Many of the economies of the region identify price stability as the statutory goal of the central bank. How do we define and measure price stability? Central banks use inflation and the consumer price index to measure price stability. Inflation is the growth rate of this index. In this segment, we also define the real interest rate as interest rate on a loan or deposit less inflation over the life of the financial transaction. We distinguish between ex ante and ex post real interest rates, the real rate we expect at the beginning of a financial transaction that we actually achieve at the end of the transaction. After reviewing this segment, you should be able to: Number 1, calculate the annualized inflation rate. Number 2, calculate the real interest rate. Now let's begin. Recall that central bank strategy has two parts, goals and the intermediate target. Goals are the ultimate objective of policy makers. As we have seen, many central banks in and out of the region concentrate on price stability. We begin with the mission statements of two countries that clear identify price stability is the goal of the central bank. Japan and the Philippines. Japan is one of the most advanced economies in East Asia, while the Philippines is surely an emerging market. Both however, state price stability to be the central objective of monetary policy. As we shall see, each economy faces interesting challenges in achieving price stability, but both adopt adopt a similar strategy for the intermediate target. The intermediate target is a macroeconomic variable which can be guided by policy makers, which anchors the public's understanding of the strategic goals. This guidance is done with a specific numerical target for the measure. Remember, unlike the operational target, the intermediate target is not under the direct control of the central bank never can be achieved with perfection. Both Japan and the Philippines specify an inflation target. Policymakers in Japan offer a specific definition of price stability. They identify numerical growth rate in a measure of the cost of living called the Consumer Price Index or the CPI. This target gives a tangible guideline for implementing monetary policy. Policymakers in the Philippines are even more specific setting both a numerical target for the CPI and then an allowance for error, setting a plus or minus 1 percent target range for the same price measure over future periods. The inflation target is set in terms of a specific Price Index. The Consumer Price Index sometimes abbreviated as CPI, is an index that measures the prices of various consumer goods. During a base or census year, government statistical agencies sample consumer purchasing patterns. They construct a hypothetical market basket based on typical purchases. Then on a monthly basis, they monitor the cost of that same market basket as time goes by. The CPI in any given month is the price of the market basket relative to the price in the base year. Usually, this is multiplied by 100 for ease of viewing. It is popular as an inflation target because it is fast and easy to measure, matches people's experience with the costs of living. We can interpret the CPI as a path measuring the cost of living over time seen here for the Philippines. We define the price relative to the base year. So, we can think of the CPI as a price of a market basket that would cost 100 in the base year 2006 in this example. The index at the end of 2016 is 146.3. So the price of the market basket has increased by 46.3 percent over the decade. Inflation is defined as a percentage growth rate of prices measured at an annual pace. The CPI is measured monthly. Often we focus on year on year inflation, the inflation that has been seen over the last 12 months. This is the difference between the CPI and the CPI from 12 months previous divided by the CPI from 12 months earlier. Sometimes, we might focus on the more immediate trajectory of inflation. Month on month inflation is the difference between the CPI and the CPI from one month previous, divided by the CPI from one month earlier. To convert into an annual rate, monthly inflation is multiplied by 12. We will use the Greek letter Pi as a symbol of the inflation rate, the growth rate of prices. Consider as an example, CPI data from the Philippines from 2016 through 2017. Refer to the data from the Philippines. First, from February and March 2017. The CPI in March is 147.5, then February is 147.2. Over the month, the CPI increases by slightly more than 0.002 relative to the previous month. Multiplying by 12, we get 0.025 or 2.5 percent. To calculate year on year inflation, we use data from March 2016 and March 2017. In March 2016, the CPI was 142.6 compared to 147.5 one year later. Over the course of the year, the CPI increased by 0.034 or 3.4 percent. Year on year inflation is much more stable than month on month inflation. For this reason, year on year inflation is a much more feasible and widely used intermediate target. We can examine the history of inflation in the Asia Pacific. Let's focus on the Philippines, which has an interesting and somewhat representative history. During the 1950s and '60s, inflation remained low and somewhat steady. In the late 60s though, the Philippines went on an extended 20 year period when inflation regularly jumped up into double digit levels and became very unstable with inflation pushing up and down by extreme amounts on a year to year basis. Over the 1990s and into this century though, inflation stabilized and was brought down to lower levels. Most other Asian economies experienced a similar pattern of inflation over the same post-war period. Historically, Japan had lower and more stable inflation than many of the countries of East Asia, with the exception of the early 1970s. Since the turn of the millennium, Japan has experienced inflation far below the target level of two percent often experiencing extended periods of negative inflation which we call deflation. Lending and borrowing are ways of transferring purchasing power across time by the exchange of money. In the next part of this segment, we will address the economic impact of inflation on the exchange of purchasing power in lending markets.