ECON LO 24 - MEASURING THE COST OF INFLATION AND LIVING

CPI

(consumer price index) a measure of the overall cost of the goods and services bought by a typical consumer -reported monthly -changes in cost of living over time

CPI formula

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

Uses of CPI

-Calculating inflation rates and policy target -Social security Cost of Living Adjustments (COLA) -Converting nominal into real variables -Tracking prices over time

How CPI is calculated

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

CPI bias leads to errors in:

1. Indexing (COLA) 2. Wages 3. Interest Payments 4. Federal task brackets

Suppose that the prices of dairy products have risen relatively less than prices in general over the last several years. To which problem in the construction of the CPI is this situation most relevant? A unmeasured quality change B substitution bias C introduction of new goods D income bias

B- Substitution bias

Of Social Security benefits and federal income tax brackets, which is indexed?

Both are indexed

The _______ is the most commonly reported measure of inflation by the media.

CPI

Which of the following is correct? A Nominal and real interest rates never move together. B Nominal and real interest rates always move together. C Nominal and real interest rates always move in opposite directions. D Nominal and real interest rates do not always move together.

D- Nominal and real interest rates do not always move together.

T or F: Inflation can only be measured by the consumer price index and not by the GDP deflator.

False - Inflation can be measured using both the consumer price index and the GDP deflator. However, the CPI is used more frequently when examining changes in prices for consumer goods.

Which of the following statements about real and nominal interest rates is correct? A Real interest rates can be either positive or negative, but nominal interest rates must be positive. B Real interest rates and nominal interest rates can be either positive or negative. C Real interest rates must be positive, but nominal interest rates can be either positive or negative. D Real interest rates and nominal interest rates must be positive.

Real interest rates can be either positive or negative, but nominal interest rates must be positive.

CPI vs GDP deflator

The GDP deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers.

T or F: The difference between the nominal interest rate and the inflation rate is equal to the real interest rate.

True

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 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

dollar figures from different times equation

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

substitution bias

consumers may change their purchasing habits away from goods that have increased in price 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 cost of living from one year to the next.

The nominal interest rate tells you

how fast the number of dollars in your bank account rises over time.

The real interest rate tells you

how fast the purchasing power of your bank account rises over time.

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 the BLS adjusts the price of a good to account for the quality change, however this still remains a problem because quality is hard to measure. *All biases in CPI lead to an overstatement of inflation

demand-pull inflation

increases in the price level (inflation) resulting from an excess of demand over output at the existing price level, caused by an increase in aggregate demand

Fisher Equation

real interest rate = nominal interest rate - inflation rate

cost-push inflation

rising prices as a result of rising production costs

A COLA automatically raises the wage when

the consumer price index increases.

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

indexed for inflation

when some dollar amount is automatically corrected for changes in the price level by law or contract