FTC1 Macro Ch 7 "CPI & Cost of Living..."

How do you calculate Inflation rate?

CPI in Current Year - CPI in previous year divided by CPI in previous year x 100 (to get % change)

How do you calculate Deflation?

Same as inflation, and the 'previous year' CPI will be higher than the current year so the resulting percentage change will be negative (have minus sign in front of it)

Define 'Inflation Rate'

The percentage change in the price level from one year to the next. INFLATION is positive change from one yr to next - "going up" 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 (or deflation)

What is the CPI's 'Reference Base Period'?

A period for which the CPI is defined to equal 100. Currently, the reference base period is 1982-1984.

What is the 'PCE Price Index'? (or Personal Consumption Expenditures price index) How does it differ from CPI? (less biased than CPI...disguises inflation trend a little less than GDP price index)

"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." ~ has the same advantages as the GDP price index— uses current information on quantities and to some degree overcomes the sources of bias in the CPI. ~ 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 is more current

What is the Cost of Living Index and why does the CPI not perfectly measure it?

1. B/C the CPI only measures PRICE changes for fixed quantities in the market basket - NOT quantity changes (like more natural gas use in wintertime) 2. 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.

Define Consumer Price Index. What is a major purpose of the CPI?

A measure of the average of the prices paid by urban consumers for a fixed market basket of consumption goods and services. A major purpose of the CPI is to measure changes in the cost of living and in the value of money

Define 'Deflation'

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

What is the 'PCE Price Index excluding Food and Energy'? (disguises inflation trend the least)

A smaller component of the PCE price index: The annual percentage change in the PCE price index is the Core Inflation Rate: the inflation rate, but excluding the prices of food and energy (because those fluctuate much more than other things so they need to be isolated out to get a clearer pic of inflation)

What is the 'GDP Price Index'? How does it differ from CPI? (less biased than CPI...disguises inflation trend a lot)

Also known as the GDP Deflator: An average of the current prices of ALL the goods and services included in GDP expressed as a percentage of base-year prices. 1. GDP uses the prices of ALL the goods/svcs in GDP (consumption, capital goods, gov't, export) whereas the CPI only considers consumption goods/svcs 2. The GDP price index weights each item using information about CURRENT QUANTITIES (as opposed to CPI using a past survey w/ fixed quantities) ***But GDP measures too many items to be used as a measure of cost of living

Why is avoiding bias important for the CPI?

Bias leads to: • Distortion of private contracts (the CPI may not adjust at the same rate as written into private contracts which can cause losses to the economy) • Increases in government outlays and decreases in taxes (Social Security and other benefits are directly tied to CPI and are to adjust w/ cost of living, so an overestimated bias in CPI costs taxpayers more money to compensate for increases in cost of living that are false...also, taxes are adjusted as prices rise according to CPI so if CPI is biased upward, less taxes are paid than need to be)

What is NOMINAL wage rate vs. REAL wage rate?

Nominal Wage Rate: The average hourly wage rate measured in current dollars Real Wage Rate: The average hourly wage rate measured in the dollars of a given reference base year.

How do you calculate the CPI?

Since the CPI avgs price increases by comparing cost of market baskets (instead of prices of individual products in baskets): 1. Multiply quantities of products by their prices in the BASE year market basket - add them up for the basket price 2. Multiply quantities of products by their prices in the CURRENT year market basket - add them up for the basket price 3. Divide Cost of CPI basket at current period prices by Cost of CPI basket at base period prices, then multiply by 100

What is a Nominal Interest Rate?

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

What is a Real Interest Rate?

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. (basically, you need $1030 to buy what $1000 previously would've, so the $50 interest you earned on your $1000 is now essentially reduced to $20 in real interest, or the REAL value of the $50 interest is $20)

What are potential sources of bias in the CPI?

The potential sources of bias in the CPI are • New goods bias (new goods change the market basket composition, for which adequate comparisons can't be made w/ past years and this skews the CPI bias) • Quality change bias (does quality warrant price increases? are price increases proportional to quality increase, or not? these inconsistencies create CPI bias) • Commodity substitution bias (CPI basket has fixed quantities so if a price rises for a carrot and a person decides to switch to more lower-priced broccoli and spends the same as previous month, the CPI doesn't take this into account - the carrots still make the market basket rise in price even if consumers AREN'T spending more b/c of substitution) • Outlet substitution bias (people get goods CHEAPER at outlets but the CPI doesn't account for this and so the basket may increase in price)

What is the purpose of the CPI?

The purpose of the CPI is to measure the cost of living or what amounts to the same thing, the value of money. 'Cost of Living Index' is another name for CPI