Understanding Consumer Price Index (CPI)

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Questions and Answers

How does the Consumer Price Index (CPI) assist in comparing salaries from different time periods, such as Babe Ruth's salary in 1931 to modern baseball player salaries?

  • By directly comparing the nominal dollar amounts without adjustments.
  • By only considering the percentage increase in salaries over time.
  • By converting the salaries to a foreign currency for a standardized comparison.
  • By calculating the real value of the salaries, adjusting for changes in the cost of goods and services. (correct)

Which economic condition is defined as a situation where the overall price level in an economy is declining?

  • Deflation (correct)
  • Inflation
  • Stagflation
  • Hyperinflation

What is the primary role of the Bureau of Labor Statistics (BLS) in relation to the Consumer Price Index (CPI)?

  • To set monetary policy targets based on the CPI.
  • To compute and report the CPI on a monthly basis. (correct)
  • To regulate prices of goods and services included in the CPI.
  • To advise consumers on how to adjust their spending based on CPI fluctuations.

When calculating the CPI, how does fixing the basket of goods and services help in measuring the cost of living over time?

<p>It isolates the effects of price changes from the effects of quantity changes. (C)</p> Signup and view all the answers

If the CPI in 2024 is 120, with 2020 as the base year, what does this value indicate?

<p>The cost of the basket of goods is 20% higher in 2024 than in 2020. (B)</p> Signup and view all the answers

Which of the following is the correct formula to calculate the inflation rate between two consecutive years using the CPI?

<p>Inflation Rate = (CPI in Current Year - CPI in Previous Year) / CPI in Previous Year * 100 (A)</p> Signup and view all the answers

What is the 'core CPI,' and why is it used by economists?

<p>The CPI excluding food and energy prices, used to better reflect underlying inflation trends. (D)</p> Signup and view all the answers

Who calculates the Producer Price Index (PPI) and what does it measure?

<p>The Bureau of Labor Statistics, measuring prices received by domestic producers. (D)</p> Signup and view all the answers

How does 'substitution bias' affect the accuracy of the CPI as a measure of the cost of living?

<p>It causes the CPI to overstate the true increase in the cost of living. (C)</p> Signup and view all the answers

Why does the introduction of new goods create a challenge in accurately measuring the cost of living using the CPI?

<p>The fixed basket of the CPI cannot immediately account for the increased value and choice that new goods provide. (B)</p> Signup and view all the answers

How does 'unmeasured quality change' affect the accuracy of the CPI?

<p>It affects the CPI because changes in quality are hard to measure and can change the value of a dollar. (C)</p> Signup and view all the answers

The CPI is used to adjust government programs. What might be a consequence of the CPI overstating inflation?

<p>Government benefits may increase more than necessary, potentially straining public finances. (A)</p> Signup and view all the answers

What action do some economists suggest be taken regarding government programs that use the CPI, given the known measurement problems with the CPI?

<p>Modifying the programs to correct for the measurement problems, such as adjusting the magnitude of automatic benefit increases. (A)</p> Signup and view all the answers

What is one reason why some argue against modifying government programs that use the CPI, even with its known measurement issues?

<p>Older people often spend more on healthcare, which can increase in price more rapidly than the standard CPI basket. (A)</p> Signup and view all the answers

In the context of CPI calculation, what does choosing a 'base year' accomplish?

<p>It sets a benchmark to compare price levels in other years. (C)</p> Signup and view all the answers

Why might the CPI be considered a more relevant measure of inflation for typical consumers than the GDP deflator?

<p>The CPI reflects the goods and services bought by consumers, while the GDP deflator reflects the prices of all goods and services produced in a country. (B)</p> Signup and view all the answers

How does the BLS attempt to account for quality changes in goods when calculating the CPI?

<p>By estimating the monetary value of the quality change and adjusting the price accordingly. (B)</p> Signup and view all the answers

If the price of gasoline increases significantly, which of the following would likely occur regarding the CPI and core CPI?

<p>The CPI would increase more than the core CPI. (A)</p> Signup and view all the answers

What is a potential consequence of using a fixed basket of goods and services in the calculation of the CPI?

<p>It overestimates the rate of inflation during periods of rapid technological advancement. (B)</p> Signup and view all the answers

Why is the choice of the base year considered arbitrary when calculating the CPI?

<p>The index is used to measure percentage changes, which remain consistent regardless of the base year. (C)</p> Signup and view all the answers

How might consumers respond to an increase in the price of beef, and how does this response affect the relevance of a fixed-basket CPI?

<p>Consumers would buy less beef and more chicken, making the CPI less accurate due to substitution bias. (B)</p> Signup and view all the answers

How would you describe the relationship between the introduction of the iPhone and the accuracy of the CPI around the time of its release?

<p>The CPI overstated the cost of living because it didn't immediately account for the added value of the iPhone. (D)</p> Signup and view all the answers

Suppose a new model of car has improved safety features but costs the same as last year's model. How would the BLS ideally treat this in the CPI calculation?

<p>Adjust the price of the car downward to reflect the improved safety. (A)</p> Signup and view all the answers

If studies suggest the CPI has an upward bias of 0.5 to 1.0 percent per year, what does this imply for real measures of economic growth that use the CPI to adjust for inflation?

<p>Real economic growth is being overestimated. (B)</p> Signup and view all the answers

How did iPod's introduction impact consumers’ economic well-being, and why was this initially missed by the CPI?

<p>Made consumers better off by enhancing choices; the CPI missed this initially. (A)</p> Signup and view all the answers

Suppose healthcare costs increase significantly faster than the standard CPI basket. What are the possible implications for older adults who rely on Social Security benefits adjusted by the CPI?

<p>Older adults may find it increasingly difficult to cover healthcare costs, potentially decreasing their living standards. (A)</p> Signup and view all the answers

Why would the BLS calculate the CPI for narrow categories of goods and services?

<p>To understand how different sectors of the economy are affected by inflation. (A)</p> Signup and view all the answers

If the quality of a specific computer has improved but the price has remained the same, what problem in calculating the cost of living does this situation illustrate?

<p>Unmeasured quality change (D)</p> Signup and view all the answers

Suppose that in 2025 you can only buy hotdogs and hamburgers. The price of 1 hotdog is $2, and the price of 1 hamburger is $4. Given that the base year is 2022, where the basket includes 4 hot dogs (priced at $1 each) and 2 hamburgers (priced at $2 each), what is the CPI in 2025?

<p>200 (C)</p> Signup and view all the answers

Suppose that in 2024 the CPI is 200 and in 2025 the CPI is 210. What is the inflation rate between 2024 and 2025?

<p>5% (D)</p> Signup and view all the answers

What is the formula for calculating the CPI?

<p>100 * (cost of basket in current year / cost of basket in base year) (D)</p> Signup and view all the answers

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Flashcards

Inflation

A situation in which the overall price level in an economy is rising.

Deflation

A situation in which the overall price level in an economy is falling.

Inflation rate

The percentage change in the price level from the previous period, often measured using the CPI or GDP deflator.

Consumer Price Index (CPI)

Measures the overall cost of the goods and services bought by a typical consumer.

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Bureau of Labor Statistics (BLS)

The government agency responsible for computing and reporting the CPI every month.

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Fixing the basket

The initial step in calculating the CPI, involving determining which prices are most important to consumers by surveying their buying habits.

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Finding the prices

Collecting price data for each of the goods and services in the CPI basket at different points in time.

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Computing the basket’s cost

Calculating the total cost of the CPI basket of goods and services at different times using the collected price data.

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Choosing a base year

Selecting a year to serve as a reference point against which other years are compared when calculating the CPI.

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Compute the inflation rate

Calculating the percentage change in the price index from the preceding period using the CPI values.

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Core CPI

A CPI calculated for all goods and services excluding food and energy, intended to better reflect underlying inflation trends.

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Producer Price Index (PPI)

Measures the prices of goods and services sold by domestic producers; formerly known as the wholesale price index.

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Substitution bias

The tendency of consumers to substitute toward goods that have become relatively less expensive in response to price changes, which is not accounted for in a fixed-basket CPI.

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Introduction of new goods

The failure of the CPI to account for the increase in consumer choices and the value of each dollar when new goods are introduced.

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Unmeasured quality change

The difficulty in measuring and accounting for changes in the quality of goods and services when calculating the CPI.

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Study Notes

  • In 1931, Babe Ruth earned $80,000, exceeding President Herbert Hoover's $75,000 salary.
  • In 2021, the average MLB salary was $4.2 million, with Trevor Bauer earning $38 million.
  • These figures need adjustment for price changes to compare living standards.
  • The consumer price index (CPI) measures the overall cost of living.
  • Rising CPI means higher expenses to maintain living standards.
  • Economists define inflation as a rising price level and deflation as a falling price level.
  • Inflation rate measures the percentage change in the price level from the prior period.
  • The CPI based inflation rate is more representative of consumer expenses than the GDP deflator.
  • Inflation trends are closely monitored, guiding macroeconomic policy.

CPI Explained

  • The consumer price index (CPI) measures the typical consumer's expenses for goods and services.
  • The Bureau of Labor Statistics (BLS) calculates and reports the CPI monthly.

CPI Calculation Steps

  • Fix the basket: Determine goods/services and their importance to consumers via surveys.
  • Find the prices: Track prices for each item in the basket over time.
  • Compute the basket’s cost: Calculate the total cost of the fixed basket in different years.
  • Choose a base year and compute the index:
    • CPI = (Price of basket in current year / Price of basket in base year) x 100
  • Compute the inflation rate:
    • Inflation rate = ((CPI in year 2 - CPI in year 1) / CPI in year 1) x 100

Additional CPI Information

  • The BLS also reports the CPI for specific categories like food, clothing, and energy.
  • The core CPI excludes food and energy, providing a view of underlying inflation trends.
  • The producer price index (PPI) measures the prices of domestic producers' output.

Problems with Measuring the Cost of Living

  • The consumer price index (CPI) aims to measure changes in the cost of living.
  • It gauges how much incomes must rise to maintain a constant standard of living.
  • The CPI is not a perfect measure, with three acknowledged problems that are hard to solve.

Substitution Bias

  • Consumers substitute toward relatively cheaper goods when prices change.
  • The fixed basket of goods in the CPI overstates the increase in the cost of living.
  • The index measures a larger increase in the cost of living than consumers actually experience.

Introduction of New Goods

  • New goods increase consumer variety, reducing the cost of maintaining well-being.
  • The CPI's fixed basket doesn't reflect the increased value of the dollar.
  • A perfect cost-of-living index would reflect the decrease in the cost of living from new goods.
  • The reduction in the cost of living associated with the initial introduction of new devices never shows up in the index.

Unmeasured Quality Change

  • Quality deterioration decreases the value of a dollar, while quality improvement increases it.
  • The BLS adjusts prices to account for quality changes, aiming for a constant-quality basket.
  • Changes in quality remain a problem, as quality is hard to measure.

CPI Measurement Problems Debate

  • Studies estimate an upward bias of 0.5 to 1.0 percent per year in measured inflation.
  • Government programs use the CPI to adjust for price changes.
  • Social Security benefits are tied to the CPI.
  • Economists suggest modifying programs to correct for measurement problems.

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