Slide 1OVERVIEW / Questions of the DayI. CPI – General BackgroundInflation: What is it?Slide 5Inflation: What is it?Inflation: What is it?Inflation: What is it?Inflation: Common MeasuresCPI: USESCPI: DEFINEDCPI: BASKET WEIGHTSII. CPI – CalculationCALCULATING CPICalculating CPI: ExampleCalculating the CPI: Steps (cont.)Calculating CPI: ExampleCalculating CPI: InterpretationPractice with U.S. CPIInflation Sources: 7/05 – 7/06U.S. Annual Inflation RateIII. CPI – UsesUSES OF THE CPIUSES OF THE CPIDEFLATING: Example 1DEFLATING: Example 1DEFLATING: Example 1DEFLATING: Example 1DEFLATING: Example 1DEFLATING: Example 1Practice – The BabeIV. CPI – AccuracyPROBLEMS WITH CPIPROBLEMS WITH CPICPI BIASES: New Goods BiasCPI BIASES: Quality BiasCPI BIASES: Substitution BiasCPI BIASESV. CPI – Real vs. NominalReal versus Nominal Interest RatesReal versus Nominal WagesVI. CPI – Types of InflationCost–Push InflationDemand–Pull InflationKey Terms and ConceptsPractice - Deflating“‘Agflation’ haunts market”Topic XII:Measuring the Cost of LivingUSING THE CPI1“Consumer Prices See Biggest Rise in 17 Years”; Reuters, Jan 16, 2008OVERVIEW / Questions of the DayWhat is ‘inflation’? How is it measured/calculated?◦What is the average U.S. inflation rate?How is it used? How well does the CPI work? ◦What are its shortcomings?2I. CPI – General BackgroundInflation: What is it?Inflation: a sustained increase in the overall level of prices of goods and services in an economy over a period of time◦ Deflation: a decrease in the overall level of prices of goods/services in an economy over a period of timeDisinflation: a slowdown in the inflation rate4Which of these are inflation?1. An increase in the price of steel leads to an increase in the price of cars2. An increase in the price of corn leads to an increase in the price of cereal, grains, pet food, corn oil, soda…3. A short spike in the price of crude oil leads to a short-term increase in the cost of doing business across country5Inflation: a sustained increase in the overall level of prices in an economy over a period of timeInflation or not?1. An increase in the price of steel leads to an increase in the price of cars1. No; this is just a supply and demand effect 6Inflation: What is it?Inflation: a sustained increase in the overall level of prices in an economy over a period of timeInflation or not?2. An increase in the price of corn leads to an increase in the price of cereals, grains, pet food, corn oil, sodas, etc7Inflation: What is it?Inflation: a sustained increase in the overall level of prices in an economy over a period of timeInflation or not?3. An increase in price of crude oil leads to an increase in the cost of doing business across the country8Inflation: What is it?Inflation: Common Measures1. CPI – Consumer Price Index◦Measures the weighted average change of prices for goods and services bought by a typical family◦Most widely reported measure2. GDP Chain Price Index◦Measures the weighted average change of prices of all new final goods and services produced in the US◦Measures the difference between nominal and real GDP3. PPI – Producer Price Index◦Measures the weighted average change of prices of common inputs bought by producers (firms)◦Often used to predict future inflation 9CPI: USES 1. As an economic indicator •Used by the public as well as policymakers for information regarding trends in inflation and making economic decisions2. As a means of adjusting dollar values (indexing)•Used to index income payments (such as social security, pay raises, pensions, etc) to provide cost of living wage adjustments 3. As a deflator of other economic series •Used to adjust other economic series into inflation-free dollars, as well as to determine the purchasing power of the dollar over time10CPI: DEFINED CPI is calculated and reported by Bureau of Labor Statistics (www.bls.gov) under the Dept. of LaborIt is reported monthly and annually“CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services”1112CPI: BASKET WEIGHTS42.00%18.00%15.00%6.00%6.00%6.00%4.00%3.00%HousingTransportationFood/BeverageMedical CareRecreationEducation/CommunicationClothesOtherII. CPI – CalculationCALCULATING CPISteps to calculating the CPI:1. Decide what goods to include and how much of each:◦BLS conducts surveys to determine what and how much of each goods households typically buy◦Produces a typical “shopping basket”2. Find the prices of each good for each year:•BLS employs hundreds to collect prices of thousands of goods around the country3. Calculate the cost of the basket:•Use the prices to determine the total cost of the “shopping basket”14Calculating CPI: Example Assume 2 goods – hamburgers and shoes Assume basket contains 2 pairs shoes and 10 hamburgers Basket cost = Amount of each good * priceYearPrice(Shoes)Price(Hamburgers) Basket Cost2008 $80 $3($80*2)+($3*10)=$1902009 85 4($85*2)+($4*10)=$2102010 90 5($90*2)+($5*10)=$230Calculating the CPI: Steps (cont.)4. Choose 1 year as the base year and construct the indexThe year picked as the base should not matter5. Calculate the inflation rate as the % difference in the index each yearCPI =Inflation rate =Cost of basket in current yearCost of basket in base yearX 100CPI last year CPI this year – CPI last yearx100Calculating CPI: Example Let 2000 be the base year How much more did the basket cost in 2001 than 2000? 2002? (in %’s) The CPI answers that question Inflation: a measure of how fast prices are changing over time, found by the annual percentage rate of change in the CPI YearBasket CostCPI(Calculation) Inflation Rate2000$190(190/190)*100=1002001 210 (210/190)*100=111 (111-100)/100*100=11%2002 230 (230/190)*100=121 (121-111)/111*100=9%Calculating CPI: Interpretation 111: The basket costs 11% more in 2001 than 2000◦$111 buys in 2001 what $100 bought in 2000121: The basket costs 21% more in 2002 than in 2000◦$121 buys in 2002 what $100 bought in 200011%: The basket costs 11% more from 2000 to 20019%: The basket costs 9% more from 2001 to 2002 What do these numbers mean?Year CPI Inflation Rate2000 10011%2001 1119%2002 121Year CPI Inflation2005 195.32006 201.6 3.2%2007 207.3 2.8%2008 215.3 3.9%2009 214.5 -0.5%2010 218.1 1.7%2011 224.9 3.1%2012 229.6 2.1%2013 233.0 1.5%Use the CPI numbers to calculate the annual U.S. Inflation rate for the last