Macroeconomics Chapter: 16

how to compute CPI

CPI = (price of basket of goods in current year) / (price of basket in base year) X 100

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

5 steps to calculating CPI and inflation rate

1. fix the basket (weigh the goods based on usage) 2. find the prices 3. compute the baskets costs 4. choose one year as base year and calculate CPI 5. compute inflation rate

typical basket of goods and services in real world? (top 3)

1. housing 2. transportation 3. food and beverage

3 problems in measuring cost of living

1. substitution bias 2. introduction of new goods 3. unmeasured quality change

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. BLS does it best to adjust for quality change but sometimes cannot keep up

GDP deflator vs CPI

The first difference is that the 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.

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. Yet because the consumer price index 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.

substitution bias

When prices change from one year to the next, they do not all change proportionately: Some prices rise more than others. 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.

producer price index (PPI)

a measure of the cost of a basket of goods and services bought by firms

how to adjust dollar figures to current times

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

how to compute inflation using CPI

inflation rate in year 2 = (CPI in year 2 - CPI in year 1) / (CPI in year 1) X 100

Consumer Price Index (CPI)

is a measure of the overall cost of the goods and services bought by a typical consumer. Each month, the Bureau of Labor Statistics (BLS), which is part of the Department of Labor, computes and reports the consumer price index.

how nominal and real interest rates and inflation are related

real interest rate = nominal interest rate - inflation rate