econ test 3 chapter 16

The main three items that account for the CPI Market basket

1) Housing (40.9%) 2) Transportation (17.2%) 3) Food and beverages (15.2%)

Differences between GDP and CPI

1) The GDP price index uses the prices of all the goods and services in GDP- consumption goods and services, capital goods, government goods and services, and export goods and services.-while the CPI uses prices of consumption goods and services only. 2) The GDP price index wights each item using information about current quantities. In contrast, the CPI weights each item using information from a past consumer expenditure survey.

What's a change in the nominal wage rate?

A change in the nominal wage rate measures a combination of a change in the quantity of goods and services that an hour's work can buy and a change in the price level. So the real wage rate removes the effects of inflation from the changes in the nominal wage rate.

Consumer Price Index CPI

A measure of the average of the prices paid by urban consumers for a fixed market basket of consumption goods and services.

Cost of living index

A measure of the change in the amount of money that people need to spend to achieve a given standard of living.

Reference base period

A period for which the CPI is defined to equal 100. Currently, the reference base period is 1982-1984

Deflation

A situation in which the price level is falling and the inflation rate is negative

Real value

A value expressed in the dollars of the given year RV= Nominal value X CPI in real year/CPI in nominal year.

GDP price Index

An average of the current prices of all the goods and services included in GDP expressed as a percentage of base year prices

Personal Consumption Expenditures (PCE) Price Index

An average of the current prices of the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base year prices.

Two consequences of the CPI bias

Avoiding Bias in the CPI is important for two main reasons. Bias leads to: 1) Distortion of private contracts 2) Increases in government oultays and decreases in taxes

Why is the real wage rate a significant economic variable?

Because it measures the real reward for labor, which is a major determinant of the standard of living. It also measures the real cost of labor services, which influences the quantity of labor that firms are willing to hire.

What's a change in the real wage rate?

Because we measure the real wage rate in constant base period dollars, a change in the real wage rate measures the change in the quantity of goods and services that an hour's work can buy.

Increases in Government outlays

Close to a third of federal government outlays are linked directly to the CPI. The CPI is used to adjust: 55 million Social Security benefit payments 45 million food stamp payments 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses The budget for 3 million school lunches

Constructing the CPI

Construction of the CPI is a huge operation that costs millions of dollars and involves three stages Selecting the CPI market basket Conducting the monthly price survey calculating the CPI

CPI formula

Cost of CPI basket at current period prices/ Cost of CPI basket at base period prices X100

The monthly Price Survey

Each month, BLS (Bureau of Labor Statistics) employees check the prices of the 80,000 goods and services in the CPI market basket in 30 metropolitan areas. Because the CPI aims to measure price changes, it is important that the prices recorded each month refer to exactly the same items.

New Goods Bias

Every year, some new goods become available and some old goods disappear. when we want to compare the price level in 2014 with that in 2004, 1994, or 1984, we must do so by comparing the prices of different baskets of goods. we can't compare the same baskets because today's basket wasn't available 10 years ago and the basket of 10 years ago isn't available today.

PCE Price Index Excluding Food and Energy

Food and energy prices fluctuate much more than other prices and their changes can obscure the underlying trends on prices. By excluding these highly variable items, the underlying price level and inflation trends can be seen more clearly. The percentage change in the PCE excluding food and energy is called the core inflation rate.

The CPI is not a perfect measure of the cost of living

For two reasons: 1) The CPI does not try to measure all the changes in the cost of living. For example: the change in weather during seasons. 2) Even those components of the cost of living that are measured by the CPI are not always measured accurately.

Commodity Substitution Bias

If consumers substitute their use of a product by another for a rise in price, The CPI says that the price of the items has increased because it ignores the consumers' substitution between goods in the CPI market basket. Example substitute broccoli for carrots.

Consumer expenditure Survey

Is a survey that discovers what people actually buy. This survey is an ongoing activity, and the CPI market basket in 2013 was based on a survey conducted during 2011

Outlet Substitution

Is when people use discount stores more frequently and convenience stores less frequently when confronted with higher prices.

Distortion of private contracts

Many wage contracts contain a cost of living adjustment. If the CPI bias was common knowledge and large, the CPI would not be used without some adjustment in contract. Unions and employers would seek agreement on the extend of the bias and make an appropriate adjustment to their contract. But for a small bias, the cost of negotiating a more complicated agreement might be too large.

Alternative measures of the price level and inflation rate

Several alternative measures of the price level and inflation rate are available: 1) GDP price index 2) Personal consumption expenditures (PCE) price index 3) PCE price index excluding food and energy

Quality Change Bias

The BLS does the best job it can to estimate the effects of quality improvements on price changes. But the CPI probably counts too much of any price rise as inflation and so overstates inflation.

The magnitude of the Bias

The BLS has taken steps to reduce the CPI bias. The more frequent consumer expenditure Survey is one of these steps. Beyond that, the BLS uses ever more sophisticated models to try to eliminate the sources of bias and make the CPI as accurate as possible

Calculating the CPI

The CPI Calculation has three steps 1) Find the cost of the CPI market basket at base period prices. 2) Find the cost of the CPI market basket at current period prices. 3) Calculate the CPI for the base period and the current period

Decrease in Taxes

The CPI is used to adjust the income levels at which higher tax rates apply. Tax rates on large incomes are higher than those on small incomes, so as incomes rise the burden of taxes would rise relentlessly if these adjustments were not made. To the extent that the CPI is biased upward, the tax adjustments overcompensate for rising prices and decrease the amount paid in taxes

Outlet Substitution Bias

The CPI says that the price of an item has increased by a certain amount because the CPI does not measure outlet substitution. Exp: The growth of online shopping in recent years has provided an alternative to discount stores that makes outlet substitution even easier and potentially makes this source of bias more serious.

PCE Compared with CPI

The PCE price index has the same advantages as the GDP price index- it uses current information on quantities and to some degree overcomes the sources of bias in the PCI. It also has an advantage shared by the CPI of focusing on consumption expenditure and therefore being a possible measure of the cost of living. A weakness of the PCE price index is that it is based on data that become known after the lapse of several months. So the CPI provides more current information about the inflation rate than what the PCE price index provides

The Core Inflation rate

The annual percentage change in the PCE price index excluding the prices of food and energy.

Nominal wage rate

The average hourly rate measured in current dollars

Real wage rate

The average hourly wage rate measured in the dollars of a given reference base year. RWR = NWR/CPI of the same year X 100

Nominal interest rate

The dollar amount of interest expressed as a percentage of the amount loaned.

Real interest rate

The goods and services forgone in interest expressed as a percentage of the amount loaned and calculated as the nominal interest rate minus the inflation rate. Real interest rate= Nominal interest rate - inflation rate.

Inflation rate

The percentage change in the price level from one year to the next Inflation rate= (CPI in Current year-CPI in previous year)/CPI in previous year X100

Sources of Bias in the CPI

The potential sources of bias in the CPI are: 1) New goods bias 2) Quality change bias 3) commodity substitution bias 4) Outlet substitution bias

CPI Market basket

This "Basket" contains the goods and services represented in the index and the relative importance, or weight, attached to each of them.

Nominal and Real values in Macroeconomics

Three nominal and real variables occupy a central position in macroeconomics. 1) Nominal GDP and Real GDP 2) The nominal wage rate and the real wage rate 3) The nominal interest rate and the real interest rate.

Nominal value

is a value expressed in current dollars. NV= real value X CPI in nominal year/CPI in real year