Chapter 6

The CPI tracks the cost of the typical consumer's...

"basket" of goods & services

Equation for the inflation rate

(CPI this year-CPI last year/CPI last year) x 100

Capital goods included and excluded from?

Included in GDP deflator (if produced domestically) Excluded in CPI

The Consumer Price Index is

a measure of the cost of living

CPI Basket uses a _______ basket

fixed

"year T " is 1963, "today" is 2013 Min wage was $1.25 in year T CPI = 30.9 in year T, CPI = 234.6 today The min wage in 1963 was....

1.25 x (234.6/30.9)= $9.49 in 2013 dollars

Unmeasured Quality Change

Problem with CPI Improvements in the quality of goods in the basket increase the value of each dollar. Thus, the CPI overstates increases in the cost of living.

Introduction of New Goods

Problem with CPI The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. In effect, dollars become more valuable. The CPI misses this effect because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

What are the problems with the CPI? How serious are they?

Substitution Bias Introduction of New Goods Unmeasured Quality Change

The increase in CPI automatically determines: (2 things)

The COLA in many multi-year labor contracts. Adjustments in Social Security payments and federal income tax brackets.

2. When the consumer price index rises, the typical family a. has to spend more dollars to maintain the same standard of living. b. can spend fewer dollars to maintain the same standard of living. c. finds that its standard of living is not affected. d. can offset the effects of rising prices by saving more.

a. has to spend more dollars to maintain the same standard of living.

3. Economists use the term inflation to describe a situation in which a. some prices are rising faster than others. b. the economy's overall price level is rising. c. the economy's overall price level is high, but not necessarily rising. d. the economy's overall output of goods and services is rising faster than the economy's overall price level.

b. the economy's overall price level is rising.

GDP deflator uses basket of ___________ goods and services

currently produced

1. Which of the following is not correct? a. The consumer price index gives economists a way of turning dollar figures into meaningful measures of purchasing power. b. The consumer price index is used to monitor changes in the cost of living over time. c. The consumer price index is used by economists to measure the inflation rate. d. The consumer price index is used to measure the quantity of goods and services that the economy is producing.

d. The consumer price index is used to measure the quantity of goods and services that the economy is producing.

Equation to find the dollar figures from different times

amount in year T dollars x (price level today/price level in year T)

5. If the consumer price index was 100 in the base year and 106 in the following year, then the inflation rate was a. 1.06 percent. b. 6 percent. c. 10.6 percent. d. 106 percent.

b. 6 percent.

Imported consumer goods included and excluded from?

included in CPI Excluded from GDP deflator

Equation for CPI

(cost of basket in current yr / cost of basket in base yr) x 100

What is the CPI

-Measure of the overall level of prices -Measure of the overall cost of goods and services -Bought by a typical consumer -Computed and reported every month by the Bureau of Labor Statistics

The real interest rate:

-corrected for inflation -Rate of growth in the purchasing power of a deposit or debt

The nominal interest rate:

-interest rate not corrected for inflation -Rate of growth in the dollar value of a deposit or debt

How to calculate CPI

1. Fix the basket 2. Find the prices 3. Compute the baskets total cost 4. Chose a base yr and compute the CPI 5. Compute the inflation rate

8. If the CPI was 90 in 1975 and is 225 today, then $100 today purchases the same amount of goods and services as a. $25.00 purchased in 1975. c. $33.33 purchased in 1975. b. $40.00 purchased in 1975. d. $135.55 purchased in 1975.

100x(90/225)= b.$40.00 purchased in 1975.

Suppose a basket of goods and services has been selected to calculate the CPI and 2012 has been selected as the base year. In 2012, the basket's cost was $50; in 2014, the basket's cost was $52; and in 2016, the basket's cost was $55. The value of the CPI in 2016 was

110

The table below pertains to Studious, an economy in which the typical consumer's basket consists of 5 books and 10 calculators. Year. Price of a Book Price of a Calculator 2013 $24 $9 2014 $30 $11 2015 $32 $12 If 2013 is the base year, then the consumer price index was _______ in 2014 (approximate to one digit decimal point).

123.8

6. The price index was 150 in the first year, 142.5 in the second year, and 138.2 in the third year. The economy experienced a. 5.0 percent deflation between the first and second years, and 3.0 percent deflation between the second and third years. b. 7.5 percent deflation between the first and second years, and 4.3 percent deflation between the second and third years. c. 5.3 percent inflation between the first and second years, and 4.1 percent inflation between the second and third years. d. 7.5 percent inflation between the first and second years, and 4.3 percent inflation between the second and third years.

142.5-150/150x100=5 deflation (first and second year. a. 5.0 percent deflation between the first and second years, and 3.0 percent deflation between the second and third years.

The table below pertains to Studious, an economy in which the typical consumer's basket consists of 5 books and 10 calculators. Year Price of a Book. Price of a Calculator 2012 $24 $9 2013 $30 $11 2014 $32 $12 Using 2013 as a base year, the inflation rate was _____ for 2014. (approximate to one digit decimal point)

7.7

7. Babe Ruth's 1931 salary was $80,000. Government statistics show a consumer price index of 15.2 for 1931 and 229.6 for 2012. Ruth's 1931 salary was equivalent to a 2012 salary of about a. $5,296. b. $1,128,421 c. $1,208,421 d. $17,152,000

80,000x(229.6/15.2)= c. $1,208,421

The table below pertains to Studious, an economy in which the typical consumer's basket consists of 5 books and 10 calculators. Year. Price of a Book Price of a Calculator 2013 $24 $9 2014 $30 $11 2015 $32 $12 If 2014 is the base year, then the consumer price index was _______ in 2013 (approximate to one digit decimal point).

80.8

find real interest rate Deposit $1,000 for one year. Nominal interest rate is 9%. During that year, inflation is 3.5%.

9.0%-3.5%=5.5% the purchasing power of the $1000 deposit has frown 5.5%

Indexation: definition

A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract.

4. If 2010 is the base year, then the inflation rate in 2015 equals

CPI in 2015-CPI in 2014/CPI in 2014x100

The CPI is used to make ___________ and to correct__________________

Cost of Living Adjustments and to correct economic variables for the effects of inflation

Substitution bias

Problem with CPI Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. The CPI misses this substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

The real interest rate is corrected for ___________ and is computed by subtracting the __________ from the ________________

inflation and is computed by subtracting the inflation rate from the nominal interest rate.

equation for real interest rate

real interest rate=(nominal interest rate)-(inflation rate)