FTC1 Chapter 7

INFLATION

-The CPI is the most widely cited and studied measure of a rise in the cost of living, or inflation. Inflation is a rise in the overall price level for an economy. -If the level of the CPI is rising, the cost of living is going up, or the value of a dollar's worth of goods and services is declining.

The price survey used to calculate CPI is conducted on a_________basis.

MONTHLY

Determining prices

Second, prices for each of the goods and services in the basket must be determined each month. The BLS has a group of shoppers that travel around recording prices for the goods and services in the market basket. The basket is kept the same for as many consecutive months as possible.

When summer comes, lots of students graduate from college and start to look for a job. The unemployment rate during this time period is a little bit higher than before. Why?

This is natural labor turnover

A real value is one that is expressed in the dollars of?

a given year

The BLS determines the basket of goods and services in the CPI by surveying businesses.

FALSE

The purpose of the CPI is to measure what?

the cost of living or what amounts to the same thing, the value of money

A situation in which the price level is falling and the inflation rate is negative

Deflation

An average of the current prices of all the goods and services included in GDP expressed as a percentage of base-year prices?

GDP price index, also called GDP deflator

Cost of the Basket

Third, the cost of the basket is computed. With a fixed basket, only prices are being allowed to change. This allows the BLS to isolate the effects of price changes over time.

There are four steps in constructing the CPI:

Survey Determining prices Cost of the Basket Index level

The dollar amount of interest expressed as a percentage of the amount loaned?

Nominal interest rate

GDP price index

-(also called the GDP deflator) is an average of the current prices of all the goods and services included in GDP expressed as a percentage of base-year prices. Two key differences between the GDP price index and the CPI result in different estimates of the price level and inflation rate. -First, the GDP price index uses the prices of all the goods and services in GDP—consumption goods and services, capital goods, government goods and services, and export goods and services—while the CPI uses prices of consumption goods and services only. For example, the GDP price index includes the prices of paper mills bought by 3M to make Post-it® Notes, nuclear submarines bought by the Defense Department, and Boeing 747s bought by British Airways. -Second, the GDP price index weights each item using information about current quantities. In contrast, the CPI weights each item using information from a past Consumer Expenditure Survey. But because of the breadth of the items that the GDP price index includes, it is not an alternative to the CPI as a measure of the cost of living. -Although the two price indexes usually move together, there are other important differences between the CPI and the GDP price deflator. Because the GDP price deflator is measuring goods and services produced rather than goods and services consumed, some goods that consumers regular purchase are not included. For example, imported goods will affect the CPI but not the GDP deflator, because imports are subtracted from GDP.

The CPI calculation has what three steps?

-1.Find the cost of the CPI market basket at base period prices, -2. Find the cost of the CPI market basket at current period prices, and -3. Calculate the CPI for the base period and the current period

ECONOMIC DECISIONS

-As an economic indicator, the CPI can assess the effectiveness of different government policies or as a guide for households and businesses making economic decisions. -The CPI is also used to adjust other economic data, such as income or wages, for price changes to compare these values over time.

What are the two key differences between the GDP price index and the CPI that result in different estimates of the price level and inflation rate

-First, the GDP price index uses the prices of all the goods and services in GDP—consumption goods and services, capital goods, government goods and services, and export goods and services—while the CPI uses prices of consumption goods and services only. -Second, the GDP price index weights each item using information about current quantities. In contrast, the CPI weights each item using information from a past Consumer Expenditure Survey. But because of the breadth of the items that the GDP price index includes, it is not an alternative to the CPI as a measure of the cost of living.

PCE price index excluding food and energy

-Food and energy prices fluctuate much more than other prices and their changes can obscure the underlying trends in prices. By excluding these highly variable items, the underlying price level and inflation trends can be seen more clearly. The percentage change in the PCE price index excluding food and energy is called the core inflation rate.

CPI

-The CPI is a(n) estimate of the prices paid for all goods and services purchased for consumption by urban wage earners. - The CPI is the most widely cited and studied measure of inflation . -The CPI can assess the effectiveness of a government policy or -act as a(n) guide for households and businesses making economic decisions.

PRICE ESTIMATES

-The CPI is an estimate of the prices paid for all goods and services purchased for consumption by urban wage earners, such as professionals, clerical workers, laborers, self-employed people, and retired people. -The index includes user fees, such as utility bills, and sales taxes paid by the consumer. Income taxes and investments, such as stocks, bonds, and life insurance, are not included.

Review

-The Consumer Price Index (CPI) measures the buying patterns of urban consumers—specifically, the average prices they pay from among a specified list of goods. Although it does not measure all goods and services, or even the entire consumer market, it demonstrates how much money people need to spend to maintain a given living standard. Even without providing a complete picture, the CPI offers insights into cost of living, inflation, and deflation.

Changes in the Cost of Living

-To determine the change in the cost of the living, we look at the inflation rate, which is the percentage change in the price level from one year to the next. -Recall that inflation is a rise in the price level. Conversely, deflation occurs when the price level is falling and the inflation rate is negative.

Personal consumption expenditures (PCE) price index

-s an average of the current prices of the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices. The PCE price index has the same advantages as the GDP price index—it uses current information on quantities and to some degree overcomes the sources of bias in the CPI. It also has an advantage shared by the CPI of focusing on consumption expenditure and therefore being a possible measure of the cost of living. -A weakness of the PCE price index is that it is based on data that become known after the lapse of several months. So the CPI provides more current information about the inflation rate than what the PCE price index provides. -The CPI and PCE index also differ in the categories of goods and services measured. The CPI uses a household survey to calculate what consumers are spending money on, whereas the PCE index is found by surveying businesses to see what they are selling. Like the GDP price deflator, the CPI and PCE indices move up and down in similar way over time. However, the previously discussed bias in the CPI causes its rate of inflation to be slightly higher than the PCE inflation rate.

Constructing the CPI is a huge operation that costs millions of dollars and involves what three stages

1. Selecting the CPI market basket, 2. Conducting the monthly price survey, and 3. Calculating the CPI

What is the difference between the nominal and real wage rates?

Because we measure the real wage rate in constant base period dollars, a change in the real wage rate measures the change in the quantity of goods and services that an hour's work can buy. In contrast, a change in the nominal wage rate measures a combination of a change in the quantity of goods and services that an hour's work can buy and a change in the price level. So the real wage rate removes the effects of inflation from the changes in the nominal wage rate.

Avoiding bias in the CPI is important for what two main reasons

Bias leads to distortion of private contracts and increases in government outlays and decreases in taxes

-A measure of the average of the prices paid by urban consumers for a fixed market basket of consumption goods and services. -The Bureau of Labor Statistics (BLS) calculates the CPI every month, and we can use these numbers to compare what the fixed market basket costs this month with what it cost in some previous month or other period.

Consumer Price Index (CPI)

The annual percentage change in the PCE price index excluding the prices of food and energy

Core inflation rate

A measure of the change in the amount of money that people need to spend to achieve a given standard of living?

Cost of living index (CPI is sometimes called this)

CPI also includes price level of national defense products.

FALSE, CPI only focuses on consumption goods, which would be purchased by an urban family of 4.

During economic recession, cyclical unemployment is positive which makes the unemployment rate lower than the natural unemployment rate.

FALSE, Unemployment rate is higher than natural unemployment rate during recession

Survey

First, the BLS surveys consumers in urban areas to determine what these consumers regularly purchase in the marketplace each month. This survey determines a representative bundle of goods and services, or market basket, purchased by a typical consumer. In 2010, the BLS's basket of goods included food and beverages (14.8%), housing (41.5%), apparel (3.6%), transportation (17.3%), medical care (6.6%), recreation (6.3%), education (3.1%), communication (3.3%), and other goods and services (3.5%). Your spending patterns may or may not follow these ratios, but the BLS survey found that these goods and their corresponding percentages make up the monthly budget of the typical U.S. consumer living in an urban area.

New goods

First, the CPI does not take into account increases in the purchasing power of the dollar attributable to the introduction of new goods. Although new goods are often more expensive than the goods they replace, consumers have a wider variety of goods and services from which to choose. This increase in choices makes every dollar more valuable, which lowers the cost of maintaining the same level of economic well-being. Because the market basket is fixed for some period of time, new goods are left out of the bundle of goods and services purchased by the typical consumer. For example, portable mp3 players were not introduced to the basket until well after they were very popular amongst consumers.

The CPI is sometimes called a cost of living index—a measure of the change in the amount of money that people need to spend to achieve a given standard of living. The CPI is not a perfect measure of the cost of living (value of money) for two broad reasons.

First, the CPI does not try to measure all the changes in the cost of living. -For example, the cost of living rises in a severe winter as people buy more natural gas and electricity to heat their homes. A rise in the prices of these items increases the CPI. The increased quantities of natural gas and electricity bought don't change the CPI because the CPI market basket is fixed. So part of this increase in spending—the increase in the cost of maintaining a given standard of living—doesn't show up as an increase in the CPI. Second, even those components of the cost of living that are measured by the CPI are not always measured accurately. The result is that the CPI is possibly a biased measure of changes in the cost of living.

Index level

Fourth, the BLS chooses the base period and computes the index level. The level of the CPI in any given month is equal to 100 mulpilied by the ratio of the basket's cost in the current month to the cost in the base period. As an index, the CPI is defined to equal 100 during some yearly period called the reference base period. The BLS is currently using 1982-1984 as the reference base period. That is, the index is set to 100 for the average CPI over those years. The base year period will likely be updated in the future as more census data are collected.

Outlet substitution

Fourth, the CPI has an outlet substitution bias. When prices rise, people use discount stores more frequently and convenience stores less frequently. Consumers are here again substituting toward relatively cheaper goods. Because the basket doesn't correct for the substitution, the CPI often overstates the increase in the cost of living over time. Because of these measurement problems, the CPI overstates annual inflation by appromiately one percentage point. A 1996 study estimated that the bias overstates the inflation rate by approximately 1.1% per year. This overestimation in the rate of inflation can lead to real problems in the economy.

Other Measures of the Cost of Living There are two other commonly used measures of the cost of living:

GDP price deflator Personal consumption expenditure index

The percentage change in the price level from one year to the next

Inflation rate

The Problem with Biases

Many contracts and payments are indexed to the CPI. According to the BLS, more than 2 million unionized workers in the United States are covered by agreements with employers that tie their wages to the CPI. If the CPI is biased, then these workers are receiving higher-than-expected increases in their wages. The CPI also affects the income of almost 50 million retired and other workers that receive Social Security benefits. If the CPI is biased, then these retirees are receiving higher-than-expected increases in their annual income. Since 1985, the U.S. federal government has used the CPI to adjust the income tax structure so as to prevent inflation-induced increases in taxes. However, the upward bias means that these adjustments are biased upward, and the government is collecting less tax revenues. To reduce the bias, the BLS now conducts consumer spending surveys more frequently. More frequent changes in the basket should reduce the upward bias over time.

The CPI is an imperfect measure of the cost of living because its construction results in four types of bias:

New goods bias, Quality change bias, Commodity substitution bias, and Outlet substitution bias

The average hourly wage rate measured in current dollars?

Nominal wage rate

When price of a product increases, people tend to buy it from a discount store. This is called__________. *

OUTLET BASIS

When calculating CPI, ________________________________

Only price changes, quantity doesn't change over time, This is CPI's assumption. This way, we can focus on quantity change only.

An average of the current prices of the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices

PCE price index (Personal Consumption Expenditures)

The Bureau of Labor Statistics (BLS) calculates and reports the CPI monthly. What does this report help to measure?

PRICE ESTIMATES INFLATION ECONOMIC DECISIONS

The goods and services forgone in interest expressed as a percentage of the amount loaned and calculated as the nominal interest rate minus the inflation rate?

Real interest rate

The average hourly wage rate measured in the dollars of a given reference base year?

Real wage rate

-A period for which the CPI is defined to equal 100. Currently, the period is 1982-1984 -Currently, the reference base period is 1982-1984. That is, the CPI equals 100 on the average over the 36 months from January 1982 through December 1984.

Reference base period

Changes in quality

Second, the CPI is biased by unmeasured changes in the quality of goods and services. Many times a rise in the price of product reflects quality improvements. For example, cars become safer, and drugs become more effective at treating diseases. If the quality of a good or a service is increasing, the value of the dollar used to purchase it also rises. That is, the cost of living is actually going down. If quality increases, the cost of living, which the CPI tries to measure, does not necessarily rise. Therefore, the price index does not rise directly with higher quality. The BLS tries to correct prices for changes in quality, but this is difficult because quality is hard to measure.

Alternative Measures of the Price Level and Inflation Rate

Several alternative measures of the price level and inflation rate are available. One based on wholesale prices and another based on producers' prices are similar to the CPI, both in the way they are constructed and their potential for bias. But three other price indexes that we'll briefly describe here are less biased. These indexes are the - GDP price index - Personal consumption expenditures (PCE) price index - PCE price index excluding food and energy

Because the CPI reflects prices for goods and services bought by consumers, it is more commonly used than the GDP deflator as a gauge of inflation.

TRUE

If the CPI declines, urban workers and residents will spend fewer dollars to maintain the same standard of living.

TRUE

Commodity subtitution

Third, the CPI does not take into account consumers' ability to substitute goods for ones that become relatively cheaper over time. This is called commodity substitution bias. The typical consumer will choose not to buy goods and services with large relative price increases. The CPI does not allow for this substitution. The index is again calculated using a fixed basket of goods and services.

Why is the real wage rate a significant economic variable?

because it measures the real reward for labor, which is a major determinant of the standard of living. The real wage rate is also significant because it measures the real cost of labor services, which influences the quantity of labor that firms are willing to hire.

A nominal value is one that is expressed in

current dollars

When the price level rises rapidly, the inflation rate is high; when the price level rises slowly, the inflation rate is low; and when the price level is falling, the inflation rate is?

negative