Transcript Ch7

The CPI and the
Cost of Living
CHAPTER
7
Eye Ons
Consumer price index
Cost of living index
Reference base period
Nominal interest rate
Nominal wage rate
Real interest rate
Real wage rate
Inflation rate
DEFINITION
CPI – Consumer Price Index
1. Measure of the AVERAGE
2. of prices PAID
3. by URBAN consumers
4. for a FIXED MARKET BASKET
5. of CONSUMPTION goods and services
•
CPI = 100, in the Reference Base Period
•
Current Reference Base Period is 1982-1984
WHY DO WE CARE
CPI – Consumer Price Index
•
Jul 2007, CPI=208.3 
•
Average of prices paid by urban consumers for fixed market
basket of goods
•
•
Aug 2007, CPI=207.9 
•
Average of prices paid by urban consumers for fixed market
basket of goods
•
•
 Was 108.3% in Jul 2007 than in 1982-1984
 Was 107.9% in Jul 2007 than in 1982-1984
Comparing July 2007 to August 2007 tells us 
•
Average of prices paid by urban consumers for fixed market
basket of goods
•
 Decreased by 0.4 from Jul to Aug 2007
CONSTRUCTING CPI
1. SELECT the MARKET BASKET
1. Weights of goods = urban household budget
2. CPI IS calculated monthly, Basket IS NOT updated monthly
3. Current basket (2007) is based on 2005 survey
CONSTRUCTING CPI
2. Conduct Monthly Price Survey
1. Prices recorded
• 80,000 goods and services
• In 30 metropolitan areas
2. Products must be exactly the same.
• Thus, specific statistics must be recorded
• Quality
• Size
• Weight
• Packaging
• And more
CONSTRUCTING CPI
2. Calculating CPI – STEP 1
CPI =
Cost of CPI basket at current period prices x 100
Cost of CPI basket at base period prices
CONSTRUCTING CPI
2. Calculating CPI – STEP 2
CPI =
Cost of CPI basket at current period prices x 100
Cost of CPI basket at base period prices
CONSTRUCTING CPI
2. Calculating CPI – STEP 3
CPI =
Cost of CPI basket at current period prices x 100
Cost of CPI basket at base period prices
For 2005, the CPI is:
$50
$50
x 100 = 100
For 2008, the CPI is:
$70
$50
x 100 = 140
6.1 THE CONSUMER PRICE INDEX
Measuring Inflation
Inflation rate is the percentage change in the price
level from one year to the next.
Inflation rate =
CPI in current year  CPI in previous yearx 100
CPI in previous year
Inflation rate =
140  120 x 100 = 16.7 percent
120
700 Years of Inflation and Deflation
These data show that
inflation became a
persistent problem only
after 1900.
During the preceding 600
years, inflation was almost
unknown.
There was a burst of
inflation during the
sixteenth century after
Europeans discovered
gold in America, but this
inflation was less than 2
percent a year.
Inflation eventually
subsided.
700 Years of Inflation and Deflation
The Industrial
Revolution was a
temporary burst of
inflation.
The graph provides
dramatic evidence
that inflation took off
during the last
century.
6.1 THE CONSUMER PRICE INDEX
Price level has increased every year.
Inflation = High in 1980’s, Low in 1990’s
CPI and the COST OF LIVING
Cost of Living =
•the amount of $$$
•a person must spend
•to achieve a certain standard of living
CPI DOES NOT measure cost of living
1.Does not measure ALL components of living
•
•
Severe winter = increase in natural gas purchase
# price is caught but not quantity – basket is fixed
2.Components of CPI are not always ACCURATE
•
Thus, it would be a biased measure of changes in
cost of living
CPI and the COST OF LIVING
BIAS in the CPI
•New goods bias
• New goods perform better but cost more [cost=quality]
• Upward bias into the CPI and inflation rate
•Quality change bias
• Better products cost more [#price due to #quality IS
NOT inflation, but would be counted as such]
• Upward bias into the CPI and inflation rate
CPI and the COST OF LIVING
BIAS in the CPI
•Commodity substitution bias
• $ of beef rises faster than $ of chicken = you buy more
chicken and less beef
• CPI Basket is fixed and does allow for substitutions and says
the price of meat has increased
•Outlet substitution bias
• Prices rise…people use discount stores more often
• CPI Basket is fixed and does allow for substitutions and says
the prices has decreased
CPI
EFFECTS of the BIAS in the CPI
•Overstates inflation
• Estimated to overstate inflation by 1.1%
•Distorts Private Contracts
• Union contracts
•Increases Government Outlays
•
•
•
•
48 Million
22 Million
4 Million
27 Million
Social security benefits
Food stamps
Pensions of Retired Personnel
School lunch budgets
ALTERNATIVES to CPI
GDP Deflator
1. Average of
2. current prices of
3. all the goods and services included in GDP
4. expressed as a percentage of base-year prices.
GDP deflator = (Nominal GDP  Real GDP)  100.
•
Price level is measured by  GDP deflator
•
Inflation measured by  % change in GDP deflator
GDP Deflator vs CPI
GDP Deflator
 Prices of ALL goods and
services
 Weights items using
CURRENT and PAST
quantities
CPI
 Prices of
CONSUMPTION goods
and services
 Weights items using
PAST quantities (from
surveys)
 In theory GDP Deflator is NOT subject to CPI biases.
[includes new goods, quality changes, and allow for
substitutions]
 In reality: the commerce department does not measure
physical quantities of produced items. It divides
expenditures by price indexes – one of which is CPI.
ALTERNATIVES to CPI
PCE Deflator
1. Average of
2. current prices of
3. all the goods and services included in consumption
expenditure component of GDP
4. expressed as a percentage of base-year prices.
•
Overcomes the biases to some degree
•
Is a measure of cost of living
ALTERNATIVES to CPI
CPI is highest
PCE lies between CPI
and GDP deflator
Deflating the GDP Balloon
Part of the increase in nominal GDP reflects increased
production and part reflects rising prices.
You can think of GDP as a balloon that is blown up by
growing production and rising prices.
Deflating the GDP Balloon
The GDP deflator lets the inflation air—the contribution
of rising prices—out of the nominal GDP balloon so that
we can see what has happened to real GDP.
Deflating the GDP Balloon
The figure shows the increase in nominal GDP from 1980 to
2007. With the inflation air removed, you can see by how
much real GDP grew.
ANOTHER USE of CPI
Prices on Different Dates
Convert the price of a 2-cent stamp in 1907 into its 2007
equivalent:
Price of stamp in 2007 dollars =
Price of stamp in 1907 dollars x
CPI in 2007
CPI in 1907
= 2 cents x
207.2
10
= 41 cents
NOMINAL vs REAL VALUES
1. Nominal vs Real GDP
 Learned in Chapter 5
2. Nominal vs Real Wage Rate - Average hourly wage rate
measured in
 current dollars
 dollars of a given reference base year
Real wage rate in 2006 =
Nominal wage rate in 2006
CPI in 2006
x 100
3. Nominal vs Real Interest Rate - Percentage return on a loan
 expressed in dollars
 calculated by purchasing power – nominal interest rate
adjusted for the effects of inflation
Real interest rate = Nominal interest rate – Inflation rate.
NOMINAL vs REAL WAGE RATE EXAMPLE
•
How to find the REAL WAGE RATE
• given that years Nominal wage rate
Nominal wage rate in 2006
Real wage rate in 2006 =
Real wage rate in 2006 =
x 100
CPI in 2006
$16.73
201.6
x 100 = $8.23
The $8.23 amount is in 19821984 dollars.
6.3 NOMINAL AND REAL VALUES
Figure 6.4 shows
nominal and real wage
rates: 1982–2006.
The nominal wage rate
has increased every
year since 1982.
The real wage rate
decreased slightly from
1982 through the mid1990s, after which
increased slightly.
6.3 NOMINAL AND REAL VALUES
Real interest rate = Nominal interest rate – Inflation rate.
Figure 6.5 shows real
and nominal interest
rates: 1967–2007.
During the 1970s,
the real interest rate
became negative.
The nominal interest
rate increased during
the high-inflation 1980s.
The Nominal and Real Price of a
First-Class Letter
The figure shows
the cost of a
first-class letter
since 1907.
The green line is the
nominal price—the
actual price of a
stamp in the dollars
(cents) of the year in
question.
The Nominal and Real Price of a
First-Class Letter
The red line is the
real price—the price
in terms of
the 2007 dollar.
The nominal price
has gradually
increased, but the
real price has
fluctuated—
sometimes rising
and sometimes
falling.
The Nominal and Real Price of a
First-Class Letter
The highest real
price, 45 cents,
occurred in 1933
and the lowest real
price, 19 cents,
occurred in 1920.
The Nominal and Real Wage Rates of
Presidents of the United States
Who earned more,
George W. Bush in
2005 or George
Washington in
1789?
George Washington
was paid $25,000 in
1789.
George W. Bush
was paid $400,000
in 2005.
The Nominal and Real Wage Rates of
Presidents of the United States
Who earned more:
Barack Obama in 2008
or George Washington
in 1789?
George Washington
was paid $25,000 in
1789 (on green line),
but in 2005 dollars, his
real pay was $521,000
(on red line).
Barack Obama was
paid $400,000 in 2009.
The Nominal and Real Wage Rates of
Presidents of the United States
The White House is
more comfortable and
presidential travel
arrangements today
are a breeze
compared to earlier
times.
So adding in the
perks of the job,
Barack Obama
doesn’t get such a
raw deal.
FORMULAS
CPI =
Cost of CPI basket at current period prices
Cost of CPI basket at base period prices
Inflation rate =
x 100
CPI in current year  CPI in previous year
CPI in previous year
x 100
GDP deflator = (Nominal GDP  Real GDP)  100.
Real wage rate in 2006 =
Nominal wage rate in 2006
CPI in 2006
x 100
Real interest rate = Nominal interest rate – Inflation rate.
Price of stamp in 2007 dollars =
Price of stamp x
in 1907 dollars
CPI in 2007
CPI in 1907
Using the CPI
Suppose you have a student loan of $80,000.
Suppose that the CPI rises by 3 percent a year each year
from now (2008) through 2028.
Also suppose that the nominal interest rate on your loan is
fixed at 5 percent a year.
How much will a $100 repayment cost you in 2008 dollars,
when you start to pay off your loan in 2018?
How much will a $100 repayment cost you in 2008 dollars,
when you make your final payment in 2028?
What is the real interest rate that you will have paid?
Using the CPI
You can answer all these questions.
Set the CPI in 2008 equal to 100.
With the CPI rising at a rate of 3 percent per year, the CPI
in 2018 will be 134.
A $100 payment in 2018 is equivalent to a $74 payment in
2008. ($100 ÷ 134) x 100 = $74.
The CPI in 2028 will be 181.
So a payment of $100 in 2028 is equivalent to a payment
of $55 in 2008.
Using the CPI
The further in the future a payment is made, the less is
your $100 payment in today’s dollars.
Your real interest rate is the 5 percent a year nominal
interest rate minus the 3 percent a year inflation rate.
Your real interest rate is 2 percent per year.