ECN 222 1st Edition Lecture 12Outline of Last Lecture - GDP Deflator- Consumer Price Index- Gross Domestic Product- CPI Calculation- Inflation %ChangeOutline of Current Lecture- Review- Problems with the CPI- CPI vs GDP- Comparisons across time- CPI IncreasesCurrent LectureReviewTalking about CPI- Fix the basket- Find Prices- Calculate basket cost- Compute InflationCPI = 100 x Current Basket Base basketProblem: Fixed basket causes CPI to overstate inflationProblems with the CPIThese 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.-Three problems with the CPI caused by the fixed basket:1) Substitution bias - Consumers substitute toward relatively cheaper goods2) Introduction of new goods- Increases variety, consumers find products that more closely meet their needs3) Unmeasured Quality Change- Improvements in goods lead to more for your dollar- The CPI overstates increase in cost of living Each of these problems causes the CPI to overstate cost of living increases. The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year This is important because social Security payments and many contracts have COLAs tied to the CPICPI vs. GDPContrasting the CPI and GDP Deflator Imported consumer goods:o Included in CPI o Excluded from GDPo Included in GDP deflator  Capital Goodso Excluded from CPIo Included in GDP deflator (If produced domestically) The basketo CPI uses fixed basketo GDP deflator uses basket of currently produced goods and servicesThis matters if differentA) Starbucks raises the price of Frappuccino’sa. The CPI and GDP deflator both rise.B) Caterpillar raises the price of industrial tractors if manufactures at its Illinois factorya. GDP deflator rises, CPI does notC) Armani raises the price of the Italian jeans it sells in the USa. CPI goes up, GDP is not affected isn’t made hereCore inflation- includes all goods less food and energyHeadline Inflation- includes all goodsHeadline inflation Core(more stable) -0.1% +1.6%The difference is driven by the fall in price of energyComparisons across timeo Comparing Dollar Figures from different times Inflation makes it harder to compare dollar amounts from different time.-Example: The minimum wage $1.15 in Dec 1964$7.25 in Dec 2012Did minimum wage have more purchasing power in Dec 1964 or Dec 2012?Amount in today’s dollars = Amount in Year T dollars x Price level today Old Price levelEquivalent price today = old price x Price level todayOld price LevelIn our example o Year T = 12/1964, today = 12(2012)o Minimum wage = $1.15 in year o CPI = 31.3 in year T, CPI = 231.1 today$1.15 x 231.1/31.3 = $8.50Annual tuition and fees, average of all public four-year colleges and universities in the USo 1982-83 : $1031 (1982 CPI= 95.85)o 2014-15 : $9139 (2014 CPI= 236.71)Students pay more in 1983 or in 2015?Convert the 1983 figure to 2015 dollars and compare1031 x 236.71/95.85 = $2546Correcting Variables for InflationIndexationA dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contractCPI IncreasesSocial Security checks increase, indexed- your wages unchanged, not indexed UAW wages increase by contract, indexedIncome tax brackets shift, indexedReal vs Nominal Interest RateThe nominal interest rate:o The interest rate not corrected for inflationo The rate of growth in the dollar value of a deposit or debtThe real interest rateo Corrected for inflationo The rate of growth in the purchasing power of a deposit or debtReal interest rate= (nominal interest rate) – (inflation rate)Example:Got to best buy to buy a stereo, $1000o Problem: cannot afford stereo cables Deposit $1000 for one year at 9% ($1090 back)Year later goes buy stereo now costs $1035Inflation was 3.5%Gained $90 but spent $35 more, netted $55Real interest rate = Nominal interest rate – Inflation9.0% - 3.5% = 5.5%Prices increasing faster than bank balanceo Loosing “Purchasing Power”o CPI increasing about 1.5% per yearo Nominal interest rate = 0.01%o Real interest rate = 0.01% - 1.5% =