Transcript Slide 1

© 2007 Thomson South-Western
Last Chapter…
• In the last chapter, we looked at how
economists use GDP to measure the quantity
of goods and services that the economy is
producing.
• To review…
– What things are factored into the GDP?
– What are the two kinds of GDP and what is the
difference?
© 2007 Thomson South-Western
This Chapter…
• This chapter examines how economists
measure the overall cost of living and how
today’s salaries compare to those of the past.
• To do this, we need to talk about something
called the CPI or Consumer Price Index.
• Also factored in is something else called
Inflation.
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Measuring the Cost of Living
• Inflation refers to a situation in which the
economy’s overall price level is rising.
• The inflation rate is the percentage change in
the price level from the previous period.
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THE CONSUMER PRICE INDEX
• The consumer price index (CPI) is a measure
of the overall cost of the goods and services
bought by a typical consumer.
• The US Bureau of Labor Statistics reports the
CPI each month.
• It is used to monitor changes in the cost of
living over time.
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THE CONSUMER PRICE INDEX
When the CPI rises, the typical family has to spend
more dollars to maintain the same standard of living.
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How the Consumer Price Index Is
Calculated
1. Fix the basket. Determine what prices are most
important to the typical consumer.
• The Bureau of Labor Statistics (BLS) identifies a
market basket of goods and services the typical
consumer buys.
•The BLS conducts monthly
consumer surveys to set the
weights for the prices of those
goods and services.
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How the Consumer Price Index Is
Calculated
2. Find the prices. Find the prices of each of the
goods and services in the basket for each point
in time.
3. Compute the basket’s cost. Use the data on
prices to calculate the cost of the basket of
goods and services at different times.
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How the Consumer Price Index Is
Calculated
4. Choose a base year and compute the index.
• Designate one year as the base year, making it the
benchmark against which other years are compared.
• Compute the index by dividing the price of the
basket in one year by the price in the base year and
multiplying by 100.
Price of basket of goods and services
Consumer price index 
100
Price of basket in base year
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How the Consumer Price Index Is
Calculated
5. Compute the inflation rate. The inflation rate is
the percentage change in the price index from
the preceding period.
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How the Consumer Price Index Is
Calculated
• The inflation rate is calculated as follows:
CPI in Year 2  CPI in Year 1
Inflation Rate in Year 2=
100
CPI in Year 1
© 2007 Thomson South-Western
EXAMPLE
basket: {4 pizzas, 10 lattes}
year
price of
pizza
price of
latte
2007
$10
$2.00
$10 x 4 + $2 x 10
2008
$11
$2.50
$11 x 4 + $2.5 x 10 = $69
2009
$12
$3.00
$12 x 4 + $3 x 10
cost of basket
= $60
= $78
Compute CPI in each year
Inflation rate:
2007: 100 x ($60/$60) = 100
115 – 100
x 100%
15% =
100
130 – 115
x 100%
13% =
115
2008: 100 x ($69/$60) = 115
2009: 100 x ($78/$60) = 130
using 2007 base year:
MEASURING THE COST OF LIVING
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ACTIVE LEARNING
1
Calculate the CPI
CPI basket:
{10 lbs beef,
20 lbs chicken}
The CPI basket cost $120
in 2004, the base year.
price price of
of beef chicken
2004
$4
$4
2005
$5
$5
2006
$9
$6
A. Compute the CPI in 2005.
B. What was the CPI inflation rate from 2005-2006?
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ACTIVE LEARNING
1
Answers
CPI basket:
{10 lbs beef,
20 lbs chicken}
The CPI basket cost $120
in 2004, the base year.
price price of
of beef chicken
2004
$4
$4
2005
$5
$5
2006
$9
$6
A. Compute the CPI in 2005:
Cost of CPI basket in 2005
= ($5 x 10) + ($5 x 20) = $150
CPI in 2005 = 100 x ($150/$120) = 125
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ACTIVE LEARNING
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Answers
CPI basket:
{10 lbs beef,
20 lbs chicken}
The CPI basket cost $120
in 2004, the base year.
price price of
of beef chicken
2004
$4
$4
2005
$5
$5
2006
$9
$6
B. What was the inflation rate from 2005-2006?
Cost of CPI basket in 2006
= ($9 x 10) + ($6 x 20) = $210
CPI in 2006 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
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What’s in the CPI’s Basket?
4% 3%
Housing
6%
Transportation
6%
Food & Beverages
43%
6%
Medical care
Recreation
Education and
communication
Apparel
15%
17%
MEASURING THE COST OF LIVING
Other
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ACTIVE LEARNING
2
Substitution bias
CPI basket:
{10# beef,
20# chicken}
2004-5:
Households
bought CPI basket.
cost of CPI
beef chicken
basket
2004
$4
$4
$120
2005
$5
$5
$150
2006
$9
$6
$210
2006: Households bought {5 lbs beef, 25 lbs chicken}.
A. Compute cost of the 2006 household basket.
B. Compute % increase in cost of household basket
over 2005-6, compare to CPI inflation rate.
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ACTIVE LEARNING
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Answers
CPI basket:
{10# beef,
20# chicken}
Household
basket in 2006:
{5# beef,
25# chicken}
cost of CPI
beef chicken
basket
2004
$4
$4
$120
2005
$5
$5
$150
2006
$9
$6
$210
A. Compute cost of the 2006 household basket.
($9 x 5) + ($6 x 25) = $195
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ACTIVE LEARNING
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Answers
CPI basket:
{10# beef,
20# chicken}
Household
basket in 2006:
{5# beef,
25# chicken}
cost of CPI
beef chicken
basket
2004
$4
$4
$120
2005
$5
$5
$150
2006
$9
$6
$210
B. Compute % increase in cost of household basket
over 2005-6, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
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Problems with the CPI:
Substitution Bias
• Over time, some prices rise faster than others.
• Consumers substitute toward goods that
become relatively cheaper.
• The CPI misses this substitution because it uses
a fixed basket of goods.
• Thus, the CPI overstates increases in the cost of
living.
MEASURING THE COST OF LIVING
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© 2007 Thomson South-Western
Problems with the CPI:
Introduction of New Goods
• 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 this effect because it uses a
fixed basket of goods.
• Thus, the CPI overstates increases in the cost
of living.
MEASURING THE COST OF LIVING
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Problems with the CPI:
Unmeasured Quality Change
• Improvements in the quality of goods in the
basket increase the value of each dollar.
• 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.
MEASURING THE COST OF LIVING
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Problems in Measuring the Cost of Living
• The substitution bias, introduction of new
goods, and unmeasured quality changes cause
the CPI to overstate the true cost of living.
• The issue is important because many
government programs use the CPI to adjust for
changes in the overall level of prices.
• The CPI overstates inflation by about 1
percentage point per year.
© 2007 Thomson South-Western
The GDP Deflator versus the Consumer
Price Index
• What was the GDP deflator?
• The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator =
 100
Real GDP
© 2007 Thomson South-Western
The GDP Deflator versus the Consumer
Price Index
• The BLS calculates other prices indexes:
• The index for different regions within the
country.
• The producer price index, which measures the
cost of a basket of goods and services bought
by firms rather than consumers.
© 2007 Thomson South-Western
The GDP Deflator versus the Consumer
Price Index
• Economists and policymakers monitor both the
GDP deflator and the consumer price index to
gauge how quickly prices are rising.
• There are two important differences between
the indexes that can cause them to diverge.
© 2007 Thomson South-Western
The GDP Deflator versus the Consumer
Price Index
• The GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
• …the consumer price index reflects the prices
of all goods and services bought by consumers.
© 2007 Thomson South-Western
The GDP Deflator versus the Consumer
Price Index
• The consumer price index compares the price of
a fixed basket of goods and services to the price
of the basket in the base year (only occasionally
does the BLS change the basket)...
• …whereas the GDP deflator compares the price
of currently produced goods and services to the
price of the same goods and services in the base
year.
© 2007 Thomson South-Western
Figure 2 Two Measures of Inflation
Percent
per Year
15
CPI
10
GDP deflator
5
0
1965
1970
1975
1980
1985
1990
1995
2000
2005
© 2007 Thomson South-Western
Contrasting the CPI and GDP Deflator
Imported consumer goods:
– included in CPI
– excluded from GDP deflator
Capital goods:
 excluded from CPI
 included in GDP deflator
(if produced domestically)
The basket:
 CPI uses fixed basket
 GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.
MEASURING THE COST OF LIVING
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© 2007 Thomson South-Western
ACTIVE LEARNING
3
CPI vs. GDP deflator
In each scenario, determine the effects on
the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
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ACTIVE LEARNING
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Answers
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
The CPI rises, the GDP deflator does not.
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Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
• Inflation makes it harder to compare dollar
amounts from different times.
• Example: the minimum wage
– $1.15 in Dec 1964
– $5.85 in Dec 2007
• Did min wage have more purchasing power in
Dec 1964 or Dec 2007?
• To compare, use CPI to convert 1964 figure into
“today’s dollars”…
MEASURING THE COST OF LIVING
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© 2007 Thomson South-Western
Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
Amount
in today’s =
dollars
Amount
in year T
dollars
x
Price level today
Price level in year T
• In our example,
– year T = 12/1964, “today” = 12/2007
– Min wage = $1.15 in year T
– CPI = 31.3 in year T, CPI = 211.7 today
The minimum wage
in 1964 was $7.78
in today’s (2007) dollars.
MEASURING THE COST OF LIVING
$7.78 = $1.15 x
211.7
31.3
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Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
• Researchers, business analysts and policymakers
often use this technique to convert a time series of
current-dollar (nominal) figures into constant-dollar
(real) figures.
• They can then see how a variable has changed
over time after correcting for inflation.
• Example: the minimum wage, from Jan 1950 to
Dec 2007…
MEASURING THE COST OF LIVING
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© 2007 Thomson South-Western
The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1950-2007
$9
$ per hour
$8
2007 dollars
$7
$6
$5
$4
$3
$2
current dollars
$1
$0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995©2000
2005
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ACTIVE LEARNING
4
Converting to “today’s dollars”
Annual tuition and fees, average of all public fouryear colleges & universities in the U.S.
– 1986-87: $1,414
(1986 CPI = 109.6)
– 2006-07: $5,834
(2006 CPI = 203.8)
After adjusting for inflation, did students pay more for
college in 1986 or in 2006? Convert the 1986 figure
to 2006 dollars and compare.
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ACTIVE LEARNING
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Answers
Annual tuition and fees, average of all public fouryear colleges & universities in the U.S.
– 1986-87: $1,414 (1986 CPI = 109.6)
– 2006-07: $5,834 (2006 CPI = 203.8)
Solution
Convert 1986 figure into “today’s dollars”
$1,414 x (203.8/109.6) = $2,629
Even after correcting for inflation, tuition and fees
were much lower in 1986 than in 2006!
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Correcting Variables for Inflation:
Indexation
A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
For example, the increase in the CPI
automatically determines
– the COLA in many multi-year labor contracts
– the adjustments in Social Security payments
and federal income tax brackets
MEASURING THE COST OF LIVING
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© 2007 Thomson South-Western
Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
The nominal interest rate:
– the interest rate not corrected for inflation
– the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
– corrected for inflation
– the rate of growth in the purchasing power of a
deposit or debt
Real interest rate
=
(nominal
interest
rate)
–
(inflation
rate)
MEASURING THE COST OF LIVING
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© 2007 Thomson South-Western
Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
Example:
– Deposit $1,000 for one year.
– Nominal interest rate is 9%.
– During that year, inflation is 3.5%.
– Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
– The purchasing power of the $1000 deposit
has grown 5.5%.
MEASURING THE COST OF LIVING
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© 2007 Thomson South-Western
Real and Nominal Interest Rates in the U.S.,
1950-2007
Interest Rates
(percent per year)
15
10
5
0
-5
-10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Nominal interest rate
MEASURING THE COST OF LIVING
Real interest rate
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What’s up in Korea with CPI?
• Korean CPI
What is the base year
for the given CPI?
10,000 won in 1995
would have been worth
how much in 2010?
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What’s up in Korea with CPI?
• CPI Info… (11/11)
• By the end of the year, the office will add items that account
for more than one-10,000th of monthly household
expenditures; those falling short of the standard will be
excluded.
• The statistics agency revises the index, currently comprising
516 items, every five years.
• New Additions This Year
• Smart phones, makgeolli (Korean rice beer) and samgak
gimbap (triangular seaweed rice rolls)
• Items Removed This Year
• Gold rings, camcorders and public phone calls
• Source: www.seriworld.org
© 2007 Thomson South-Western
What’s up in Korea with CPI?
• The country’s average CPI growth for the first 10 months of this year was
4.4 percent compared to 2010. The new CPI system is aimed at lowering
inflation for the January-October period by 0.4 percentage points to 4
percent. Critics claim the overhaul is merely an attempt to lower the inflation
index, especially given the steep drop. When the government revised the
index in 1991, CPI growth fell 0.3 percentage points. Five years later,
another slew of amendments saw it fall by 0.1 percentage points, then 0.3
percentage points in 2001 and 0.2 percentage points in 2006.
• Statistics Korea refuted the accusation by countering that the biggest impact
to the new CPI gauge would be caused by the omission of gold ring prices,
as these have surged recently. With these alone taken out of the equation, the
country’s overall CPI growth drops by 0.25 percentage points. The
government said it will announce two separate CPIs for November
calculated using each of the systems on Thursday.
• Posted on November 11, 2011 on seriworld.org
© 2007 Thomson South-Western
Summary
• The consumer price index shows the cost of a
basket of goods and services relative to the
cost of the same basket in the base year.
• The index is used to measure the overall level
of prices in the economy.
• The percentage change in the CPI measures
the inflation rate.
© 2007 Thomson South-Western
Summary
• The consumer price index is an imperfect
measure of the cost of living for the following
three reasons: substitution bias, the
introduction of new goods, and unmeasured
changes in quality.
• Because of measurement problems, the CPI
overstates annual inflation by about 1
percentage point.
© 2007 Thomson South-Western
Summary
• The GDP deflator differs from the CPI because
it includes goods and services produced rather
than goods and services consumed.
• In addition, the CPI uses a fixed basket of
goods, while the GDP deflator automatically
changes the group of goods and services over
time as the composition of GDP changes.
© 2007 Thomson South-Western
Summary
• Dollar figures from different points in time do
not represent a valid comparison of purchasing
power.
• Various laws and private contracts use price
indexes to correct for the effects of inflation.
• The real interest rate equals the nominal
interest rate minus the rate of inflation.
© 2007 Thomson South-Western