Macro Ch 11

Problems in Measuring the Cost of Living

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

4 - Choose a base year and compute the (CPI) INDEX. Choose a year as Base year, benchmark against other years are compared. (Base year choice s arbitrary, as the index is used to measure changes in the cost of living.) Once the base year is chosen, the index is calculated as follows:

Consumer price index = $ of basket of G&S in current Yr. / $ of basket in Base Yr. x 100 or CPI = $ Current year / $ Base year x 100

Unmeasured Quality Change - problem 3

If quality of a good deteriorates over the years and prices remain the same, value of a dollar falls, because you get a lesser good for the same cost. Similarly, if quality rises from one year to the next, the value of a dollar rises. BLS tries to account for quality change but it's hard to measure.

indexed

the automatic correction by law or contract of a dollar amount for the effects of inflation

real interest rate

the interest rate corrected for the effects of inflation

To understand how much a person earns in a savings account

we need to consider both the interest rate and the change in prices

Q5 If the consumer price index is 200 in year 1980 and 300 today, then $600 in 1980 has the same purchasing power as______ today.

$400 $500 $700 ---> $900

Babe Ruth salary compared to today example at $80k

$80k x 229.5 (2012 CPI) / 15.2 (1931 CPI) = $1,207,894 (Value of to today's salary)

BLS calculates several other price indexes

It reports the index for specific metropolitan areas within the country such as Boston, New York, and Los Angeles and for some narrow categories of goods and services such as food, clothing, and energy.

Relative Importance - of the category of inflation rate %

The Bureau of Labor Statistics calls each category of percentage inflation rate the "Relative Importance" of the category.

Goal of the consumer price index

To measure changes in the cost of living, In other words, CPI tries to gauge how much incomes must rise to maintain a constant standard of living.

GDP Deflator versus the Consumer Price Index

Two important differences can cause them to diverge GDP Deflator reflects prices of all goods and services produced domestically. CPI reflects the prices of all goods and services bought by consumers.

3 - Compute the basket's cost

Use the data on prices to calculate the cost of the basket of goods and services at different times. The table shows this calculation for each year. Notice only the prices in the calculation change, quantity of the basket of goods stay same (4 hot dogs & 2 hamburgers), we are isolating the effects of price changes from the effect of any quantity changes that might be occurring at the same time.

producer price index

a measure of the cost of a basket of goods and services bought by firms

price indexes are used to correct for the effects of inflation when comparing dollar figures from different times.

index to compare a dollar figure from the past to a dollar figure in the present.

Real and Nominal Interest Rates

...

Calculating the: Consumer Price Index and the Inflation Rate - Method

1 - Find the Basket 2 - Find the Prices 3 - Compute the Basket 4 - Choose the Base Year and Compute the Index 5 - Compute the Inflation Rate

Three problems with the index (CPI) are widely acknowledged but difficult to solve.

1 Substitution Bias 2 Introduction of New Goods 3 Unmeasured Quality Change

Q6 You deposit $2000 in a savings account, and a year later you have $2100. Meanwhile, the consumer price index rises from 200 to 204. In this case, the nominal interest rate is ______ percent, and the real interest rate is ______ percent.

1,5 3,5 5,1 -->5,3

Summary - Item 6

A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation.

Q4 Because consumers can sometimes substitute cheaper goods for those that have risen in price,

---> the CPI overstates inflation. the CPI understates inflation. the GDP deflator overstates inflation. the GDP deflator understates inflation.

BLS

Bureau of Labor Statistics

Summary - Item 2

The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers' ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates true inflation.

Summary - Item 1

The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate.

Step 2: Find the Price of Each Good in Each Year

Year--------Price-Hot Dogs (HD)--------Price-Hamburgers(HB) 2010--------$1----------------------------------$2 2011--------$2----------------------------------$3 2012--------$3----------------------------------$4

Q3 If a Pennsylvania gun manufacturer raises the price of rifles it sells to the U.S. Army, its price hikes will increase

both the CPI and the GDP deflator. neither the CPI nor the GDP deflator. the CPI but not the GDP deflator. --->the GDP deflator but not the CPI.

COLA

cost-of-living allowance, automatically raises the wage when the consumer price index rises

Q1 The consumer price index measures approximately the same economic phenomenon as

nominal GDP. real GDP. ---> the GDP deflator. the unemployment rate.

indexation

the automatic correction by law or contract of a dollar amount for the effects of inflation nominal interest rate real interest rate example - COLA

nominal interest rate

the interest rate as usually reported without a correction for the effects of inflation

Summary - Item 5

Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.

Substitution Bias - problem 1

When prices change each year, they don't all change proportionately: Consumers respond to these differing price changes buying less of the goods whose prices rise and by buying more of goods whose prices are less. CPI ignores this thus overestimates cost of living one year to the next.

Summary - Item 4

Dollar figures from different times do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index.

Introduction of New Goods - problem 2

Each year new good are introduced, consumers have more variety to choose from thus reduces the cost of maintaining the same level of economic well-being. With more choices, each dollar is worth more. CPI is based on a fixed basket of G&S and don't reflect increase in the value of the dollar that arises from the introduction of new goods.

Step 1: Survey Consumers to Determine a Fixed Basket of Goods

Example: Basket = 4 hot dogs, 2 hamburgers

2 - Find the prices

Find the prices of each of the goods and services in the basket at each point in time. The table shows the prices of hot dogs and hamburgers for three different years.

Inflation Rate

the percentage change in the price index from the preceding period. Inflation Rate = Nominal Interest Rate - Real Interest Rate

Step 3: Compute the Cost of the Basket of Goods in Each Year

2010 ($1 per HD × 4 HB's)+($2 per HB × 2 HB's) = $8 per basket 2011 ($2 per HD × 4 HB's)+($3 per HB × 2 HB's) = $14 per basket 2012 ($3 per HD × 4 HB's)+($4 per HB × 2 HB's) = $20 per basket

Step 4: Choose One Year as a Base Year (2010) and Compute the - CPI - Consumer Price Index in Each Year

2010 ($8 / $8) × 100 = 100 2011 ($14 / $8) × 100 = 175 2012 ($20 / $8) × 100 = 250

Step 5: Use the - CPI - Consumer Price Index to Compute the - IR - Inflation Rate from Previous Year

2011 (175 − 100) / 100 × 100 = 75% 2012 (250 − 175) / 175 × 100 = 43%

Formula for turning dollar figures from year T into today's dollars

Amount in today's dollars = Amount in year T dollars x Price level today / Price level in year T or Current Salary = Salary in T year x Current CPI / T year CPI

1 - Find the Basket Determine which prices are most important to the typical consumer. The BLS sets these weights by surveying consumers to find the basket of goods and services bought by the typical consumer.

If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important than the price of hamburgers and, therefore, should be given greater weight in measuring the cost of living.

5 - Compute the inflation rate. Use the CPI to calculate the IR, which is the (%) percentage change in the price index from the preceding period. That is, the inflation rate between two consecutive years.

Inflation Rate in year 2 = CPI in year 2 - CPI in year 1 / CPI in year 1 x 100 Yields (%) percentage change in the price index from the preceding period.

Summary - Item 3

Like the consumer price index, the GDP deflator measures the overall level of prices in the economy. The two price indexes usually move together, but there are important differences. The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

nominal interest rate, the real interest rate, and inflation are related approximately as follows:

Real Interest Rate = Nominal Interest Rate - Inflation Rate

Real Interest Rate - (from Text)

The interest rate corrected for inflation. The interest rate corrected for the effects of inflation. Tells you how fast the purchasing power of your bank account rises over time.

Nominal Interest Rate - (from Text)

The interest rate that measures the change in dollar amounts. Or, the interest rate as usually reported without a correction for the effects of inflation. Tells you how fast the number of dollars in your bank account rises over time.

consumer price index (CPI)

a measure of the overall cost of the goods and services bought by a typical consumer. It's used to monitor changes in the cost of living over time.

Inflation

a situation in which the economy's overall price level is rising. When the consumer price index rises, the typical family has to spend more money to maintain the same standard of living.

Q2 The largest component in the basket of goods and services used to compute the CPI is

food and beverages. ---> housing. medical care. apparel.