Econ Chapter 24

The CPI always equals ______ in the base year

100

if the CPI is 175 in 2011 is what percent of its price in the base year?

175% of its price in the base year. In other words a basket of goods that costs 100$ in the base year costs 175$ in 2011

Why are changes in the producer price index often thought to be useful in predicting changes to the consumer price index?

Because firms eventually pass on their costs to consumers in the form of higher consumer prices

Which is the more common gauge of inflation, GDP deflator or the consumer price index?

CPI

Consumer price index (CPI)

measure of the overall cost of the goods and services bought by a typical consumer - Can be used to turn dollar figures into meaningful measures of purchasing power

Explain the issue of unmeasured quality change when computing CPI

-If the quality of a good deteriorates from one year to the next while its price remains the same, the value of a dollar falls because you are getting a lesser good for the same amount of money -If the quality rises from one year to the next the value of a dollar rises

Explain substitution bias

-Problem with CPI in calculating cost of living -When prices change from year to year they do not change proportionately, consumers respond to price changes by buying less of a more expensive good and more of a less expensive good -If a price index is computed assuming a fixed basket of goods it ignores the possibility of consumer substitution due to price and therefore overstates the increase in the cost of living from one year to the next.

Explain the issue in computing CPI concerning the issue of the introduction of new goods

-When more goods are introduced the value of the dollar increases and the cost of maintaining the same level of economic well being reduces. - Because the CPI is based on a fixed basket of goods it does not reflect the increase in the value of the dollar that arises from the introduction of new goods

5 steps used in calculating CPI

1. Fix the basket 2. Find the prices 3. Compute the basket's cost 4. Choose a base year and compute the index 5. Compute the inflation rate

Name two main differences between GDP deflator and CPI

1. 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. 2. The CPI compares the price of a FIXED basket of goods and services to the price of the basket in the base year. 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, thus the group of goods and services used to compute the GDP deflator changes automatically over time.

What are the three problems acknowledged to exist when using the consumer price index in computing changes in the cost of living?

1. Substitution bias 2. Introduction of new goods 3 Unmeasured quality change

How do you use the CPI to calculate the inflation rate?

Inflation rate in year 2

Producer Price Index (PPI)

Measures the cost of a basket of goods and services bought by firms rather than consumers.

CPI formula

Price of basket in current year -------------------------------------- X100 Price of basket in base year

Indexation

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

Nominal Interest Rate

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

Real interest rate

The interest rate corrected for the effects of inflation