Changes in the price levels of goods and services we consume have very real and present effects on our daily lives. Say for instance, you noticed that the total price of a basket of groceries you typically purchase has gone up by 5% over the past year, and yet, your annual income has increased by only 3%. Then, it is not difficult to appreciate that compared to a year ago, you are actually economically worse-off.
Besides the erosion of consumer purchasing power, changes in the inflation rate, particularly when they are unexpected, can impact business revenues, which in turn affects the real returns on your investments. In this second instalment of a series on macroeconomics, we explore:
- the different methods to measure inflation rates
- the types of changes in inflation rates
- how inflation rates indicate the state of the economy
- what is the ideal inflation rate
Measuring the Inflation Rate
Stated formally, the inflation rate represents the percentage change in the overall price levels of goods and services in an economy. This definition implies that to accurately compute the inflation rate, economists should theoretically track the prices of all goods and services available for purchase, but to do so would be quite an insurmountable task. In practice, economists construct a basket of consumer goods and services to represent what the average consumer in a particular economy would purchase. They then track the aggregate price levels of this basket, known as the consumer price index (CPI) to compute the inflation rate.
There are a number of ways to construct the CPI. To illustrate, let’s assume that for a particular economy the consumer basket consists only of chicken and rice. Further assume the following prices and quantities purchased by a typical consumer in June 2016 and June 2017:
The most commonly used method to compute the inflation rate is to calculate the price index by holding the composition of the consumption basket constant throughout time. This is known as the Laspeyres index. From the above example, the June 2016 and June 2017 price indices are (5 × 6) + (50 × 2.50) = 155 and (5 × 7) + (50 × 3) = 185, respectively. The inflation rate over this year is then computed as 185 / 155 − 1 = 19.4%.
The second method to compute the inflation rate is to use the current composition of the consumption basket. This is known as the Paasche index. Continuing from the example, the June 2016 and June 2017 Paasche price indices are (7×6) + (55×2.50) = 137.5 and (7 × 7) + (55 × 3) = 214, respectively. This gives an inflation rate of 214 137.5 − 1 = 55.6%.
In practice, economists usually construct a consumption basket for each category of goods and services, and then apply weights to the categories to compute the CPI. Examples of these categories include food and beverage, transportation, housing and utility, medical care, etc. Because the scope and methodology for constructing price indices can vary widely across countries, one should be careful when comparing inflation rates between countries.
Another key point to note is most policy makers focus on the core inflation rate, which is the rate based on consumption baskets that exclude food and energy instead of the headline inflation rate. This is because prices of food and energy are more susceptible to short term fluctuations than other goods and services, and policy makers prefer to avoid overreacting to temporary price volatility represented by the headline inflation rate.
Types of Inflation and What They Tell Us about the Economy
There are various terms economists use to describe the changes in the inflation rate. Very often, the type of inflation a particular economy undergoes is a manifestation of the current state of the economy. Thus, the type of changes in the inflation rate is a useful indicator of the economy’s health.
Deflation. This describes a consistent decrease in the CPI, or in other words, a negative inflation rate. Whenever deflation occurs, it means the value of money actually increases since goods and services are becoming cheaper. At first pass, deflation seems like a great thing for consumers. But, as prices of goods and services fall, revenues of companies start declining. In addition, debt of companies also increase in real terms. The combined effect often leads companies to scale back investments and workforce, resulting in high unemployment. Thus, deflation is a clear indicator of an economic slowdown, which may lead to a recession.
Hyperinflation. This describes a very fast increase in the inflation rate (e.g. 500% a year). Very often, hyperinflation occurs as a result of a chronic shortage in supply of goods and services. And, as price levels rise quickly, more cash changes hands at a rapid rate, feeding greater price increases. Another cause of hyperinflation is unencumbered government spending through increasing the money supply (i.e. printing more money) without being backed by real revenue. Hyperinflation is extremely bad news. Because consumers lose their purchasing power very quickly, economic distress ensues and if left unrectified, will lead to outright economic collapse.
What is the Ideal Inflation Rate?
As discussed, neither deflation nor hyperinflation is good for the economy. In fact, even a high inflation rate that is coupled with fast economic growth and low unemployment (the latter two conditions are associated with a healthy economy) is not a good sign because it indicates the economy is overheating. If you guessed that the best outcome must be a zero inflation rate, then you are absolutely right!
Well the problem is, it is almost impossible for the economy either on its own or through the guiding interference of the monetary authority to achieve zero inflation. Policy makers actually avoid targeting a zero inflation rate because it could easily enter negative territory. For most developed economies, the typical preferred inflation rate is around 2% per year. A low and sustained positive inflation rate does not adversely affect consumer purchasing power and real asset values too much, while ensuring that the economy is growing at a sustainable pace.
An important takeaway from our discussion here is despite conscientious efforts by policy makers to maintain near-ideal inflation rates, actual inflation can still deviate because of self-sustaining inflation expectations. Fortunately in most developed economies, markets attempt to measure such expectations and structure investments to protect investors from high inflation rates.
Missed macroeconomic matters part 1? Click here to catch up.
Dr. Alvin Ang is a management consultant at Research Room with specialized expertise in analysis and research on finance and economics. Dr. Ang is a former investment banker and portfolio manager in the United States. He was also a lecturer in finance at the University of New South Wales in Australia.