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consumer price index (CPI)
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measures the prices of a fixed basket of goods and services purchased by typical urban households
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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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inflation rate
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the percentage change in the price index from the preceding period
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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
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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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real interest rate
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the interest rate corrected for the effects of inflation
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Which do you think has a greater effect on the consumer price index: a 10 percent increase in the price of chicken or a 10 percent increase in the price of caviar? Why?
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A 10 percent increase in the price of chicken would have a greater effect on the consumer price index because it is purchased by the typical family, and would have to spend more money to maintain the same standard of living that includes chicken.
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If the price of a Navy submarine rises, is the consumer price index or the GDP deflator affected more? Why?
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The GDP deflator is affected more because the CPI concerns goods bought by typical consumers.
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Explain the meaning of nominal interest rate and real interest rate. How are they related?
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Nominal interest rate - measures the change in dollar amounts
Real interest rate - corrected for inflation
They both measure the change in dollar amounts, but real interest rate is corrected for inflation.
Real interest rate - corrected for inflation
They both measure the change in dollar amounts, but real interest rate is corrected for inflation.
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Substitution Bias
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If the price of a good increases, quantity demanded decreases and consumers will substitute this good for something else, so quantity demanded of the substitute increases..
but CPI holds quantities fixed, so the cost of the basket is overstated, as well as the inflation rate.
but CPI holds quantities fixed, so the cost of the basket is overstated, as well as the inflation rate.
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Introduction of New Goods
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When a new good is introduced, it increases the variety of goods consumers have to choose from, in turn reducing the cost of maintaining the same level of economic well-being. The CPI does not reflect the increase in the value of the dollar that arises from the introduction of new goods.
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Unmeasured Quality Change
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If the quality of a good deteriorates from one year to the next while its price remains unchanged, the value of a dollar falls. Similarly, if the quality rises from one year to the next, the value of a dollar rises.
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What are the three problems with the consumer price index?
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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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What are the differences between CPI and GDP deflator?
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CPI uses a fixed basket (fixed quantities); GDP deflator does not -- allows quantity to vary over time
GDP deflator includes I, G, exports
CPI includes imports
GDP deflator includes I, G, exports
CPI includes imports
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producer price index (PPI)
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prices of inputs (factors of production)
often used to forecast future CPI
often used to forecast future CPI
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