ECON 2203 1st Edition Lecture 5KeyEquationsExamplesDefinitionsImportant InformationOutlineWhat is CPI? What is Inflation? How to calculate CPI and inflation rate? What is CPI?Consumer Price Index (CPI) measures the overall cost of the goods and services bought by a typical consumer- Consumer price index (CPI) is used to monitor changes in the cost of living over time- When CPI rises, the typical consumer has to spend more money to maintain the same standard of livingIn this class, when we talk about the Cost of Living, it refers to the overall cost of living for an economy. What is inflation and inflation rate?Inflation - the overallprice level is rising (CPI is rising) – Note:1) Itdoesnotmeanthepriceofeverygoodand service is rising2) When the price of an individual good increases, it is not inflation• True/False: The price of a 12-ounce bottle of Pepsi rises from last year, so the economy is experiencing inflationDeflation - the overall price level is decreasingInflation rate - is the percentage changein the price level from previous periodInflation Rate= Price Level in Period 2 – Price Level in Period 1/(Price Level in Period 1) x 100%Inflation Rate in 2012 = CPI in 2012 – CPI in 2011/(CPI in 2011) x 100%Inflation Rate from 2009 to 2012 = CPI in 2012 – CPI in 2009/(CPI in 2009) x 100%How to calculate CPI and inflation rate?A Simple Example: Your weekly cost of living• Housing: $100 • Cokes: 10 @ $1.5 each These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.• Hot dogs: 10 @ $1 each • Book: 2 @ $50 each • Hair cut: 1 @ $20 each $100+$1.5 x 10+$1 x 10 +$50 x 2+$20= $245Your cost of living is the cost of total goods and services you bought (consumed) to maintainyour standard of living. (It’s not the cost to maintain you alive)A basket of goods is sold at $245 in Union Express Inside the basket:- 10 Hot Dogs- 10 Cokes- 2 Books- 1 Contract for living in the apartment- 1 Coupon to get a free haircutThe price of this basket measures your personal cost of living each week• We monitor the change in the price of this basket• When the price of this basket increases, your cost of living increases• When price decreases, your cost of living decreasesLet’s assume a simple economy in which a typical consumer buy only two goods, 10 hot dogs and 6 cokes, to maintain his standard of livingStep 1: Fix the basket with 10 hot dogs and 6 cokes- Fix both goods type and quantity- Quantity measures weights of different goods consumed- In this case, changes of hot dogs’ price is more important to the customerStep 2: Find the prices in each year Quantity 2010 2011 2012Hot dog 10 $1 $2 $2.5Coke 6 $1.5 $2 $1.5Step 3: Compute the basket’s cost (per basket)Hot Dog Coke Cost of the basketPrice Quantity Costs Price Quantity Costs2010 $1 X 10 = $10 $1.5 X 6 = $9 $192011 $2 X 10 = $20 $2 X 6 = $12 $322012 $2.5 X 10 = $25 $1.5 X 6 = $9 $34Step 4: Choose One Year as Base Year (2010) and Compute the Consumer Price Index������������������ =Price of basket in current year/(Price of basket in base year) x 100Year Price of basket Consumer Price Index2010 $19 (19/19) x 100 = 1002011 $32 (32/19) x 100 = 1682012 $34 (34/19) x 100 = 1792010  20112011CPI in 2011 is 168. It means the price of the basket in 2011 is 168 percent of 2010 its price in the base year. It also means a basket of goods that costs $100 in the base year costs $168 in 20112010  20122010 2012CPI in 2012 is 179. It means the price of the basket in 2012 is 179 percent of its price in the base year. It also means a basket of goods that costs $100 in the base year costs $179 in 2012.Step 5: Use CPI to Compute the Inflation Rate from Previous YearCPI Inflation Rate2010 100 ---------------2011 168 168 – 100/(100) x 100% = 68%2012 179 179 – 168/(168) x 100% = 65%– The inflation rate is 68% in 2011. It means the price level increased68% from 2010M – The inflation rate is 65% in 2012. It means the price level increased 68% from 2011If we choose 2011 as base year in Step 4, what’s the CPI and inflation rate?Year Price of basket Consumer Price Index2010 $19 (19/32) x 100 = 592011 $32 (32/32) x 100 = 1002012 $34 (34/32) x 100 = 1062011  2010CPI in 2010 is 59. It means the price of the basket in 2010 is 59 percent of its price in the base year. It also means a basket of goods that costs $100 in the base year costs only $59 in 2010.2011  2012CPI in 2012 is 106. It means the price of the basket in 2012 is 106% of its price in the base year. It also means a basket of goods that costs $100 in the base year costs $106 in 2012.Step 5: Use CPI to Compute the Inflation Rate from Previous YearYear CPI Inflation Rate2010 59 ------------2011 100 100 – 59/(59) x 100% = 69%2012 106 106 – 100/(100) x 100% = 6%– The inflation rate is 69% in 2011. It means the price level increased 69% from 2010. M – The inflation rate is 6% in 2012. It means the price level increased 6% from 2011.M> The choice of the base year does not matter to the inflation (with CPI it does matter)- The slight difference between the two cases is due to