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Consumer price index (CPI)
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The overall cost of the goods and services bought by a typical consumer
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How often is the CPI measured?
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The BLS measures the CPI monthly
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CPI calculation
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=Price of basket of goods current year / Price of base year x 100
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Inflation Rate calculation
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Inflation rate year 2 = CPI year 2 - CPI year 1 / CPI year 1 x 100
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What does the inflation rate (CPI) determine?
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It determines how quickly the cost of living for the typical consumer is rising
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Producer price index
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A measure of the cost of a basket of goods and services bought by firms
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Why is the PPI useful?
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It is useful in predicting changes in CPI because firms eventually pass their costs to consumers in the form of higher consumer prices
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What are the three problems with CPI?
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1. Substitution bias
2. Introduction of new goods
3. Unmeasured quality change
2. Introduction of new goods
3. Unmeasured quality change
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Substitution bias
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When prices change year to year, they don't change proportionally
-Consumers then buy less of the higher priced good and more of the lower priced good
-CPI doesn't calculate substitution bias and thus, overstates the increase in cost of living
-Consumers then buy less of the higher priced good and more of the lower priced good
-CPI doesn't calculate substitution bias and thus, overstates the increase in cost of living
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Introduction of new goods
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When a new good is introduced, consumers have more variety
-Reduces the cost of maintaining the same level of economic well-being
-CPI doesn't reflect the increase in the value of the dollar
-Reduces the cost of maintaining the same level of economic well-being
-CPI doesn't reflect the increase in the value of the dollar
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Unmeasured quality of change
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If the quality of a good deteriorates, but the price stays the same, the value of the dollar falls (and vice versa)
-Quality is hard to measure
-Overstates CPI
-Quality is hard to measure
-Overstates CPI
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Dollar figures from different times calculation
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Amount in today's $ = Amount in T $ x price level today / price level in year T
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Two differences between GDP deflator and CPI
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1. GDP deflator reflects the prices of all goods produced domestically and the CPI reflects the prices bought by consumers
Ex. Increase price of Boeing being bought by France
-CPI - doesn't change because this transaction is not part of the basket
-CDP increases
2. Concerns how various prices are weighted to yield a single # for the overall price levels
-CPI - fixed basket with base year
-Deflator - prices of currently produced goods
Ex. Increase price of Boeing being bought by France
-CPI - doesn't change because this transaction is not part of the basket
-CDP increases
2. Concerns how various prices are weighted to yield a single # for the overall price levels
-CPI - fixed basket with base year
-Deflator - prices of currently produced goods
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Indexation
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The automatic correction by law or contract of a dollar amount for the effects of inflation
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Cost of living allowance (COLA)
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Contracts between firms and unions include partial or complete indexation of the wage to the CPI
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Other things that are indexed
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Social security benefits
Brackets of federal income tax
Brackets of federal income tax
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Nominal interest rate
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The interest rate as usually reported without a correction for the effects of inflation
-how fast the # of dollars in your bank account rises overtime
-how fast the # of dollars in your bank account rises overtime
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Real interest rate
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The interest rate corrected for the effects of inflation
-how fast the purchasing power in your bank account rises overtime
-how fast the purchasing power in your bank account rises overtime
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Real interest rate calculation
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=nominal interest rate - inflation rate
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What happens to real and nominal interest rates during deflation?
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Real IR > Nominal IR
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