Ecological EconomicsLecture 07

Tiago DomingosAssistant Professor

Environment and Energy SectionDepartment of Mechanical Engineering

Doctoral Program and Advanced Degree in Sustainable Energy SystemsDoctoral Program in Mechanical Engineering

Doctoral Program in Environmental Engineering

• Inflation – changes in consumer prices

• Affects:– Exports,

– Erosion of consumer power

– Distorts the intertemporal comparisons of variables in monetary units, e.g., evaluating the profitability of an investment.

• What part of the change in national accounts aggregates at current prices comes from a change in the quantities (changes in volume) produced and what part comes from a change in prices (inflation)?

Temporal Comparison - Real vs Nominal

i ii

GDP P Q

• What is the nominal GDP in each year and the nominal GDP growth rate?

• What does the above value represent?

• How to obtain real (volume) growth changes?

Temporal Comparison - Real vs Nominal

Item Quantity

Price

2007

Bread 100 €1.00

Butter 20 €5.00

2008

Bread 160 € 0.50

Butter 22 € 22.50

Nominal GDP in:

- 2007, €200

- 2008, €575

Growth rate: 187,5 %

• Consumer Price Index (CPI)

– It is based on a fixed (changes every 5 years) basket of goods that are normally an important part of households’ consumption.

• 1 – Fix the Basket – which prices are most important to the typical consumer? Put weights by surveying consumers and finding the basket of goods and services that the typical consumer buys.

• 2 – Find the prices for each good and service in the basket.

• 3 – Compute the basket’s cost (price times quantity)

• 4 – Choose a base year and compute the CPI Formula

• 5 – Compute inflation as the rate of change in CPI

Price Level and CPI

• Basket of goods: 5 Breads, 1 Butter

• What is the inflation rate?

• Inflation rate = rate of change of price level, • 150% = (250-100)/100

Price Level and CPI

Item Quantity Price Cost of Basket CPI

2007 €10 100

Bread 100 €1.00

Butter 20 €5.00

2008 €25 250

Bread 160 € 0.50

Butter 22 € 22.50

• Using the CPI to deflate Vyear x to Vbase year:

• Vbase year = (CPIbase year ÷ CPIyear x ) Vyear x.

• What is the real GDP and its real growth rate?

• 15 %

• What does the above value represent, compared to nominal growth 187,5%?

Price Level and CPI

Item Nominal GDP CPI Real GDP

2007 €200 100 €200

2008 €575 250 €230

• First national CPI (PT) in 1977, after “inquérito às despesas das famílias” 1973/1974.

• Increase in number of items, establishments and reference population

• Now: Fixed base year using average prices of 2008 (Changed in 1976, 1983, 1991, 1997)

• CPI is in fact composed of several indexes for different classes of consumption (COICOP - Classification Of Individual COnsumption by Purpose)

• More than 700 items (goods and services) in more than 10 000 establishments yielding more than 70 000 prices on a monthly basis for a given reference population (total population).

• These basket is changed every 5 years.

CPI in Portugal

CPI in Portugal: Basket

COICOP (1) Divisions, Groups and Classes Year: 2009  Jan Feb Mar Apr         

Food and non alcoholic beverages 99,9 99,4 98,8 98,3Food 99,9 99,4 98,8 98,2 Bread and cereals 101,1 101,3 101,1 101,2 Meat 101,8 100,2 99,7 99,4 Fish 98,9 98,4 95,5 93,4 Milk, cheese and eggs 99,0 97,3 96,4 95,3 Oils and fats 98,2 96,4 94,4 93,1 Fruit 95,8 96,1 97,9 98,7 Vegetables 100,7 102,8 104,9 105,3 Sugar, jam, honey, chocolate and confectionery 101,1 101,1 100,9 101,0 Food products n.e.c. 99,5 99,9 100,4 100,7 Non-alcoholic beverages 100,1 99,8 100,0 100,7 Coffee, tea and cocoa 101,5 101,0 100,8 101,6 Mineral waters, soft drinks, fruit and vegetable juices 99,6 99,3 99,7 100,4 Alcoholic beverages, tobacco 101,4 101,5 103,1 103,1 Alcoholic beverages 102,4 102,5 102,4 102,4 Spirits 99,9 101,2 100,1 99,5 Wine 103,0 103,0 103,5 103,7 Beer 101,9 101,4 100,4 100,1 Tobacco 101,0 101,0 103,2 103,3

Clothing and footwear 88,5 85,8 103,0 103,7Clothing 87,7 85,1 103,2 103,8 Clothing materials 101,0 100,3 100,2 102,0 Garments 87,1 84,3 103,4 104,0 Other articles of clothing and clothing accessories 88,2 87,5 95,7 97,5 Cleaning, repair and hire of clothing 100,8 101,1 101,2 101,4Shoes and other footwear including repair and hire of footwear 90,9 87,8 102,2 103,4 Footwear 90,6 87,5 102,2 103,4 Repair and hire of footwear 102,2 102,5 102,6 102,7 Housing, water, electricity, gas and other fuels 101,8 101,9 102,0 101,9 Actual rentals for housing 101,4 101,7 102,2 102,4 Actual rentals paid by tenants including other actual rentals 101,4 101,7 102,2 102,4 Maintenance and repair of the dwelling 101,4 101,4 101,5 101,8 Materials for the maintenance and repair of the dwelling 101,9 102,0 102,2 102,6 Services for the maintenance and repair of the dwelling 101,1 101,1 101,1 101,3 Water supply and miscellaneous services relating to the dwelling 103,2 104,0 104,4 104,6 Water supply 101,9 102,9 103,4 103,6 Refuse collection (2) 101,4 101,8 102,6 103,9 Sewerage collection (2) 102,5 104,4 104,7 104,7 Other services relating to the dwelling n.e.c. 105,5 105,5 105,5 105,5 Electricity, gas and other fuels 101,0 100,8 100,5 100,1 Electricity 104,2 104,2 104,2 104,2 Gas 95,1 94,5 94,5 92,6 Liquid Fuels (2) 97,2 96,4 90,9 95,0 Solid fuels 100,2 100,5 98,4 98,6

Furnishings, household equipment and routine maintenance of the house 101,9 101,7 101,8 101,8 Furniture and furnishings, carpets and other floor covering 99,8 99,4 99,6 99,6 Furniture and furnishings 99,8 99,4 99,6 99,5 Carpets and other floor coverings 99,4 98,8 98,1 99,5 Repair of furniture, furnishings and floor coverings 101,9 102,3 102,4 102,8 Household textiles 100,3 99,3 98,8 99,4 Household textiles 100,3 99,3 98,8 99,4 Household appliances 100,5 100,4 100,5 100,4 Major electric household appliances 100,4 100,2 100,3 100,1 Small electric household appliances 100,6 100,7 101,0 100,9 Repair of household appliances 101,5 102,4 102,6 102,8 Glassware, tableware and household utensils 100,8 100,8 100,9 101,1 Glassware, tableware and household utensils 100,8 100,8 100,9 101,1 Tools and equipment for house and garden 101,6 101,9 101,8 101,9 Major tools and equipment for house and garden 100,3 100,2 100,4 99,9 Small tools and miscellaneous 101,7 102,3 102,1 102,5 Goods and services for routine household maintenance 103,5 103,4 103,5 103,5 Non-durable household goods 100,4 100,0 100,4 100,3 Domestic services and household services 105,6 105,6 105,6 105,7

Health 99,6 99,3 99,3 99,4 Medical products, appliances and equipment 98,2 98,3 98,2 98,4 Pharmaceutical products 97,2 97,2 97,0 97,1 Other products and medical appliances 101,3 101,4 101,4 101,1 Therapeutic appliances and equipment 101,1 101,3 101,6 101,9 Out-patient services 100,7 100,9 100,9 101,1 Medical services 100,9 101,3 101,4 101,5 Dental services 100,7 100,7 100,7 100,9 Paramedical services 100,0 100,2 100,2 100,3 Hospital services 100,7 95,7 95,7 95,9

Transport 93,6 94,7 94,4 95,7 Purchase of vehicles 101,5 101,4 101,3 101,1 Motor cars 101,5 101,4 101,3 101,1 Motor cycles 100,6 101,2 101,8 102,9 Bicycles 100,8 100,4 99,6 98,9 Operation of personal transport equipment 86,2 88,0 87,6 89,8 Spare parts and accessories 98,1 97,5 96,7 96,2 Fuels and lubricants 78,6 80,9 80,3 83,1 Maintenance and repair of personal transport equipment 100,8 101,2 102,1 102,7 Services in respect of personal transport equipment 101,8 101,9 102,0 102,1 Transport services 95,9 97,7 96,8 98,3 Passenger transport by railway 101,0 101,7 101,7 101,7 Passenger transport by road 102,8 103,3 103,4 103,4 Passenger transport by air 79,7 85,8 82,0 88,0 Passenger transport by sea and inland waterway 103,2 103,5 103,5 105,9 Combined passenger transport 100,1 100,1 100,1 100,1 Other purchased transport services 99,1 99,1 99,1 99,3

Communication 98,3 98,2 99,3 99,3 Postal services 102,2 103,9 103,9 103,9 Postal services 102,2 103,9 103,9 103,9 Telephone and telefax equipment 89,0 88,6 88,5 89,0 Telephone and telefax equipment 89,0 88,6 88,5 89,0 Telephone, telegraph and telefax services 98,4 98,3 99,5 99,5

Education 102,5 102,7 102,7 102,7 Pre-school and primary education 102,8 102,8 102,8 102,8 Pre-school and primary education 102,8 102,8 102,8 102,8 Primary and secondary school 100,9 101,2 101,2 101,2 Primary and secondary school 100,9 101,2 101,2 101,2 Higher education 103,0 103,0 103,0 103,0 Higher education 103,0 103,0 103,0 103,0 Other types of education 102,6 103,1 103,2 103,4 Other types of education 102,6 103,1 103,2 103,4 Hotels and restaurants 101,3 101,5 101,9 102,4 Catering services 101,7 102,1 102,4 102,5 Restaurants, cafes, bars and like 101,2 101,5 101,9 102,0 Canteens 106,1 106,3 106,5 106,7 Accommodation services 89,5 87,0 89,6 98,9

Recreation and culture 99,1 99,1 98,4 98,6 Audio-visual, photographic and data processing equipment 96,1 94,2 92,2 92,0 Equipment for the reception, recording and reproduction of sound and pictures 96,0 94,6 92,5 92,1 Photographic and cinematographic equipment and optical instruments 90,9 91,1 90,0 88,8 Data processing equipment 92,5 90,2 87,9 87,4 Recording media for pictures and sound 99,0 96,6 94,8 95,7 Repair of audio-visual, photographic and data processing and accessories 102,7 103,2 103,7 104,6 Other major durables for recreation and culture 98,0 98,4 98,9 98,9 Major durables for outdoor recreation (2) 100,0 100,2 100,2 100,2 Major durables for indoor recreation including musical instruments 97,6 98,4 99,3 99,4Other recreational items and equipment, garden and pets 102,1 103,3 100,0 99,7 Games, toys and hobbies, equipment for sport camping and open-air recreation 97,0 95,8 95,6 94,7 Other recreational items for hobbies and recreation 98,8 98,9 98,9 99,3 Gardening 108,7 115,2 98,1 94,4 Pets and related products 102,1 102,6 102,7 103,8 Recreational and cultural services 99,8 100,2 100,3 101,3 Recreation and sporting services 98,4 100,1 100,4 100,3 Cultural services 100,4 100,6 100,7 102,6 Games of chance 100,0 100,0 100,0 100,0 Newspapers, books and stationery 102,1 102,0 101,5 101,7 Books 101,6 101,3 100,0 100,4 Newspapers and periodicals 103,5 103,6 103,6 103,7 Miscellaneous printed materials 100,6 100,7 101,5 101,6 Package holidays 91,8 90,8 91,2 90,0 Package holidays 91,8 90,8 91,2 90,0

Miscellaneous goods and services 101,4 101,5 101,6 101,9 Personal care 101,2 101,5 101,8 102,2 Hairdressing salons and personal grooming establishment 101,2 101,4 101,7 102,0 Articles for personal care 101,0 101,4 101,3 100,8 Products for personal care 101,2 101,6 101,9 102,3 Personal effects n.e.c. 102,2 100,8 101,4 102,1 Jewellery, clocks and watches 104,1 103,1 103,2 103,7 Other personal effects 99,5 97,8 98,8 99,7 Social protection 103,0 103,1 103,1 103,1 Social protection services 103,0 103,1 103,1 103,1 Insurance 100,5 100,3 100,3 100,3 Insurance connected with the dwelling 102,2 102,2 102,2 102,2 Insurance connected with health (2) 100,9 101,7 101,7 101,7 Insurance connected with transport 100,0 99,6 99,6 99,5 Other insurance (2) 100,6 100,6 100,6 100,6 Financial services n.e.c. 100,7 100,7 100,8 101,0

CPI in Portugal: Basket

• Example:

• Washing machine; white; frontal door; 5 kg of clothes; 2200 W; 12 – 14 programs

• Pants; Wool (45%) and polyester (55%), two lateral pockets; one back pocket, no fold; good finishings, 46/48.

Source: AMECO database

Inflation rate in Portugal [%]

Real vs. Nominal (Portugal) [Mrd euros]

Source: AMECO database

• Objective: Measure changes in the cost of living

• Substitution bias:

• prices change differently consumers buy more of cheaper goods, yet the basket is fixed.

• Overstates the increase in prices

• Technological progress

• New goods more variety each € is more valuable since it buys more goods. E.g., introduction of VCRs

• CPI even with the revised basket never shows the decrease in life cost due to new products.

• Quality Change:

• Quality increases value of one € decreases even if the price of the good stays the same

• Prices are adjusted but quality is hard to measure

• No environmental goods, …

Problems with the CPI

Present Value of Money

• Present Value– Conversion of money flows to their present value

• NPV: Net Present Value

• i: interest rate

• VFt(t): value at instant t

• If VF is in current prices then i is the nominal interest rate

• If VF is in constant prices then i is the real interest rate

t

T

ttVF

iNPV

0 1

1

Nominal vs. real interest ratesThe Fisher relation

)inflation1)(real1(nominal1

For low rates, this is approximately equal to

inflationrealnominal

Present Value of Utility

• Welfare– Discrete time

– Continuous time

T

tt tUW

0 1

1

T

t

t- dttUW0

e

Discount RateJustification and Components

• The same monetary flow at different instants does not have the same value (time preference)

– CONSUMPTION: Uncertainty• Being alive in the future (individual vs. society)

• Preferences in the future

• Value of the benefit or the cost

– CONSUMPTION: Impatience

– PRODUCTION: Capital productivity (opportunity cost of capital)

• Under certain conditions, the discount rate is equal to the real market interest rate

consumption discount rate

per capita consumption growth rate

elasticity of the marginal utility of consumption

utility discount rate

Turner et al. (1994), pp. 102-106.

.

p L

pure time preference rate

variation in survival probability

C

Cr