Slide 1Slide 2OVERVIEW / Questions of the DayI. Inflation and the CPI: General BackgroundInflation: What is it?Slide 6Inflation: What is it?Inflation: What is it?Inflation: What is it?Inflation: Common MeasuresCPI: USESCPI: DEFINEDII. CPI – CalculationCALCULATING CPICPI: BASKET WEIGHTSCalculating 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 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”‘THE ECONOMY’WHAT IS IT AND HOW DOES IT WORK?The Economy I: Gross Domestic ProductThe Economy II: Business Cycles and UnemploymentThe Economy III: Inflation and the Cost of LivingThe Economy IV: Modeling The Economy1THE ECONOMY III:INFLATION AND THE COST OF LIVINGUnderstanding and Using the CPI2“Consumer Prices See Biggest Rise in 17 Years”; Reuters, Jan 16, 2008OVERVIEW / Questions of the Day•What exactly is ‘inflation’?•How do we measure/calculate inflation•What has been the average U.S. inflation rate?•What do we use the CPI for once we’ve calculated it?•How well does the CPI work?•What are its shortcomings?•What is the difference between ‘real’ and ‘nominal’ variables?3I. INFLATION AND THE 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 rate5Which 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 country6Inflation: 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 cars7Inflation: 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, etc8Inflation: 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 country9Inflation: What is it?Inflation: Common Measures1. CPI – Consumer Price Index•Measures the weighted average change of prices of •Most widely reported measure2. GDP Chain Price Index•Measures the weighted average change of prices of •Measures the difference between nominal and real GDP3. PPI – Producer Price Index•Measures the weighted average change of prices of •Often used to10CPI: USES 1. As an•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•Used to index income payments (such as social security, pay raises, pensions, etc) to3. As a•Used to adjust other economic series into inflation-free dollars, as well as to determine the purchasing power of the dollar over time11CPI: 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”12II. CPI – CALCULATIONCALCULATING CPISteps to calculating the CPI:1. Decide•BLS conducts surveys to determine what and how much of each goods households typically buy•Produces a typical “shopping basket”2. Find•BLS employs hundreds to collect prices of thousands of goods around the country3. Calculate•Use the prices to determine the total cost of the “shopping basket”1415CPI: BASKET WEIGHTS42.00%18.00%15.00%6.00%6.00%6.00%4.00%3.00%HousingTransportationFood/BeverageMedical CareRecreationEducation/CommunicationClothesOtherCalculating 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 Cost2012 $80 $32013 $85 $42014 $90 $5Calculating 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 =Calculating CPI: Example •Let 2012 be the base year•How much more did the basket cost in 2013 than 2012? 2014? (in %’s)•The CPI answers that question•Inflation: a measure of how fast prices are YearBasket CostCPI(Calculation) Inflation Rate2012 $1902013 2102014 230Calculating CPI: Interpretation 111: The basket costs 11% more in 2013 than 2012•$111 buys in 2013 what $100 bought in 2012121: The basket costs•$121 buys in 2014 what $100 bought in 201211%: The basket costs 11% more from 2012 to 20139%: The basket costs 9% more from 2013 to 2014 What do these numbers mean?Year CPI Inflation Rate2012 10011%2013 1119%2014 121Year CPI Inflation2005 195.32006 201.62007 207.32008 215.32009 214.52010 218.12011 224.92012 229.62013 233.0Use the CPI numbers to calculate the annual U.S. Inflation rate for the last four yearsPractice with U.S. CPI20Source: U.S. Bureau of Labor Statistics; www.bls.gov21Inflation Sources: 7/05 – 7/06U.S. Annual Inflation Rate1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 2015-15%-10%-5%0%5%10%15%20%22Source: Department of Labor, Bureau of Labor Statistics; www.bls.govIII. CPI – USES 23USES OF THE CPI1. Economic Indicator: Measure of