Macroeconomics - Ch. 7

Real Wage

The average hourly wage rate measured in dollars corrected for inflation.

Inflation Rate

The percentage of change in CPI from one year to the next.

Deflation

A situation in which the CPI in the previous year is higher than the CPI in the current year resulting in a negative inflation rate.

The Magnitude of the CPI Bias

*A govt. commission by the name of Boskin Commission estimated the bias to be 1.1 percentage points per year. **If inflation is measured as 3.1 percent a year, it is most likely actually 2.0 percent a year. *To reduce the bias, the BLS has increased the frequency of its Consumer Expenditure Survey and revises the CPI basket every 2 years. *When the BLS revises the CPI basket, the base period does not change.

Alternatives Measures of the Price Level

*Chained Consumer Price Index (C-CPI) *Personal Consumption Expenditures Price Index (PCEPI) *PCEPI excluding food and energy

Nominal v. Real Values

*Nominal GDP and real GDP *Nominal wage rate and real wage rate *Nominal wage rate and real wage rate *The real values measure the buying power of money.

Two Main Consequences of Bias in the CPI

1. distortion of private contracts 2. increases in govt. outlays

Cost of Living Index

A measure of changes in the amount of money that people would need to spend to achieve a given standard of living. *The CPI is used to adjust the cost of living but it is not a perfect measure because it doesn't count all the changes in the prices of the goods and services that consumers buy. **Possible sources of bias in the CPI: new goods bias, quality change bias, commodity substitution bias

Consumer Price Index (CPI)

A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services, and is calculated by the Bureau of Labor Statistics (BLS) every month. *It is used to compare the cost of a fixed basket of goods in the current year/month with the cost of the same basket of goods in the base/reference year/month. **CPI = 100 in the base period (1982-1984)

Chained Consumer Price Index

A measure of the price level calculated using current month and previous month prices and expenditures. It is called a "chained" CPI because the inflation rate calculated for the current month is linked back to a base period. *C-CPI avoids bias in CPI because it uses current period expenditures that are updated every month, and takes into account new goods, quality change, and substitution effects. *The only weakness of the C-CPI is that it gets revised several times as the data on recent expenditures get revised.

Personal Consumption Expenditures Price Index (PCEPI)

An average of current prices of all goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices. *The PCEPI, like the C-CPI, uses current information on quantities and prices, so it avoids the sources of bias in the CPI.

GDP Price Index

An average of current prices of all the goods and services included in GDP expressed as percentage of base-year prices. *A broader alternative measure of the price level *A measure of the overall price level *The percentage change in the GDP price index is a alternative measure of the inflation rate.

New Goods (bias)

Are usually better than the old goods they replace, but cost more and this puts an upward bias in the CPI and it is considered as inflation rate when actually it is not.

Quality Change Bias

Better cars and televisions cost more than the versions they replace. The price increase for improved quality is not inflation but could be measured as inflation.

How CPI is Calculated

CPI is calculated by using the price of goods bought by a typical urban household, and applying different weights based on the importance of the good to the consumer. *Each month BLS employees check the prices of the 80,000 goods and services in the 8 large groups shown in the CPI basket in 30 metropolitan areas. *Because the CPI measures price changes, it is important that the prices recorded refer to exactly the same items.

Increases in Govt. Outlays

Close to 1/3 of federal govt. outlays are linked directly to the CPI. The CPI is used to adjust SS benefit payments, food stamp payments, and pensions for retired people.

Commodity Substitution Bias

Consumers substitute cheaper goods for expensive goods. The CPI basket does not allow substitution between goods, and thus overstates inflation. *Ex: the price of beef rises faster than the price of chicken, people buy more chicken and less beef.

PCEPI Excluding Food and Energy Prices

Food and energy prices fluctuate much more than other consumer good prices, and can obscure the underlying trends in other consumer goods prices. The underlying price level and inflation trends can be seen more clearly if food and energy prices are excluded. *The annual percentage change in PCEPI excluding food and energy is called the core inflation rate.

Distortion of Private Contracts

Occur when wage contracts are linked to the CPI. If the CPI is biased, these contracts might affect the involved parties differently than intended - it might benefit one party at the expense of the other party.

Nominal Wage

The average hourly wage rate measured in current dollars.

Nominal Interest Rate

The nominal dollar amount that a borrower pays or a lender earns per $100 borrowed.

Real Interest Rate

The nominal interest rate adjusted for inflation. *Measures the buying power of the money earned interest.

Differences Between GDP Price Index and CPI

Two Main Differences: 1. The GDP price index uses the prices of all the goods and services in GDP, whereas the CPI uses prices of only consumption goods and services. 2. The GDP price index weights each item using information about current as well as past quantities. In contrast, the CPI weights each item using information from a past Consumer Expenditure Survey. **Because the GDP price index uses information on current year quantities, it includes new goods and quality improvements and even allows for substitution effects of both commodities and retail outlets. So in principle, the GDP price index is not subject to the biases of the CPI.