Price Index. According the Consumer Price Index website, there are eight categories used by data collectors:
The Eight Major Categories in the Consumer Price Index
In recent years, the statisticians have paid considerable attention to a subtle problem: that the change in the total cost of buying a fixed basket of goods and services over time is conceptually not quite the same as the change in the cost of living, because the cost of living represents how much it costs for a person to feel that his or her consumption provides an equal level of satisfaction or utility.
To understand the distinction, imagine that over the past 10 years, the cost of purchasing a fixed basket of goods increased by 25% and your salary also increased by 25%. Has your personal standard of living held constant? If you do not necessarily purchase an identical fixed basket of goods every year, then an inflation calculation based on the cost of a fixed basket of goods may be a misleading measure of how your cost of living has changed. Two problems arise here: substitution bias and quality/new goods bias.
When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important. Consider, as an example, a rise in the price of peaches by $100 per pound. If consumers were utterly inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to whether they have peaches or other types of fruit. Now, if peach prices rise, people completely switch to other fruit choices and the average price of food does not change at all. A fixed and unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption. Thus, substitution bias—the rise in the price of a fixed basket of goods over time—tends to overstate the rise in a consumer’s true cost of living, because it does not take into account that the person can substitute away from goods whose relative prices have risen.
The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and minerals—and also if a box of the cereal costs 5% more. It would clearly be misleading to count the entire resulting higher price as inflation, because the new price is being charged for a product of higher (or at least different) quality. Ideally, one would like to know how much of the higher price is due to the quality change, and how much of it is just a higher price. The Bureau of Labor Statistics, which is responsible for the computation of the Consumer Price Index, must deal with these difficulties in adjusting for quality changes.
Visit this website to view a list of Ford car prices between 1909 and 1927. Consider how these prices compare to today’s models. Is the product today of a different quality?
A new product can be thought of as an extreme improvement in quality—from something that did not exist to something that does. However, the basket of goods that was fixed in the past obviously does not include new goods created since then. The basket of goods and services used in the Consumer Price Index (CPI) is revised and updated over time, and so new products are gradually included. But the process takes some time. For example, room air conditioners were widely sold in the early 1950s, but were not introduced into the basket of goods behind the Consumer Price Index until 1964. The VCR and personal computer were available in the late 1970s and widely sold by the early 1980s, but did not enter the CPI basket of goods until 1987. By 1996, there were more than 40 million cellular phone subscribers in the United States—but cell phones were not yet part of the CPI basket of goods. The parade of inventions has continued, with the CPI inevitably lagging a few years behind.
The arrival of new goods creates problems with respect to the accuracy of measuring inflation. The reason people buy new goods, presumably, is that the new goods offer better value for money than existing goods. Thus, if the price index leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the price of a new good is often higher when it is first introduced and then declines over time. If the new good is not included in the CPI for some years, until its price is already lower, the CPI may miss counting this price decline altogether. Taking these arguments together, the quality/new goods bias means that the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer’s true cost of living, because it does not take into account how improvements in the quality of existing goods or the invention of new goods improves the standard of living. The following Clear It Up feature is a must-read on how the CPI is comprised and calculated.
The CPI and Core Inflation Index
Imagine if you were driving a company truck across the country- you probably would care about things like the prices of available roadside food and motel rooms as well as the truck’s operating condition. However, the manager of the firm might have different priorities. He would care mostly about the truck’s on-time performance and much less so about the food you were eating and the places you were staying. In other words, the company manager would be paying attention to the production of the firm, while ignoring transitory elements that impacted you, but did not affect the company’s bottom line.
In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned, CPI measures prices as they affect everyday household spending. Well, a core inflation index is typically calculated by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living.
Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for the nation’s gasoline was nearly knocked out. Gas prices quickly shot up across the nation, in some places up to 40 cents a gallon in one day. This was not the cause of an economic policy but rather a short-lived event until the pumps were restored in the region. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged. As a result, the Federal Reserve’s decisions on interest rates would not be influenced. Similarly, droughts can cause world-wide spikes in food prices that, if temporary, do not affect the nation’s economic capability.
As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, “It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level.” Bernanke also noted that it helps communicate that every inflationary shock need not be responded to by the Federal Reserve since some price changes are transitory and not part of a structural change in the economy.
In sum, both the CPI and the core inflation index are important, but serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is a preferred gauge from which to make important government policy changes.
Practical Solutions for the Substitution and the Quality/New Goods Biases
By the early 2000s, the Bureau of Labor Statistics was using alternative mathematical methods for calculating the Consumer Price Index, more complicated than just adding up the cost of a fixed basket of goods, to allow for some substitution between goods. It was also updating the basket of goods behind the CPI more frequently, so that new and improved goods could be included more rapidly. For certain products, the BLS was carrying out studies to try to measure the quality improvement. For example, with computers, an economic study can try to adjust for changes in speed, memory, screen size, and other characteristics of the product, and then calculate the change in price after these product changes are taken into account. But these adjustments are inevitably imperfect, and exactly how to make these adjustments is often a source of controversy among professional economists.
By the early 2000s, the substitution bias and quality/new goods bias had been somewhat reduced, so that since then the rise in the CPI probably overstates the true rise in inflation by only about 0.5% per year. Over one or a few years, this is not much; over a period of a decade or two, even half of a percent per year compounds to a more significant amount. In addition, the CPI tracks prices from physical locations, and not at online sites like Amazon, where prices can be lower.
When measuring inflation (and other economic statistics, too), a tradeoff arises between simplicity and interpretation. If the inflation rate is calculated with a basket of goods that is fixed and unchanging, then the calculation of an inflation rate is straightforward, but the problems of substitution bias and quality/new goods bias will arise. However, when the basket of goods is allowed to shift and evolve to reflect substitution toward lower relative prices, quality improvements, and new goods, the technical details of calculating the inflation rate grow more complex.
Additional Price Indices: PPI, GDP Deflator, and More
The basket of goods behind the Consumer Price Index represents an average hypothetical U.S. household, which is to say that it does not exactly capture anyone’s personal experience. When the task is to calculate an average level of inflation, this approach works fine. What if, however, you are concerned about inflation experienced by a certain group, like the elderly, or the poor, or single-parent families with children, or Hispanic-Americans? In specific situations, a price index based on the buying power of the average consumer may not feel quite right.
This problem has a straightforward solution. If the Consumer Price Index does not serve the desired purpose, then invent another index, based on a basket of goods appropriate for the group of interest. Indeed, the Bureau of Labor Statistics publishes a number of experimental price indices: some for particular groups like the elderly or the poor, some for different geographic areas, and some for certain broad categories of goods like food or housing.
The BLS also calculates several price indices that are not based on baskets of consumer goods. For example, the Producer Price Index (PPI) is based on prices paid for supplies and inputs by producers of goods and services. It can be broken down into price indices for different industries, commodities, and stages of processing (like finished goods, intermediate goods, crude materials for further processing, and so on). There is an International Price Index based on the prices of merchandise that is exported or imported. An Employment Cost Index measures wage inflation in the labor market. The GDP deflator, measured by the Bureau of Economic Analysis, is a price index that includes all the components of GDP (that is, consumption plus investment plus government plus exports minus imports). Unlike the CPI, its baskets are not fixed but re-calculate what that year’s GDP would have been worth using the base-year’s prices. MIT’s Billion Prices Project is a more recent alternative attempt to measure prices: data are collected online from retailers and then composed into an index that is compared to the CPI (Source: http://bpp.mit.edu/usa/).
What’s the best measure of inflation? If concerned with the most accurate measure of inflation, use the GDP deflator as it picks up the prices of goods and services produced. However, it is not a good measure of cost of living as it includes prices of many products not purchased by households (for example, aircraft, fire engines, factory buildings, office complexes, and bulldozers). If one wants the most accurate measure of inflation as it impacts households, use the CPI, as it only picks up prices of products purchased by households. That is why the CPI is sometimes referred to as the cost-of-living index. As the Bureau of Labor Statistics states on its website: “The ‘best’ measure of inflation for a given application depends on the intended use of the data.”
