Chapter 11

Which price index would we use in this situation?

A price index such as the CPI measures the price level and thus determines the size of the inflation correction.

The formula for turning dollar figures from year T into today's dollars is the following:

The amount in today's dollars = amount in year T's dollars x (price level today/price level in year)

What is the difference between nominal and real interest rates?

The nominal interest rate tells you how fast the number of dollars in your bank account rises over time, while the real interest rate tells you how fast the purchasing power of your bank account rises over time.

What is the goal of the consumer price index?

To measure changes in the cost of living. In other words, the CPI tries to gauge how much incomes must rise to maintain a constant standard of living.

Consumer Price Index (CPI)

a measure of the overall cost of the goods and services bought by a typical consumer

How to calculate CPI?

look at book and exercises you should know

What are price indexes used for?

price indexes are used to correct for the effects of inflation when comparing dollar figures from different times. This type of correction shows up in many places in the economy.

What is indexation?

the automatic correction by law or contract of a dollar amount for the effects of inflation; this is done with social security too

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; real interest rate = nominal interest rate - inflation rate

What's the second problem with the consumer price index?

The second problem with the CPI is the introduction of new goods. When a new good is introduced, consumers have more variety from which to choose, and this, in turn, reduces the cost of maintaining the same level of economic well-being. As new goods are introduced, consumers have more choices, and each dollar is worth more. But because the CPI is based on a fixed basket of goods and services, it does not reflect the increase in the value of the dollar that arises from the introduction of new goods.

What is the first difference between the GDP deflator and the CPI index?

The first difference is that the 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. ex: This first difference between the CPI and the GDP deflator is particularly important when the price of oil changes. The United States produces some oil, but much of the oil we use is imported. As a result, oil and oil products such as gasoline and heating oil make up a much larger share of consumer spending than of GDP. When the price of oil rises, the CPI rises by much more than does the GDP deflator.

What is the 1st reason why consumer price index isn't the perfect measure?

The first problem is called substitution bias. When prices change from one year to the next, they do not all change proportionately: Some prices rise more than others. Consumers respond to these differing price changes by buying less of the goods whose prices have risen by relatively large amounts and by buying more of the goods whose prices have risen less or perhaps even have fallen. That is, consumers substitute toward goods that have become relatively less expensive. If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution and, therefore, overstates the increase in the cost of living from one year to the next. ex: magine that in the base year, apples are cheaper than pears, so consumers buy more apples than pears. When the BLS constructs the basket of goods, it will include more apples than pears. Suppose that next year pears are cheaper than apples. Consumers will naturally respond to the price changes by buying more pears and fewer apples. Yet when computing the CPI, the BLS uses a fixed basket, which in essence assumes that consumers continue buying the now expensive apples in the same quantities as before. For this reason, the index will measure a much larger increase in the cost of living than consumers actually experience.

What is the second difference between the GDP deflator and the CPI index?

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 level of prices. The CPI 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 BLS change the basket of goods. By contrast, 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. This difference is not important when all prices are changing proportionately. But if the prices of different goods and services are changing by varying amounts, the way we weight the various prices matters for the overall inflation rate.

What is the third problem with the CPI?

The third problem with the CPI is unmeasured quality change. 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. Similarly, if the quality rises from one year to the next, the value of a dollar rises. The BLS does its best to account for quality change. When the quality of a good in the basket changes—for example, when a car model has more horsepower or gets better gas mileage from one year to the next—the Bureau adjusts the price of the good to account for the quality change. It is, in essence, trying to compute the price of a basket of goods of constant quality. Despite these efforts, changes in quality remain a problem because quality is hard to measure.