ch 24
GDP deflator vs CPI
GDP Deflator reflects the price of all goods and services produced domestically while the CPI reflects the price of all goods and services bought by consumers
producer price index
a measure of the cost of a basket of goods and services bought by firms (measure of inflation) ex: intermediate goods- raw timber, paper pulp, aluminum
consumer price index
an index of the cost of all goods and services to a typical consumer (way to measure inflation)
PPI is good indicator of
coming changes in CPI as firms pass on higher costs to consumers -prices of aluminum, paper pulp, timber go up it means in a couple months you will see the prices of houses, cans, books go up
introduction of new goods
consumers have more variety from which to choose, and this in turn reduces the cost of maintaining the same level of economic well-being -new goods tend to be left out of the market basket -overstates inflation
winners and losers with inflation
fixed rate: winners- borrowers losers- fixed income, lenders, retirees, savers uncertain- those with adjustable rate
cpi inflation rate
(CPI Year 2 - CPI Year 1)/ (CPI Year 1 ) x 100
cpi formula
(cost of basket in current year/cost of basket in base year) x 100
CPI tends to overstate inflation by
1% ex: if your wages index increased by 1% and CPI increased by 1.5%, you would think your losing but in reality CPI is truly 0.5, so you gain
How is CPI calculated?
1. Fix the basket (made up of 200 goods an average consumer buys) 2. Find the prices 3. Compute the basket's cost 4. Choose a base year and compute the index
problems in measuring the cost of living
1. substitution bias 2. introduction of new goods 3. unmeasured quality change
For example, suppose your grandfather earned $17,000 in 1969 and earned $55,000 in 1994. Over those 25 years, did his standard of living increase? CPI in 1969 = 36.7 CPI in 1994 = 148.2
17,000 x (148.2/36.7) = 68,649 68,649 > 55,000 A $17,000 salary in 1969 would buy as much as a $68,649 salary in 1994. Since your grandfather only earned $55,000 in 1994, his real income fell and his standard of living actually decreased
If workers and firms negotiate a wage increase based on their expectation of inflation, who gains or loses (the workers or the firms) if actual inflation turns out to be higher than expected? Why?
Firms gain, workers lose, because wages didn't rise as much as the cost of living.
Which would have a greater impact on the CPI: a 20 percent increase in the price of Rolex watches or a 20 percent increase in the price of new cars? Why?
New cars, because there are a greater number of new cars in the typical consumption basket.
unanticipated inflation
When inflation is higher than expected, borrowers gain and lenders lose because borrowers pay back with dollars worth less When inflation is lower than expected, lenders gain and borrowers lose because borrowers pay back with dollars worth more.
CPI can fall
if deflation is present
change in quality
if quality down, the value of the dollar down if quality up, the value of the dollar up
inflation means
prices on average are rising -value of dollar goes down
real interest rate formula
real interest rate = nominal interest rate - inflation rate ex: bank pays 0.6% interest rate on your savings. CPI is 1.6%. real interest rate is -1%
substitution bias
tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute goods whose prices rise by a lot -CPI does not allow substitution thus it overstates inflation ex: if price of fruit pebbles (say it is a market basket good) goes up, then you will buy another cereal. so truly, you are not impacted by the inflation.
indexation
the automatic correction by law or contract of a dollar amount for the effects of inflation -sometimes seen in priv sector (COLA)
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
