Economists Do It With Models

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Random Link: Inflation, Explained In Terms Of Bees…

May 22nd, 2010 · 13 Comments
Econ 101 · Macroeconomics · Random Links

I’m enough of an econ nerd to find things like this interesting on a Saturday afternoon:

(If you must have some context, the video explains a little bit about the Consumer Price Index and inflation and then discusses an alternate measure of inflation that might be an improvement on the status quo. With a bee analogy of course.)

I’m pretty sure that I am in the minority on this point, but personally I find it difficult to get all worked up about inflation. This is probably because my sometimes too simplistic view of the world concludes that inflation-indexed investments and wage contracts would render inflation pretty inconsequential. (If prices go up by 5% but so do my wages and dividends, then who cares? I suppose this speaks to my lack of net worth, since I don’t think that inflation-indexed investments actually scale the amount of principal to cover inflation. On the flip side, I get a good deal on money I’ve borrowed when inflation is high, since the money is worth less when I have to pay it back, so maybe it’s all a wash.) I suppose that a the very least I get the general distaste for uncertainty, which makes efforts to manage inflation intuitively appealing. The video is pretty spot on in its discussion, especially when it explains the difference between demand-driven price changes for individual goods versus changes in the overall price level. (What it leaves out is that, in its example, the increase in the price of tea would likely be coupled by a decrease in demand and thus a price decrease of things that are substitutes for tea, so it’s not clear what the overall effect on the CPI would be.)

In general, the Consumer Price Index overstates the effective cost of living increases, since it assumes that people keep their consumption constant as prices change and just deal with the price increases. In reality, people are able to shift their consumption away from the things that got disproportionately more expensive, at least to some degree, and thus don’t have to just sit and accept the price increases.

The power of suggestion is a surprisingly powerful force, since my throat hurts and I all of a sudden decided that I need some tea with honey.

Tags: Econ 101 · Macroeconomics · Random Links

13 responses so far ↓

  • 1 Marc Cuevas // May 22, 2010 at 4:34 pm

    I think the important distinction missing, price level change is a symptom of monetary inflation as opposed to the common misconception that price change is in and of itself inflation.

    Inflation itself is the increase in money supply. What complicates it’s measure on consumer prices movement is that when new money is created it’s entry into the system is non-homogenous.

    In particular, the flow of money will follow a path of least resistance. Where incentives have been created we will see increases, also elasticity of demand on consumer purchase will also have a profound effect on where increased spending is directed.

    This brings up a core issue with the Core CPI. The excluded categories, arguably have relatively inelastic demand, food and energy. It’s conceivable that in an environment of high inflation as the prices of food and energy go up, and our demand for those relatively inelastic, we will see an income effect on other prices. This could cause something such rents to initially decrease as an effect of inflation.

    This is a simple example but it is meant to illustrate the flaws in the current models. Pricing in theoretical models is well understood. When applying modeling to real economies, we are dealing with complex adaptive systems, that as far as we currently know may not be model-able.

  • 2 Trent Rock // May 22, 2010 at 7:36 pm

    I just discovered the MEAN CPI. I like it much better. Although there isn’t a HUGE diff from the “regular” CPI. Gotta have SOME way of measuring inflation. What would we do with NO inflation data?? As long as the same method is used, you can still use them to compare. Even if the actual # is not 100% accurate.
    http://www.clevelandfed.org/research/data/us-inflation/mcpi.cfm

  • 3 Chuck Dolci // May 23, 2010 at 1:18 am

    Jodi:
    You are in a minority on this issue – most likely because you are young, employed and are carrying debt (I assume such from your comment).
    Problem is, inflation IS a significant burden on those who are not lucky enough to have union contracts with automatic, CPI tracking, pay raises and those who are on “fixed incomes”.
    Also, the person who lent you the money (through the bank that acts only as an intermediary) is not too keen on being paid back with dollars that are worth less. I assume the interest rate on your debt is fixed and not floating, otherwise you would not be paying it off with “money that is worth less”.
    Even if the bank raises interest rates on customer’s deposits it will not keep up with inflation because it will still have a lot of the “old”, fixed rate loans that are dragging down what it could pay its depositors.
    In addition, we do have to operate in a global economy, and high inflation of the dollar is going to make borrowing harder and more expensive.
    America might then be forced to live within its means.
    Now you’ve gotta admit THAT is a frightening prospect.

  • 4 Howard // May 23, 2010 at 1:38 am

    Jodi,

    Your site’s moniker “Economists Do it With Models” is accurate and cute. But you’re in Behavioral Finance/Economics. So I would suggest the moniker: “Behavioral Economists Just Do It!”.

    Best, Howard

  • 5 Alex Rodriguez // May 23, 2010 at 1:50 am

    in response to Howard, if we’re going to throw behavioral in there then how about something like “behavioral economists do it while bound”

    haha, ok i might just think myself funnier than i am, but Jodi i think that needs to go on your list! (and being credited for it wouldn’t hurt if it makes it up there) 😉

  • 6 PF // May 23, 2010 at 12:35 pm

    Jodi, as someone with a ton of debt I wouldn’t mind some debt deflation as well, but what are your thoughts on the way inflation distorts after-tax returns and capital allocation decisions? Since we are taxed on nominal and not real returns inflation would seem to shift private returns on capital to the gov’t, and can have some highly distortionary effects on capital allocation at even only moderate levels. What are your thoughts on…

    Real Int Rate + Inflation = Nominal
    Ex #1:
    2% real + 0% infl = 2% nominal return
    2% * (1-.4) = 1.2% after-tax return & 0.8% gov’t revenue

    Ex#2
    2% real + 2% infl = 4% nominal
    4% * (1-.4) = +2.4% AT nominal return
    2.4% – 2% infl = +0.4% real ROI, & +1.6% increase in gov’t revenue

    Ex#3
    2% real + 4% inflation = 6% nominal return
    6% * (1-.4) = 3.6% AT nominal return
    3.6% – 4% inflation = -0.4% real ROI & +2.4% gov’t revenue

    Would seem that the incentive to invest in new capital decreases rapidly as inflation increases.

  • 7 econgirl // May 23, 2010 at 2:50 pm

    Let me clarify in response to some of the above comments. I meant that inflation is a potential non-issue because it is possible to write contracts that adjust for inflation. I did not mean to imply that inflation is a non-issue in the status quo world because I have debt (a mortgage, to be specific, which does have a fixed rate) and you don’t. But I’ll give a “neener neener” anyway. =P

  • 8 Warren // May 24, 2010 at 12:14 am

    Actually, I would think that being under contract with automatic inflation-adjusted wages would interest you quite a bit on the subject. As you admit, the CPI “overstates the effective cost of living increases,” which I believe to be true, as well (and have used it in salary bargaining, I must admit). So, you have a vested interest in maintaining the status quo, do you not?

  • 9 Veronica // May 24, 2010 at 6:18 pm

    “The video is pretty spot on in its discussion, especially when it explains the difference between demand-driven price changes for individual goods versus changes in the overall price level. (What it leaves out is that, in its example, the increase in the price of tea would likely be coupled by a decrease in demand and thus a price decrease of things that are substitutes for tea, so it’s not clear what the overall effect on the CPI would be.)”

    Shouldn’t it be “Compliments” for tea that
    see a decrease in demand and thus a price decrease?

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