ECON 2: Chapter 11

How much does the CPI overstate by?

1. CPI probably still overstates inflation by about 0.5 percent per year. 2. This is important because Social Security payments and many contracts have COLAs tied to the CPI.

Problem with CPI: Substitution Bias

1. Over time, some prices rise faster than others. 2. Consumers substitute toward goods that become relatively cheaper. 3. The CPI misses this substitution because it uses a fixed basket of goods. 4. Thus, the CPI overstates increases in the cost of living.

Problems with the CPI

1. Substitution bias 2. Introduction of new goods 3. Unmeasured quality change

Nominal Interest Rate

1. The interest rate not corrected for inflation 2. The rate of growth in the dollar value of a deposit or debt

Problem with CPI: Introduction of new goods

1. The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. 2. In effect, dollars become more valuable. 3. The CPI misses this effect because it uses a fixed basket of goods. 4. Thus, the CPI overstates increases in the cost of living.

Indexation

A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract.

Real Interest Rate Equation

Real Interest Rate = Nominal interest rate - Inflation rate

Contrasting the CPI and GDP Deflator: The basket

1. CPI uses a fixed basket 2. GDP deflator uses basket of currently produced goods and services (This matters if different prices are changing by different amounts).

Real Interest Rate

1. Corrected for inflation 2. The rate of growth in the purchasing power of a deposit or debt

Contrasting the CPI and GDP Deflator: Capital goods

1. Excluded from CPI 2. Included in GDP deflator (If produced domestically)

How the CPI is calculated

1. Fix the basket: The Bureau of Labor Statistics (BLS) surveys consumers to determine what's in the typical consumer's "shopping basket." 2. Find the prices: The BLS collects data on the prices of all the goods in the basket. 3. Compute the basket's cost: Use the prices to compute the total cost of the basket.

Problem with CPI: Unmeasured quality change

1. Improvements in the quality of goods in the basket increase the value of each dollar. 2. The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. 3. Thus, the CPI overstates increases in the cost of living.

Contrasting the CPI and GDP Deflator: Imported consumer goods

1. Included in CPI 2. Excluded from GDP deflator

How CPI is calculated

100 x (Cost of basket in current year / Cost of basket in base year)

Comparing Dollar Figures from Different Times Equation

Amount in today's dollars = Amount in year T's dollars x (Price level today / Price level in year T)

How does the CPI state the cost of living

It overstates it because of the fixed basket

Consumer Price Index (CPI)

Measures the typical consumer's cost of living. The CPI tracks the cost of the typical consumer's "basket" of goods & services.

How to compute CPI's inflation rate

[(CPI this year - CPI last year) / CPI last year] x 100%