Socratic Economics IV: How is inflation calculated? | 41 comments (41 topical, editorial, 0 hidden)

There are two basic ways to measure ... (4.00 / 3)

... inflation.

First, you can define a "basket" of goods, and measure how the total cost of buying the basket changes over time. Here, the inflation rate is simply the percentage rate of change of the sum total to buy the basket. This is used for Consumer Price Index, Producer Price Index, and a range of others.

A limitation here is that this approach will always only represent the change in prices of the representative items in the basket. So the Second way is to take the value of a set of transactions, such as GDP, and measure what would have been the value if the prices had not changed. This gives the so-called "Real" GDP. The ratio of actual GDP to "real" GDP gives the index, called a "deflator", and the rate of inflation is the percentage change in the deflator.

This still has the problem what to do with goods that appeared in one year and where not present previously, either because they did not exist, or because they represent a qualitative improvement. At one time, the US used a base set of prices that was fixed for a decade or more, so there was a series of deflators "indexed to 1982", for example, if the prices were from 1982.

But while a personal computer from 1982 can, with sufficiently clever programming, connect to the internet, it does not have the processing power or memory to run, for example YouTube clips of claymation political satire. And so there has been a move from a fixed index to comparing each year to the previous year, which is called a "chain index".

More critical for the US is that the Fed focuses on the s0-called "base" inflation rate, excluding prices of goods that have historically had more price volatility than inflation over time ... like food and gasoline. However, if in fact we have entered a period of a long term rising trend in energy prices, this is no longer warranted.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Oct 10th, 2007 at 02:46:10 PM EST

Re: There are two basic ways to measure ... (none / 1)

I see.

Does the resulting inflation numbers vary greatly between approaches or are they somewhat the same? When Central banks are fighting inflation which index do they use? Different ones?

Ron Paul is then (one can assume) writing about the difference between the Fed base inflation rate and something else (that includes food and gasoline ( perhaps consumer price index))?

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Wed Oct 10th, 2007 at 03:31:00 PM EST
[ Parent ]

Re: There are two basic ways to measure ... (4.00 / 3)

Have you checked the Wikipedia article on Price Indices?

Some notable price indexes include:

Consumer price index

Producer price index

Personal consumption expenditures price index

And to that one must add at least the GDP Deflator.

So, there are at least four indices one can call "inflation", and for each of them one can ank the methodological question of how it is calculated.

We have met the enemy, and it is us — Pogo

by Migeru (migeru at eurotrib dot com) on Wed Oct 10th, 2007 at 06:11:20 PM EST
[ Parent ]

The 'market basket' price indices almost always .. (4.00 / 5)

... are different ... that is the point of doing them, to view the impact of price changes on the typical consumer, or a typical low-income consumer, or a typical producer (or heavy industry producer, or light industry producer), etc.

For the GDP deflators, I believe that the differences between the overall inflation rate and the "core" rate excluding food and fuel are more important than the difference between using a single base year and using a chain index, but that is an off the cuff reaction ... I haven't checked that out.

Anytime the inflation rate is reported, it is a lie ... but the lie is in "the". There is no such thing as "the" inflation rate ...

... the only precise rate of price inflation is the price inflation of a particular product over time, which means that there are as many exact inflation rates as there are products, with a new series coming into existence every time a new product is introduced or a substantial change is made, and an old series extinguished every time an existing product is withdrawn from production or substantially changed.

SO, for example, to compare gas prices in the US today with prices at the peak of the second OPEC oil price shock, to get at any kind of detail at all, I should use:

The overall CPI to look at it in terms of a typical consumer
The low-income CPI to look at it in terms of the most vulnerable consumers
The PPI to look at it in terms of impacts on producers (and likely employment)

However, if I am making a sweeping statement, I will likely reach for the GDP deflator, since it includes all newly produced goods and services for all final customers ... households, government, business ... and net impact on trade.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Oct 10th, 2007 at 06:41:40 PM EST
[ Parent ]

Re: There are two basic ways to measure ... (4.00 / 3)

A limitation here is that this approach will always only represent the change in prices of the representative items in the basket.

Why is that a limitation? If you make your list out of relevant and largely unavoidable expenses - food, housing, transport and utilities - surely your represenative list will remain representative for long periods.

So the Second way is to take the value of a set of transactions, such as GDP, and measure what would have been the value if the prices had not changed. This gives the so-called "Real" GDP. The ratio of actual GDP to "real" GDP gives the index, called a "deflator", and the rate of inflation is the percentage change in the deflator.

This also ties GDP closely to 'growth', because a lot of apparent growth will come from increased prices - and this has a worrying circularity about it, as a notion.

And so there has been a move from a fixed index to comparing each year to the previous year, which is called a "chain index".

This is now making less and less sense, and moving further and further away from anything that might pass as a coherent understanding of what inflation really means to most people, which is the fact that the same sum of money buys less than it used to.

The PC utility argument is nonsensical, because it's equating being able to watch claymation with being able to eat and keep the rain out - or in other words equating discretionary disposable income with basic living costs.

I can buy the volatility argument, however, especially for prices with reliable seasonal variations. But it should be easy enough to average those out - it's standard practice for retail sales figure in the UK.

So I think the basket idea remains the most useful by a long way - especially now.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Wed Oct 10th, 2007 at 04:52:14 PM EST
[ Parent ]

Re: There are two basic ways to measure ... (none / 1)

I think I have argued along the following lines before in a comment thread, but let's do it again...

The nominal GDP is easily understood: the price of all goods and services purchased in a year:

G = sum_i p_i q_i

where i labels the products, p is price (or the average average for similar products/services) and q is quantity. (Price here is properly replaced by value added, but for the purposes of this argument that's a nitpick)

Then, approximately from one time period to the next...

dG = sum_i dp_i q_i + sum_i p_i dq_i + O(dt²)

The first term is inflation, the second term is real GDP growth, and the third term is an error term that becomes negligible when the time periods are small enough.

We have met the enemy, and it is us — Pogo

by Migeru (migeru at eurotrib dot com) on Wed Oct 10th, 2007 at 06:20:04 PM EST
[ Parent ]

Its not circular, its a correction ... (4.00 / 2)

... even if it can only ever be an approximate correction:

This also ties GDP closely to 'growth', because a lot of apparent growth will come from increased prices - and this has a worrying circularity about it, as a notion.

GDP deflator = [Actual GDP/"Real" GDP]x100

so:

GDP deflator inflation rate approximately equals
% growth in Actual GDP minus % growth in "Real" GDP.

I put the "Real" in ironic quotes, because the number is constructed by supposing that prices had not changed but that the precise same quantities of goods had been sold anyway.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Oct 10th, 2007 at 06:46:40 PM EST
[ Parent ]

Re: Its not circular, its a correction ... (4.00 / 3)

Well, that's a nice way to fudge it. :)

I still think it's circular because it's not making a qualitative distinction between different kinds of prices.

The simplest social definition of inflation is that it decreases the choices available to participants in the economy.

This means not all prices are equal. If food becomes 50% more expensive, I have little or no choice but to buy it. (Assuming I'm on a standard and not on a luxury diet.) That means my choices decrease - I have less money to spend on non-essentials, and I have no flexibility in this.

If luxury yachts become 50% more expensive, no one's choices are seriously diminished. Yacht wannabes may feel the inflationary sting of not being able to afford the model they want, but yacht buying remains a discretionary activity. And if a yacht becomes unaffordable, it's always possible to spend an equivalent amount on something equally weighed down with bling.

So even though increased yacht prices may count towards inflation using the GDP definition, the price increase is voluntary, the decision to buy is voluntary, and the profit will most likely be recycled into the economy.

But with food prices, the price increase may not be voluntary (because it may be going on overheads), the decision to buy isn't voluntary (or is at least tightly constrained) and the money effectively disappears. (I suppose technically some of it could be recycled as profit, but that's not how it seems to work out.)

So - some prices affect freedom of choice much more than others. And price inflation in some parts of the economy is much more damaging than in other parts. A proper analysis would pick out price elasticity and capital mobility as elements too. (E.g. capital tied up in house prices is, at least partly, lost to the economy, and therefore house price rises are highly inflationary - even thought they're not counted as such today.)

by ThatBritGuy (thatbritguy (at) googlemail.com) on Thu Oct 11th, 2007 at 05:18:25 AM EST
[ Parent ]

Re: Its not circular, its a correction ... (4.00 / 4)

I still think it's circular because it's not making a qualitative distinction between different kinds of prices.
The simplest social definition of inflation is that it decreases the choices available to participants in the economy.
This means not all prices are equal. If food becomes 50% more expensive, I have little or no choice but to buy it. (Assuming I'm on a standard and not on a luxury diet.) That means my choices decrease - I have less money to spend on non-essentials, and I have no flexibility in this.

I guess economists would wiggle out of this one by pointing out that, unless price rises happen in non-substitutable staples, people can always switch to other foodstuffs.

If there are Giffen Goods in the economy, of course, that is not the case.

But I think however you construct it (even if you do it in what you'd call a "socially sensible way") the GDP Deflator and the Real GDP are not directly measurable, but have to be constructed from the details of the Nominal GDP, which is measurable (at least in principle).

I guess this is another case of an economist going and saying "look here: nominal GDP growth consists of two components: real GDP growth and inflation", and people going "ooh, ahh", and after giving the economist his Nobel price going "but how do you calculate real GDP and inflation?". And after much debating turning to the statisticians and saying "guys, here's the data on all the goods and services traded over time, with amounts and prices". Please figure out a way to calculate the Real GDP and the GDP Deflator.

By the way, there's the following juicy quotation from Keynes:

That the units, in terms of which economists commonly work, are unsatisfactory can be illustrated by the concepts of the national dividend, the stock of real capital and the general price-level:
...
Thirdly, the well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purposes of causal analysis, which ought to be exact.
Nevertheless these difficulties are rightly regarded as 'conundrums'. They are 'purely theoretical' in the sense that they never perplex, or indeed enter in any way into, business decisions and have no relevance to the causal sequence of economic events, which are clear-cut and determinate in spite of the quantitative indeterminacy of these concepts. It is natural, therefore, to conclude that they not only lack precision but are unnecessary. Obviously our quantitative analysis must be expressed without using any quantitatively vague expressions. And, indeed, as soon as one makes the attempt, it becomes clear, as I hope to show, that one can get on much better without them.
The fact that two incommensurable collections of miscellaneous objects cannot in themselves provide the material for quantitative analysis need not, of course, prevent us from making approximate statistical comparisons, depending on some broad element of judgement rather than of strict calculation, which may possess significance and validity within certain limits.
But the proper place for such things as net real output and the general level of prices lies within the field of historical and statistical description, and their purpose should be to satisfy historical or social curiosity, a purpose for which perfect precision—such as our causal analysis requires, whether or not our knowledge of the actual values of the relevant quantities is complete or exact—is neither usual nor necessary. To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better Queen but not a happier woman than Queen Elizabeth—a proposition not without meaning and not without interest, but unsuitable material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of our quantitative analysis.
— John M. Keynes in The General Theory of Employment, Interest and Money

We have met the enemy, and it is us — Pogo

by Migeru (migeru at eurotrib dot com) on Thu Oct 11th, 2007 at 05:43:20 AM EST
[ Parent ]

Re: Its not circular, its a correction ... (4.00 / 4)

I guess economists would wiggle out of this one by pointing out that, unless price rises happen in non-substitutable staples, people can always switch to other foodstuffs.

They could, but they'd also admit that the switch was being forced and not a matter of choice. Whereas if prices dropped while wages rose, buyers would have increased choice.

I think if you use choice as the bottom-line criterion a lot of the conceptual confusion disappears.

The problem becomes quantifying that choice. And it's possible a simple one-line model may not be the best way to do that - and also that choice will vary for different groups, and optimising choice for one demographic may lower the choice of another.

As usual it's a political problem, not an econometric one. You can't create good metrics until you decide what you're trying to achieve socially and politically.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Thu Oct 11th, 2007 at 07:42:29 AM EST
[ Parent ]

The inflation rate according to that ... (4.00 / 2)

... definition are the various CPI's and PPI's (depending on the group of participants you want to focus on).

For the definition of inflation as a sustained, ongoing increase in the average price level in the economy, where the "social definition" above is understood as one possible but not necessary consequence, then some form of GDP deflator is the only practicable approach to encompass that.

And, of course, the "social definition" does not in fact encompass every important scenario involving price inflation, as when there is rapid economic growth accompanied by mild inflation, where the inflation may be redistributing some of the gains but is not imposing substantial losses, and the main concern for those wishing to push the the rate of inflation down is that the redistribution is going from people holding wealth denominated in monetary terms to people holding wealth in real productive capacity and most workers.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Oct 11th, 2007 at 02:15:34 PM EST
[ Parent ]

Re: There are two basic ways to measure ... (none / 1)

But what is the accuracy of the computation of GDP?

IIRC, GDP is not a measurement, per se, but an estimate. Which is a horse of a different guacamole, epistemologically speaking.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Thu Oct 11th, 2007 at 06:55:03 AM EST
[ Parent ]

Re: There are two basic ways to measure ... (none / 0)

But at least Nominal GDP is a well-defined concept, in principle, even if it is hard to quantify.

For the thermodynamics buffs, this makes Nominal GDP Growth an exact differential, but Real GDP Growth and Inflation are inexact differentials. This means Nominal GDP is a "state variable" and path-independent, but Real GDP and the GDP Deflator are path-dependent and not state variables.

We have met the enemy, and it is us — Pogo

by Migeru (migeru at eurotrib dot com) on Thu Oct 11th, 2007 at 07:02:04 AM EST
[ Parent ]

Yes, as actual GDP is an aggregate of ... (none / 1)

... something which can be aggregated, a monetary amount, while inflation and/or "real" GDP (whichever comes first ... with a market basket it is the inflation index that comes first and "real" values are imputed from that, with a deflator it is the other way around) are an effort to provide a simple index value to summarize a relationship between vector quantities.

Keynes' basic argument for working in terms of nominal amounts and employment was that the ability of a person to work as unskilled labor if need be provided a connection between various specialized and more restricted skilled labor markets in terms of their renumeration as a multiple of the wage of unskilled labor, providing a quantity that could be aggregated with greater justification than the vector of the amount produced of each and every different type of final product for sale in the economy.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Oct 11th, 2007 at 02:22:09 PM EST
[ Parent ]

Socratic Economics IV: How is inflation calculated? | 41 comments (41 topical, 0 editorial, 0 hidden)

Top Diaries

City Agriculture - March 17, 2023

What's Next, After the Slam?

Shock Election Loss Rutte IV In Senate Race

Honduras Establishes Close Ties with China

A Return to Normalcy?

A Grand Slam for Ireland?

Recent Diaries

History Hillsdale College, Alumni and Domestic Terror

Struggle NWO Unipolar or Multilateralism

Neo-Nazi Marches Across Europe

Fascism Unites America, Israel and EU Neo-Nazis

What's Next, After the Slam?

Settler Extremism Blessed by Jerusalem Leaders

US Interference In Lebanon-Syria-Ira
q

City Agriculture - March 17, 2023

Shock Election Loss Rutte IV In Senate Race

Stalemate Endures, Pessimism Grows, Deaths Mount

Honduras Establishes Close Ties with China

A Grand Slam for Ireland?

Living In Spain and Social-Democracy

USA Censorship Act to Kill Disinformation

Flying Fortresses and Nuclear Threat

Universal Criticism Asylum Threshold EU Fortress

China Trade and Relations

SBU As a Terror Network

A Return to Normalcy?

Georgia and Foreign Agents or Spy Law

Occasional Series