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CPI Concerns

Jan 25, 2011 • Demand, Supply, and Markets, Developing Economies, Economic Debates, Macroeconomic Measurement, Money and Monetary Policy, Thinking Economically • 137 Views    1 Comment

Should we care if China has a 5.1% annual inflation rate?  A little.

The International Herald Tribune tells us that just 1/4 to 2/5 of the price we pay in the U.S. for an imported item reflects the cost of the good. Other slices of the price pie such as transportation, wages and salaries, profit, and electricity bills have more of an impact.

Instead, it is the Chinese citizen that will suffer. One Chinese official said, “4 percent, China can bear it-beyond 5 percent, people will complain a lot.” And, according to this journalist, because the Chinese use an outdated list of goods and services, the actual rate could even be twice as high.

But then, many people challenge the contents of the market basket on which we base our inflation statistics. With 8 categories of goods and services (food and beverages, housing, apparel, transportation, medical care, recreation, education & communication, other goods & services), the CPI might not be changing fast enough to reflect changes in spending. Here, we talked about the Billion Prices Project as an alternative.

The Economic Lesson

For the U.S. Consumer Price index (CPI) monthly, we not only hear an inflation rate but also the core rate that excludes food and energy. Some economists believe that the most accurate way to track inflation is through that “core” inflation rate. Why? Because a basic goal of inflation statistics is to convey price trends. By eliminating food and energy which tend to be more volatile than the other 6 categories of the CPI, the actual trajectory of prices might be more accurately displayed. To see trends firsthand, you might want to look here for a history of inflation rates in different countries until 2009.

Using the rule of 70 (70 divided by the percent change), 5.1% Chinese inflation means that prices will double every 14 years. Looking at recent US inflation, $1987.70 in 2010 had the same purchasing power as $1000 in 1986 according to a Federal Reserve bank of Cleveland Inflation Calculator.

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  • sherg11

    According to “New Ideas from Dead Economists”, “wealth is measured by the goods and services it can buy, not by numerals.” If $1987.70 in 2010 can purchase the same amount of goods and services that $1000 could in 1986, then more money today is worth the same as less money back then. This rise in the inflation rate, which would also lead to a rise in prices, could be controlled by the Fed. According to monetary policy, the Fed can put the “brakes” on the economy by selling bonds to the public in order to contract the money supply. The new owners of the bonds would pay the Fed for these bonds, and the money that the Fed now owns is no longer considered part of the money supply. The Fed can also control the amount of loans that banks make, and if the Fed tells banks to make fewer loans, the money supply will shrink. Lastly, the Fed can also raise the interest rate on the loans they make to banks, which discourages the banks from making their own loans. This also lowers the money supply. Less money supply means lower prices and lower inflation.

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