Transcript Chap 11, Mankiw - Measuring cost of living

Chap 11, Mankiw - Measuring cost of
living
• The price indices – consumer, producer
• Issues related to the measurement of cost of living
• Adjusting variables for the rate of inflation
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I. The price indices
the consumer price index (CPI)
the producer price index (PPI)
steps in calculating CPI and measuring cost
1.
2.
3.
4.
5.
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Calculating the Consumer Price Index and
the Inflation Rate: An Example
Step 1:Survey Consumers to Determine a Fixed
Basket of Goods
4 hot dogs, 2 hamburgers
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Calculating the Consumer Price Index and
the Inflation Rate: An Example
Step 2: Find the Price of Each Good in Each Year
Year
Price of
Hot dogs
Price of
Hamburgers
2001
$1
$2
2002
$2
$3
2003
$3
$4
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Calculating the Consumer Price Index and
the Inflation Rate: An Example
Step 3: Compute the Cost of the Basket of Goods in
Each Year
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Calculating the Consumer Price Index and
the Inflation Rate: An Example
Step 4: Choose One Year as the Base Year (2001) and
Compute the Consumer Price Index in Each Year
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Calculating the Consumer Price Index and
the Inflation Rate: An Example
Step 5: Use the Consumer Price Index to Compute the
Inflation Rate from Previous Year
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What’s in the CPI’s Basket?
5%
6%
6% 5% 5%
Housing
Food/Beverages
Transportation
40%
17%
16%
Medical Care
Apparel
Recreation
Other
Education and
communication
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II. Issues in the measurement of cost of living
A. Problems in constructing the CPI
1. Substitution bias
Consumers substitute toward goods
and away
The basket
The index _____________ the increase in cost of living by not
considering consumer substitution.
ex:
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2. Introduction of new goods
The basket
New products result in
dollar
, which in turn makes each
ex:
3. Unmeasured quality change
If the quality of a good rises from one year to the next, the value
of a dollar
, even if the price of the good
.
By not
ex:
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B. The GDP Deflator versus the Consumer Price Index
Both the GDP deflator and the consumer price index measures how
quickly prices are rising - two important differences between the
two,
1. The GDP deflator reflects the prices of all goods and services
and includes
The CPI reflects the prices of all goods and services
2. The CPI compares the price of a fixed basket of goods & services
The GDP deflator compares the price of currently
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Two Measures of Inflation
Percent
per Year
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CPI
10
5
GDP deflator
0
1965
1970
1975
1980
1985
1990
1995
2000
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III. Correcting for effects of inflation
deflating dollar figures from different times
salary in 2006 dollars = salary in 2000 dollars x
Suppose US economy has a 3% inflation rate. If the CPI for 2000 is
100, (price level in 2006/price level in 2000) =
A person getting $50,000 in 2000 must get
today, in order to enjoy the same standard of living
indexation of contracts
The above formula is very often used to write salary or other
financial contracts
real and nominal interest rates
Real interest rate = nominal interest rate – inflation rate
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Real and Nominal Interest Rates
Interest Rates
(percent per
year)
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Nominal
interest rate
10
5
0
Real interest rate
-5
1965
1970
1975
1980
1985
1990
1995 1998
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