MACRO Chapter 23: CPI and the Cost of Living

CPI equation

CPI = (Cost of CPI basket (of the year you want) prices / cost of CPI basket at base prices) x 100

Monthly Price Survey: Each month, BLS employees check the prices of the 80,000 goods and services in the eight large groups shown in the ___ ______

CPI basket in 30 metropolitan areas.

The CPI basket is based on information obtained from the ____ ____ ______

Consumer Expenditure Survey, which is conducted frequently.

How often does the BLS calculate the CPI?

Every month

GDP Index Equation

GDP price index = (Nominal GDP / Real GDP) x 100.

What is the purpose of the CPI (one of several alternative price level) measures

Its purpose is to measure the cost of living.

By excluding these highly variable items, the underlying price level and inflation trends can be seen

More clearly

Macroeconomics makes a big issue of the distinction between nominal values and real values:

Nominal GDP and real GDP Nominal wage rate and real wage rate Nominal interest rate and real interest rate

Deflation

is a situation in which the inflation rate is negative.

Personal Consumption Expenditures Price Index (PCEPI)

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

Nominal interest rate

is the dollar amount of interest expressed as a percentage of the amount loaned.

Real interest rate

is the goods and services forgone in interest expressed as a percentage of the amount loaned.

Inflation rate

is the percentage change in the price level from one year to the next.

Because the CPI measures price changes

it is important that the prices recorded refer to exactly the same items.

The CPI is defined to equal 100 for a period called the....

reference base period

To reduce the bias, the BLS has increased the frequency of its Consumer Expenditure Survey and...

revises the CPI basket as new data is available.

When the BLS revises the CPI basket

the reference base period does not change

The PCEPI uses current information on quantities and prices, so it avoids

the sources of bias in the CPI.

3 stages of constructing CPI

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

Equation for comparing dollar amounts

(Price recently) x (CPI recently /CPI way past)

Quality Change Bias

1. Better cars and televisions cost more than the versions they replace. 2. A price rise that is a payment for improved quality is not inflation but might get measured as inflation.

Two main consequences of the bias in the CPI are

1. Distortion of private contracts 2. Increases in government outlays and decreases in taxes

The CPI calculation has three steps:

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

Top 5 items (categories) that the average household buys

1. Housing 2. Transportation 3. Food and beverages 4. Medical Care 5. Education and communication

Outlet Substitution Bias

1. If prices rise more rapidly, people use discount stores more frequently. 2. The CPI basket doesn't change to allow for the effects of outlet substitution.

The CPI does not measure the cost of living because

1. It does not measure all the components of the cost of living. 2. Some components are not measured exactly. So the CPI is possibly a biased measure.

New Goods Bias

1. New goods do a better job than the old goods that they replace, but cost more. 2. The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate.

The CPI is used to adjust:

54 million Social Security benefit payments 47 million food stamp payments 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses The budget for 3 million school lunches

Extra CP-CPI notes

Because it uses current period expenditures that are updated every month, the C-CPI avoids the bias in the CPI. The C-CPI takes account of new goods, quality change, and substitution effects. The only weakness of the C-CPI is that it gets revised several times as the data on recent expenditures get revised.

Alternative Consumer Price Indexes

Chained Consumer Price Index (C-CPI) Personal Consumption Expenditures Price Index (PCEPI) • PCEPI excluding food and energy

Increases in Government Outlays and Decreases in Taxes

Close to a third of federal government outlays are linked directly to the CPI.

Core inflation on a graph

Core inflation is biased downward because food and energy prices rise faster than other prices.

inflation rate equation

Inflation rate = (CPI in current year- CPI in pervious year) / CPI in previous year ) x 100

Consumer Price Index (CPI)

Is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services.

Distortion of Private Contracts

Many wage contracts are linked to the CPI. If the CPI is biased, these contracts might deliver an outcome different from that intended by the parties

The potential sources of bias in the CPI are

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

We can use the numbers in the CPI to compare what a fixed basket of goods costs this month with what it cost in some .....

Pervious months

real interest rate equation

Real interest rate = Nominal interest rate - Inflation rate.

Wage rate equation

Real wage rate= (nominal wage rate / CPI) x 100

Commodity Substitution Bias

The CPI basket doesn't change to allow for the effects of substitution between goods.

core inflation rate

The annual percentage change in the PCEPI excluding food and energy

Wage rate written equation

To calculate the real hourly wage rate, we divide the nominal hourly wage rate by the CPI and multiply by 100.

The CPI basket is not....

Updated each month

The relative importance of the items in the CPI basket is the same as in the ....

budget of an average urban household.

Food and energy prices fluctuate much more than other prices, so their changes

can obscure the underlying trends in prices.

The CPI is used to adjust the income levels at which

higher tax rates apply.

Cost of living index

is a measure of changes in the amount of money that people would need to spend to achieve a given standard of living.

Def: Reference base period

is a period for which the CPI is defined to equal 100.

GDP price index

is an average of the current prices of all the goods and services included in GDP expressed as a percentage of the base-year prices.

Chained Consumer Price Index (C-CPI)

is measure of the price level calculated using current month and previous month prices and expenditures.

Nominal wage rate

is the average hourly wage rate measured in current dollars.

Real wage rate

is the average hourly wage rate measured in the dollars of a given reference base year.

Tax rates on large incomes are higher than those on small incomes, so as incomes rise the burden of taxes would _______

rise relentlessly if these adjustments were not made.

To the extent that the CPI is biased upward, the tax adjustments overcompensate for ______

rising prices and decrease the amount paid in taxes.

To compare dollar amounts at different dates, we need to know

the CPI at those dates.

C-CPI is called a "chained" CPI because....

the inflation rate calculated for the current month is linked back, like the links in a chain, to a reference base month.