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Modern economies are characterised by two major problems: inflation and unemployment.  In the previous chapter we have briefly analysed these two variables in the context of a simple classical model using the AS\AD framework.  Now we study inflation more closely, trying to understand the nature, the causes, the costs and the possible solutions.  We have also to be aware that not only inflation is bad for a society, but the distribution of its costs is not equal among groups of citizens and components of the economy.

To establish and maintain price stability is a major task for any government.  Inflation can disrupt the business environment and easily get out of control.  Given the relationships with exchange rates, interest rates and monetary policy (which will be highlighted in next chapters), business needs to understand inflation and its consequences if investment decisions are to be properly assessed.


Q1 How is the inflation rate calculated? Why might standard measures of inflation overestimate the 'true' rate of price increase? Why does it matter if they do?

Inflation is calculated as the percentage change of the total money cost of a basket of consumer goods and services.  The basket of goods should be a representative sample of the spending pattern of the average household in the economy.  Problems of calculation include:

i) The choice of the goods and services included in the basket. Consumption patterns change along the time. As the standard of living rises, new goods are consumed, old goods are not produced anymore, certain goods change specifications and improve quality. The basket has to register as much as possible all the movements in the type and quality of household's spending, and for this reason it is revised periodically.

ii) The choice of how to calculate prices: prices differ according to the type of shop (small shop vs. supermarket), the place (city centre vs. suburbs), the type of consumer (i.e., student discounts) and the time of purchasing (i.e., discounted cinema tickets in the afternoon).

There are three main sources of overestimation bias:

i) Composition bias: this refers to the delay in incorporating new goods into the consumer basket. If consumers substitute old expensive record players with new cheap CD players, the delay in recording this change can lead to overestimation of true inflation.

ii) Quality bias: this refers to the changing quality of existing goods. New cars can be more expensive than old cars, but the difference in price can be due to higher quality (increased resistance, new technology…). If the new car is considered as the old car, this creates an upward bias in recorded inflation.


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