03 14 2013 VOCAB Consumer Price Index CPI A measure of the overall cost of the goods and services bought by a typical consumer 1 Fix the Basket The Bureau of Labor Statistics BLS surveys consumers to determine what s in the typical consumer s shopping basket goods in the basket 2 Find the prices The BLS collects data on the prices of all the 3 Compute the Basket s cost Use the prices to compute the total cost of the basket 4 Choose a base year and compute the index 5 Compute the Inflation Rate The percentage change in the CPI from the preceding period CPI is used to monitor changes in the cost of living over time When the CPI rises the typical family has to spend more money to maintain the same standard of living Base year is ALWAYS 100 Price of basket of goods and services in current year CPI x 100 Price of basket in base year Inflation Rate Percent change in price index from the preceding period CPI in yr 2 CPI in yr 1 Inflation rate in yr 2 x 100 CPI in yr 1 Producer Price Index PPI A measure of the cost of a basket of goods and services bought by firms rather than consumers Indexation Indexed The automatic correction by law or contract of a dollar amount for the effects of inflation Nominal Interest Rate Interest rate that measures the change in dollar amounts inflation Real Interest Rate The interest rate corrected for the effects of Real Interest Rate Nominal Interest Rate Inflation Rate NOTES others cheaper goods being more Problems in measuring the cost of living Substitution Bias When prices change from one year to the next they do not all change proportionately Some prices are more than Over time some prices raise more than others Consumers substitute towards goods that become relatively The DPI misses this substitution because it uses a fixed basket of Thus the CPI overstates increases in the cost of living Introduction of New Goods When a new good is introduced consumers have more variety from which to choose and this in turn reduces the cost of maintaining the same level of economic well The introduction of new goods increases variety allows consumers to find products that more closely meet their needs In effect dollars become more valuable The CPI misses the effect because it uses a fixed basket of goods Thus CPI overstates increases in the cost of living The evolution of the economy over time As new goods are introduced consumers have more choices and each dollar is worth Unmeasured Quality Change If the quality of a good deteriorates from one year to the next while its price remains the same the value of a dollar falls because you are getting a lesser good for the same amount of money value of each dollar Improvements in the quality of goods in the basket increase the 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 GDP Deflator vs Consumer Price Index GDP Deflator reflects the prices of all goods and services produced DOMESTICALLY Consumer Price Index reflects the prices of all goods and services bought by consumers Dollar figures from different times formula Price level today CPI Amount in today s Amount in yr T x Price level yr T CPI Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times Cost of Living Allowance COLA automatically raises the wage when the consumer price index rises Higher the rate of inflation Smaller the increase in Purchasing Power If the rate of inflation exceeds the rate of interest Purchasing Power falls Deflation Negative rate of Inflation Purchasing Power rises by more than the rate of interest Inflation reduces the purchasing power of each unit of money over time Imported Consumer Goods Included in CPI Excluded from GDP Deflator Included in GDP Deflator If produced Domestically Capital Goods Excluded from CPI The Basket CPI uses fixed basket GDP uses basket of current produced goods and services This matters if different prices are changing
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