Chapter 13 - Measuring the Cost of Living

Consumer Price Index (CPI)

-A measure of the overall cost of the goods and services bought by a typical consumer -The Office of National Statistics reports the CPI each month -It is used to monitor changes in the cost of living over time

GDP deflator vs Consumer Price Index

-Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising There are two important differences between the indexes that can cause them to diverge: -The GDP deflator reflects the prices of all goods and services produced domestically, whereas... ...the consumer price index reflects the prices of all goods and services bought by consumers -The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the ONS change the basket)... ...whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year

How the CPI is calculated

-Fix the Basket: Determine what prices are most important to the typical consumer -The Office of National Statistics (ONS) identifies a market basket of goods and services the typical consumer buys -The ONS conducts regular consumer surveys to set the weights for the prices of those goods and services -Find the Prices: Find the prices of each of the goods and services in the basket for each point in time -Compute the Basket's Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times -Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. -Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period

Money and Prices during Hyperinflation (Case study 1)

-Hyperinflation is inflation that exceeds 50 percent per month -Hyperinflation occurs in some countries because the government prints too much money to pay for its spending

Unmeasured quality changes

-If the quality of a good rises from one year to the next, the value of a euro rises, even if the price of the good stays the same -If the quality of a good falls from one year to the next, the value of a euro falls, even if the price of the good stays the same -The ONS tries to adjust the price for constant quality, but such differences are hard to measure

Relative-Price Variability and the Misallocation of Resources

-Inflation distorts relative prices -Consumer decisions are distorted, and markets are less able to allocate resources to their best use

Inflation-Induced Tax Distortion

-Inflation exaggerates the size of capital gains and increases the tax burden on this type of income -With progressive taxation, capital gains are taxed more heavily -The nominal interest earned on savings is treated as income for income tax purposes, even though part of the nominal interest rate merely compensates for inflation -The after-tax real interest rate falls when inflation rises, making saving less attractive

Inflation

-Term used to describe a situation in which the economy's overall price level is rising -The inflation rate is the percentage change in the price level from the previous period

Problems in Measuring the Costs of Living

-The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living -This is due to: Substitution bias Introduction of new goods Unmeasured quality changes -These cause the CPI to overstate the true cost of living -The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices

Substitution Bias

-The basket does not change to reflect consumer reaction to changes in relative prices -Consumers substitute toward goods that have become relatively less expensive -The index overstates the increase in cost of living by not considering consumer substitution

Introduction of new goods

-The basket does not reflect the change in purchasing power brought on by the introduction of new products -New products result in greater variety, which in turn makes each euro more valuable -Consumers need less money to maintain any given standard of living

Menu Costs

-The costs of adjusting prices -During inflationary times, it is necessary to update price lists and other posted prices -This is a resource-consuming process that takes away from other productive activities

Nominal Interest Rate

-The nominal interest rate is the interest rate usually reported and not corrected for inflation -It is the interest rate that a bank pays

Real Interest Rate

-The nominal interest rate that is corrected for the effects of inflation

Shoe leather Costs

-The resources wasted when inflation encourages people to reduce their money holdings -Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings -Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts -The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand -Also, extra trips to the bank take time away from productive activities

A special cost of unexpected inflation: arbitrary redistribution of wealth

-Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need -These redistributions occur because many loans in the economy are specified in terms of the unit of account—money

Indexation

-When some money amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation

Confusion and Inconvinience

-When the central bank increases the money supply and creates inflation, it erodes the real value of the unit of account -Inflation causes money at different times to have different real values -Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time

Costs of Inflation

-When the government raises revenue by printing money, it is said to levy an inflation tax -An inflation tax is like a tax on everyone who holds money -The inflation ends when the government institutes fiscal reforms such as cuts in government spending