EC 111 1st Edition Lecture 8PREVIOUS LECTUREI. Real Vs Nominal GDPII. The GDP DeflatorIII. GDP and Economic Well-BeingIV. GDP Does Not Value…V. Why Do We Care About GDPVI. The Consumer Price Index (CPI)VII. How CPI Is CalculatedCURRENT LECTUREI. Problems With The CPI: Substitution BiasII. Problems With The CPI: Introduction of New GoodsIII. Problems With The CPI: Unmeasured Quality ChangeIV. Problems With The CPIV. Contrasting The CPI And GDP DeflatorVI. Correcting Variables For Inflation: Comparing Dollar Figures From Different TimesVII. Correcting Variables For Inflation: IndexationVIII. Correcting Variables For Inflation: Real Vs. Nominal Interest RatesPROBLEMS WITH THE CPI: SUBSTITUTION BIAS- Overtime, some prices rise faster than others- Consumers substitute toward goods that become relatively cheaper- The CPI misses this substitution because it uses a FIXED basket of goods- Thus, the CPI overstates increases in the cost of living- The basket is fixed it does not change- The CPI can overstate the cost of living- CPI can overstate inflation because it doesn’t take into account substitution- This is the number one issuePROBLEMS WITH THE CPI: INTRODUCTION OF NEWGOODS- The introduction of new goods increases variety and allows consumers to find products that more closely meet their needs- In effect, dollars become more valuable- The CPI misses this effect because it uses a fixed basket of goods- Thus, the CPI overstates increases in the cost of livingGradeBuddy- Every 5 to 6 years when the basket is updated things are added and dropped out- Takes a while for things to enter the basketPROBLEMS WITH THE CPI: UNMEASURED QUALITYCHANGE- Improvements in the quality of goods in the basket increases the value of each dollar- The BLS tries to account for quality changes but probably misses some, as quality is hard to measure- Thus, the CPI overstates increases in the cost of living- We used to have the outlet shopping effectPROBLEMS WITH THE CPI- Each of these problems causes the CPI to overstate cost of living increases- The BLS has made technical adjustments, but the CPI probably still overstatesinflation by about 0.5% per year- This is important because social security payments and many contracts have COLAs tied to the CPI- AARP has a lot of powerCONTRASTING THE CPI AND GDP DEFLATOR- Imported consumer goods:o Included in CPIo Excluded from the GDP deflator- Capital Goods (goods bought for businesses)o Excluded from CPIo Included in the GDP Deflator- The basketso CPI uses fixed basketso GDP Deflator uses basket of currently produced goods and serviceso *this matters if there are different prices are changing by different amounts- CPI updated every five to six years- GDP Deflator updated automatically- The CPI and GDP tend to move together overtimeCORRECTING VARIABLES FOR INFLATION: COMPARINGDOLLAR FIGURES FROM DIFFERENT TIMES- Inflation makes it harder to compare dollar amounts from different times- Minimum wages:o $1.15 December 1964GradeBuddyo $7.25 December 2010- Which had more purchasing power?o We must convert it to today’s dollars- Computed as:o Amount in year T dollars*(price level today/price level in year T)- Minimum wage in 1964 had more purchasing power- Researchers, business analysts, and policy makers often use this technique to convert a time-series of current dollar (nominal) figures into the constant dollar (real) figures- They can see how a variable has changed over time after correcting for inflationCORRECTING VARIABLES FOR INFLATION: INDEXATION- A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contractCORRECTING VARIABLES FOR INFLATION: REAL VSNOMINAL INTEREST RATES- The nominal interest rate:o The interest rate NOT corrected for inflationo The rate of growth in the dollar value of a deposit or debt- The real interest rateo Corrected for inflationo The rate of growth in the purchasing power of a deposit or debt- Real Interest Rate=Nominal Interest