CHAPTER 11

If the nominal interest rate is 2% in the real interest rate is 4%, then inflation inflation rate is

-2%

Problems in measuring the cost of living

-substitution bias, introduction of new goods, unmeasured quality change

Calculating the consumer price index and the inflation rate

1) Fix the basket: 2) Find the prices 3) compute the baskets cost 4) Choose a base year and compute the index CPI = price of basket of goods and services in current year / price of basket in base year x 100 5) Compute the inflation rate: which is the percentage change in the price index from the proceeding period. Inflation rate in year 2 = CPI in year 2 - CPI in year 1 / CPI in year 1 x 100

Dollar figures from different years

Amount in today's dollars = Amount in year "T" dollars x price level today / price level in year "T"

Cost-of-living adjustment (COLA)

Automatically raises the wage when the CPI raises

What's in the CPI basket

By far the largest category is housing, which makes it 42% of the typical consumers budget. This category includes the cost of shelter at 33%, fuel and utilities at 5%, and household furnishings and operations at 4%. The next largest category, at 17% is transportation which includes spending on cars, gasoline, buses, subways, and so on. The next largest category at 14%, is food and beverages; this category includes food at home which is 7%, food away from home at 6 percent, and alcoholic beverages at 1%. Next are medical care at 9%, education and communication at 7%, and recreation at 6%. Apparel, which includes clothing, footwear, and jewelry, makes up 3 percent.

Which of the following pairs of values of the consumer price index is consistent with an inflation rate of 2% from 2018 to 2019

CPI in 2018 = 110; CPI in 2019 = 112.2

The GDP deflator versus the Consumer Price index

GDP deflator reflects the prices of all goods and services "produced" domestically, whereas the CPI reflects the prices of all goods and services "bought" by consumers. For example, suppose at the price of an airplane produced by Boeing and sold to the Air Force rises. Even though the plane is part of GDP, it is not part of the basket of goods and services bought by a typical consumer. Thus, the period increase shows up in the GDP deflator and not in the CPI. Another example, suppose that Volvo raises the price of its cars. Because Volvo's are made in Sweden, the car is not part of the US GDP. But US consumers by Volvos, so the car is part of the typical consumers basket of goods. Hence, a price increase in an imported consumption good, such as Volvo, shows up in the CPI but not in the GDP deflator.

real interest rate equation

Real interest rate = nominal interest rate - inflation rate

Indexation is a feature of many laws

Such as social Security benefits, for instants, are adjusted every year to compensate the elderly for increases in prices. The brackets of the federal income tax - the income levels at which the tax rates change -are also indexed for inflation. Tax laws, are only partially indexed for inflation

What the BLS calculates in addition to the CPI for the overall economy

The BLS reports the index for some narrow categories of goods and services, such as food, clothing, and energy. It also calculates the CPI for all goods and services excluding food and energy, a statistic called the core CPI. Because food and energy prices show substantial short run volatility, The core CPI better reflects underlying inflation trends. Finally, the BLS also calculates the producer price index which measures the cost of a basket of goods and services bought by firms rather than consumers.

The most commonly reported measure of inflation by the media is

The CPI

Consumer Price Index (CPI)

The consumer price index is a measure of the overall cost of the goods and services brought by a typical consumer. Every month, the bureau of labor statistics (BLS), which is a part of the department of labor, computes and reports the CPI.

2nd Difference between GDP deflator and CPI

The second and subtler difference between the GDP deflator and the CPI concerns how various prices are weighted to yield a single number for the overall levels of prices. The CPI compares the price of a fixed basket of goods and services with the price of the basket in the base year. The GDP deflator compares the price of currently produced goods and services with the price of those goods and services in the base year.

Indextation

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