ECON 205 1st Edition Lecture 7 Outline of Last Lecture Using Gross Domestic Product GDP to measure a nation s income Correcting for inflation GDP and Economic well being Outline of Current Lecture How does Consumer Price Index CPI measure change in cost of living How does CPI compare with GDP deflator Using the CPI to compare dollar values over time and correct for inflation Current Lecture Consumer Price Index CPI Measure of the overall cost of the goods and services brought by a typical consumer CPI is calculated by o Fix the basket Bureau of Labor Statistics BLS surveys consumers to determine what s in the typical consumer s shopping basket o Find the Prices the BLS collects data on the price of all the goods in the basket o Compute the basket s cost use the prices to compute the total cost of the basket o Choose base year and compute the index 100 x cost of basket in current year cost of basket in base year o Compute the inflation rate percentage change in CPI from each year CPI of the current year CPI of the comparison year CPI of comparison year What is in the CPI basket Housing is 43 Transportation is 17 Food is 15 Medical Care is 6 Recreation is 6 Education and communication 6 Apparel 4 Other 3 Problems with CPI Substitution Bias over time some prices rise faster than others o Consumers will substitute towards cheaper goods i e if the price of chicken increases faster than that of turkey consumers may switch to turkey The CPI still has to use chicken in its measurements even though many people have switched to turkey o CPI lacks the flexibility to account for this because it has a fixed basket Introduction of New Goods introduction of new goods increases variety and allows consumer to find different products o The dollar increases in value o CPI misses this because it uses a fixed basket and does not account for the purchasing of new products Unmeasured Quality Change improvements in the quality of goods in the basket increase the value of each dollar o BLS tries to adjust for these changes but it is hard to measure quality changes These factors cause CPI to overestimate the cost of living CPI usually overstates inflation by about 5 per year The minor inaccuracies in CPI are important because Social Security payments and many contracts are tied to CPI Contrasting CPI and GDP Deflator Imported consumer goods o Included in CPI o Excluded in GDP deflator Capital Goods office buildings structures etc o Excluded from CPI o Included in GDP Deflator The Basket o CPI uses a fixed basket o GDP deflator uses basket of currently produced goods and services o This matters is prices of separate goods are changing by different amounts GDP deflator and CPI graphs are relatively similar Neither is more accurate than the other because we don t know what exactly the correct answer is Doesn t account for the underground market o Makes certain nations appear poorer than they actually are i e Peru seems poor but its underground drug deals make it a richer nation than it appears in official statements Correcting Variables for Inflation Comparing dollar figures from different times is complicated by inflation o Better question than what was the minimum wage in year T compared to the minimum wage now is did minimum wage in year T have more purchasing power than it does now o Amount in today s dollar Amount in year T dollars x CPI today CPI in year T o Professionals use this technique to convert nominal dollars to real dollars o Graphs of minimum wage in nominal dollars looks like a stair case Because government changes the minimum wage once every few years not a gradual change o Graphs of minimum wage in real dollars jumps and then slowly decreases and then repeats The jump is caused by the increase of minimum wage by the government The slow decrease is caused by the slowly rising inflation rate o Indexation dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract Increase in CPI determines the COLA cost of living adjustments in multiyear labor contracts Adjustments in Social Security and tax brackets o Real vs Nominal Interest Rates Nominal interest rate is the rate of growth in the dollar value of a deposit or debt Real interest rate is the rate of growth in purchasing power Because it is corrected for inflation nominal interest rate inflation Production and Growth Productivity A country s standard of living depends on its ability to produce goods and services Productivity is the average of quantity of goods and services produced per unit of labor output Y real GDP quantity of output L quantity of labor Productivity Y L