ECON 2105 1nd Edition Lecture 9 Outline of Last Lecture I. Inflation Intro II. Real Variables III. Inflation CostsIV. Real Interest Rate V. PracticeOutline of Current Lecture I. Why we measure inflation?II. CPI Formula III. CPI to Inflation RateIV. Inflation Adjustment V. Practice Current LectureModule 15 The Measurement and Calculation of Inflation I. Why we measure inflation?- We measure inflation to adjust for interest rates, to see how our standard of living has changed. EtcConsumer Price Index (CPI) These 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.• A measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods• It represents the buying habits of urban consumers• Prices are collected monthly from about 4,000 housing units and approximately 26,000 retail establishments across 87 urban areas.• It includes the prices of food, clothing, shelter, and fuels; transportation fares; service fees• To calculate the index, price changes are averaged with weights representing their importance in the spending of the particular group. - Chained CPI- use the same prices but different formula and weights, it accounts for consumers’ ability to achieve the same standard of living from alternative sets of consumer goods and services. - Core CPI- all items in CPI less food and energy, a reliable measure of inflationary and deflationary periods CPICPIUnadjusted Index Unadjusted Index It reflects all factors that may influence a change in pricesIt reflects all factors that may influence a change in pricesSeasonally adjusted indexSeasonally adjusted indexIt removes the effects of seasonal changes, such as weather, school year, production cycles, and holidays.It removes the effects of seasonal changes, such as weather, school year, production cycles, and holidays.Incldued?- Breakfast cereal- YES - Wine- YES - Fuel oil- YES - Bedroom furniture- YES - Jewelry- YES - Airline fares- YES - Vehicle insurance- YES - Stocks and bonds- NO, considered investment - Life insurance- NO - Water fees- YES - Auto registration- YES - Sales taxes- YES- Income tax and social security tax- NOII. CPI formula - Price index in a given year= cost of market basket in a given year/ cost of market basket in a base year X 100- How to read an index number? - An index of 120 means there has been a 20% increase in price since the reference period - An index of 80 means there has been a 20% decrease in price since the reference period Practice Set the items to be included in the market basketSet the items to be included in the market basketSet the weights of each item in the basketSet the weights of each item in the basketRecord the prices through surveysRecord the prices through surveysCalculate the cost of market basketCalculate the cost of market basketUse the formula to create the CPIUse the formula to create the CPI- Assume that the market basket consists of 200 oranges, 100 apples, and 100 bananas.- What is the cost of market basket in 2011?o (200x .50) + (100x .25) +(100x .4) = 170- in 2012?? o (200x .4) + (100x .25) + (100x .5) = 165- inflation rate? o ((170-165) / 165) X 100 = - What is the value of the price index in 2012, using 2011 as the base year?o CPI 2012= (170/165)X100o 103.03 = CPI 2012 III. CPI to Inflation Rate - Inflation Rate= ((CPI in year 2- CPI in year 1) / CPI in year 1) X 100 IV. Inflation adjustment - Convert prices on the time horizon - In 1982, the price of gasoline= $1.25 per gallon CPI=100- In 2006, the price of gasoline= $2.5 per gallon CPI=210 - In which year the gasoline was cheaper? o 1.25X (210/100) = 2.625- it is expensive in 1982 - Converting current prices to the future o Dollar value now/ price index now X price index in the future - Converting current prices to the past o Dollar value now/ price index now X price index in the past- Producer price index (PPI): similar to the CPI but measures changes in the prices of goods purchased by producers.- Economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP. - The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year.V. Practice - Suppose the consumer price index last year was 180.5 and this year the CPI is equal to 202.2. What is the rate of inflation between last year and this year? What is the rate of inflation between the base year and this year? o This year CPI =202.2 o CPI base year = 100 o 202.2- 100 / 100 X 100 =