Questions and Answers
What is the primary purpose of the Consumer Price Index (CPI)?
What is the Core CPI?
What is the problem with the CPI that arises because consumers substitute toward goods that become relatively cheaper?
What is the first step in calculating the CPI?
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What is the Producer Price Index (PPI)?
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What is the effect of the introduction of new goods on the CPI?
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What is the effect of unmeasured quality change on the CPI?
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What is the key difference between the CPI and the GDP deflator?
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What is the purpose of indexation?
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What is the formula to calculate the real interest rate?
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Study Notes
The CPI and the Cost of Living
- The Consumer Price Index (CPI) measures the overall cost of goods and services bought by a typical consumer.
- It monitors changes in the cost of living over time.
Calculating the CPI
- The Bureau of Labor Statistics (BLS) surveys consumers to determine what's in the typical consumer's "shopping basket".
- The BLS collects data on the prices of all the goods in the basket.
- The total cost of the basket is computed using the prices.
Core CPI
- A measure of the overall cost of consumer goods and services, excluding food and energy.
Producer Price Index (PPI)
- A measure of the cost of a basket of goods and services bought by firms.
Problems with the CPI
- Substitution bias: consumers substitute towards goods that become relatively cheaper, mitigating the effects of price increases.
- Introduction of new goods: the introduction of new goods increases variety, making dollars more valuable.
- Unmeasured quality change: improvements in the quality of goods in the basket increase the value of each dollar.
GDP Deflator vs. CPI
- Imported consumer goods are included in CPI but excluded from GDP deflator.
- Capital goods are excluded from CPI but included in GDP deflator (if produced domestically).
- The basket: CPI uses a fixed basket, while GDP deflator uses prices of all goods and services currently produced domestically.
Indexation
- Indexation is a process where a dollar amount is automatically corrected for inflation by law or in a contract.
- The increase in CPI determines the Cost of Living Adjustment (COLA) in many multi-year labor contracts, adjustments in Social Security payments, and federal income tax brackets.
Real and Nominal Interest Rates
- Nominal interest rate: the interest rate not corrected for inflation, measuring the rate of growth in the dollar value of a deposit or debt.
- Real interest rate: the interest rate corrected for inflation, measuring the rate of growth in the purchasing power of a deposit or debt.
- Real interest rate = nominal interest rate - inflation rate.
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Description
This quiz covers the consumer price index (CPI), its measurement, and its problems. It also distinguishes between CPI and GDP Deflator.