Transcript Some Important Ideas in Macroeconomics

CHAPTER 6:
MEASURING THE COST
OF LIVING
The Consumer Price Index
(CPI)
&
What it Means
CALCULATING THE CPI
1 Select a market basket.
2 Find the prices of the goods and
services in the basket.
3 Compute the cost of the basket.
4 Choose a base year and compute
the index.
5 Calculate the inflation rate.
EXAMPLE
• STEP 1: Set the basket based on spending
patterns in the base year (1998):
4 sodas & 12 chips
• STEP 2: Gather prices
Price of Soda
Price of Chips
1998
75¢
50¢
1999
85¢
55¢
2000
99¢
70¢
• STEP 3: Compute the cost of the
basket
• 1998: 75¢ x 4 + 50¢ x 12 = $9.00
• 1999: 85¢ x 4 + 55¢ x 12 = $11.00
• 2000: 99¢ x 4 + 70¢ x 12 = $12.36
• STEP 4: Set the price index equal to
100 in the base year as shown in the
following slide and then calculate the
price index for the remaining years.
Cost of Basket in 1998
CPI(1998)  100
Cost of Basket in 1998
$9.00
 100
 100
$9.00
Cost of Basket in 2000
CPI(2000)  100
Cost of Basket in 1998
$12.36
 100
 137.3
$9.00
• STEP 5: Calculate the inflation rate.
Pt  Pt 1
 t  100
Pt 1
EXAMPLE
In 1995, the price index is 220.
In 1996, the price index is 240.
 96
P96  P95
 100

P95
240  220
100
 9.1%
220
The End Result
Year
199
8
Basket
Price
CPI
Inflation
$9.00
100.0
?????
199 $10.00
9
111.1
11.1%
200 $12.36
0
137.3
26.2%
Producer Price Index
• Measures the cost of raw materials used
by producers.
– Only good, no services
• PPI leads CPI
PROBLEMS WITH THE CPI
• Substitution Bias
• Introduction of New Goods
• Unmeasured Quality Changes
Changes in the CPI overstate
changes in the true cost of
living.
INDEXATION
• Some wages and retirement benefits
automatically rise as the CPI rises.
• Indexation is designed to keep real
values constant.
• But indexation raises the standard of
living by perhaps 1% each year because
the CPI overstates inflation.
CPI vs GDP DEFLATOR
• Different Baskets
• CPI uses a fixed basket over time while
the GDP Deflator reflects the current
composition of output.
• Behavior is very similar.
• We use Pt to denote either the CPI or the
GDP Deflator in year “t.”
GDP DEFLATOR
CPI
2005
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
PP I
1950
22
20
18
16
14
12
10
8
6
4
2
0
-2
-4
-6
-8
1945
Percent
CPI, PPI, and the GDP Deflator
CALCULATING REAL VALUES
• Nominal values are misleading
indicators of the standard of living.
• We must use real values instead.
• Consider the following numbers:
Nominal Wage Rate
1998
$12.00
2000
$15.00
CPI
100.0
137.3
Am I better off in
1998 or 2000?
Real wage rate in 2000
Nominal Wage Rate in 2000

CPI in 2000/100
Real wage rate in 1998 =
Nominal Wage Rate in 1998 $12.00

 $12.00
CPI in 1998/100
100/100
Real wage rate in 2000 =
Nominal Wage Rate in 2000 $15.00

 $10.92
CPI in 2000/100
137.3/100
ANOTHER APPROACH
THE GROWTH RATE OF THE REAL WAGE
RATE =
GROWTH RATE OF THE NOMINAL WAGE INFLATION RATE
W


W
• Example: My boss gives me a 4% raise
and the inflation rate is 7%
– My standard of living declines by 3%
Comparing Values
From Different Years
• The President’s Salary over 50 years
– 1949:Truman received $100,000 per year
•The CPI was 23.8
– 1999: Clinton received $200,000 per year
•The CPI was 166.6
Convert Truman’s salary to its 1999
equivalent.
THE CALCULATION
Truman' s 1949 salary in year 1999 dollars
1999 CPI
=
x 1949 Salary
1949 CPI
166.6
=
x$100, 000 = $700,000
23.8
Notice we do not specify the base year.
Calculating the
Real Interest Rate
Real interest rate =
Nominal interest rate - 
or
r=i-
EXAMPLE
• I am broke but I wish to purchase a
$100 bicycle.
• You agree to lend me $100 today in
exchange for $120 one year from today.
– The nominal interest rate is 20%.
• I believe the bicycle will cost $112 one
year from today.
– I expect 12% inflation.
• The real interest rate is 8%
The Comparison
• I buy the bike now and use it this year.
– The cost is $120 one year from today.
• I save my money and buy the bike next
year.
– The cost is $112 one year from today.
• I can use the bike this year for $8.00.
• $8.00 is 8% of $100.
EXAMPLE
Supose the nominal interest rate is 10%.
Nominal
interest rate
Real interest
rate
10%
Inflation rate
π
-10%
10%
0%
10%
10%
5%
5%
10%
10%
0%
10%
15%
-5%
20%