Chapter 11 Measuring the Cost of Living 1 The Consumer Price Index CPI Measures overall level of prices Measures overall cost of goods and services o Bought by typical customer Calculated by Bureau of Labor Statistics Calculating CPI 1 Fix the basket Which prices are most important to the typical consumer Different weight 2 Find the prices at each point in time 3 Compute the basket s cost Same basket of goods Isolate the effects of price changes 4 Choose a base year and Compute the CPI Base year benchmark o Cost of basket of goods services in Current Year x 100 Cost of basket in Base Year 5 Compute the Inflation rate Inflation rate in year 2 CPI yr 2 CPI yr 1 CPI yr 1 x 100 Interpreting Inflation Rate Average Price level in 2014 have increased by 75 since 2013 Inflation rate change in price index Example Chapter 11 Measuring the Cost of Living 2 Producer Price Index PPI Measure of the cost of a basket of goods services bought by firms Changes in PPI useful in predicting changes in CPI Typical Basket of Goods Services Relative Importance of each category Problems in Measuring the Cost of Living Substitution bias o Prices does not change proportionately o Consumers substitute toward goods that have become relatively less expensive Introduction of new goods more variety Unmeasured changes in quality CPI overstates inflation b c consumers can sometimes substitute cheaper goods for those that have risen in price Chapter 11 Measuring the Cost of Living 3 GDP Deflator vs CPI both measure overall price level GDP Deflator Ratio of nominal GDP to real GDP x 100 o Nom GDP same yr Real GDP same yr Reflects prices of all goods services produced domestically Excludes imports includes exports Compares price of currently produced goods services to the price of the same goods and services in the base year CPI Reflects prices of goods and services bought by consumers Compares price of a fixed basket of goods and services to price of basket in Includes imports excludes exports base year Side note 1980s oil crisis Correcting Economic Variables Dollar figures from different times Amount in today s dollars Amt in year T dollars x Price level Today Price level in yr T Indexation Automatic correction by law of contract of a dollar amt For effects of inflation Chapter 11 Measuring the Cost of Living 4 COLA Cost of Living Allowance Nominal lnterest Rate Interest rate as usually reported Without a correction for the effects of inflation New interest rate old interest rate Old interest rate Real Interest Rate Interest rate corrected for the effects of inflation nominal interest rate inflation rate Side note Why are there interest rates It s an incentive to put money in the bank to make up for the opportunity cost of not being able to invest the money put the money to better use Interest Rates in the U S Economy Nominal interest rate Always exceeds real interest rate U S econ has experienced rising consumer prices in every year Inflation is variable Real and nominal interest rates do not always move together Periods of Deflation Real interest rate exceeds the nominal interest rate vertical distance between nominal interest rate real interest rate inflation Chapter 11 Measuring the Cost of Living 5 Practice Questions Notes Goods services for GDP deflator updated every year Inflation implies higher cost of living money has lost its value but you must know the wage increase to determine whether it hinders the consumers ability to buy Law of Demand inverse relationship between quantity of goods demanded and prices CPI does not take into account spending switching overstates rate of inflation