Understanding Inflation and the Consumer Price Index

• Inflation is when the economies overall price level is rising.
• Inflation rate is the percentage change in the price level from the previous period.

The Consumer Price Index (CPI)

• The CPI measures the overall cost of goods and services bought by a typical consumer.
• The CPI is reported regularly by the national statistical agency.
• The CPI is used to monitor changes in the cost of living over time.
• When the CPI rises, the typical family spends more money to maintain their standard of living.

How the Consumer Price Index Is Calculated

• Step 1: Fix the basket by determining what prices are most important to the typical consumer.
• A statistical agency identifies a market basket of goods and services the typical consumer buys.
• Consumer surveys are conducted to set the weights for the prices of goods and services.
• Step 2: Find the prices of each of the goods and services in the basket for each point in time.
• Step 3: Compute the basket’s cost using prices to calculate the cost of the goods and services at different times.
• Step 4: Choose a base year and compute the index, which compares other years against the base year.
• The index is computed by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

CPI = (Price of basket of goods and services / Price of basket in base year) ×100

• Step 5: Compute the inflation rate, which is the percentage change in the price index from the preceding period.

Inflation Rate in Year 2= (CPI in Year 2 – CPI in Year 1) / CPI in Year 1 ×100

Problems in Measuring the Cost of Living

• The CPI is an accurate measure of selected goods in a typical bundle, but is not a perfect measure of the cost of living.
• CPI inaccuracies: substitution bias, introduction of new goods, and unmeasured quality changes.

Substitution Bias

• The market basket doesn't change to reflect consumer reactions to changes in relative prices.
• Consumers substitute toward goods that become relatively less expensive.
• The index overstates the increase in the cost of living by ignoring consumer substitution.

Introduction of New Goods

• The market basket does not reflect the change in purchasing power brought on by new products.
• New products give a greater variety, which in turn makes money more valuable.
• Consumers need less money to maintain any given standard of living.

Unmeasured Quality Changes

• If the quality of a good rises from one year to the next, the value of money rises, even if the price of the good stays the same.
• If the quality of a good falls from one year to the next, the value of money falls, even if the price of the good stays the same.
• National statistical agencies adjust prices for constant quality, but such differences are hard to measure.
• The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the rise in the cost of living.
• The inaccuracy is important because many government programs use the CPI to adjust for changes in the overall level of prices.
• The CPI overstates inflation by about 1 percentage point per year.

The GDP Deflator vs. the Consumer Price Index

• Economists and policymakers monitor both the GDP deflator and CPI to gauge how quickly prices are rising.
• The GDP deflator reflects the prices of all goods and services produced domestically.
• The CPI reflects the prices of all goods and services bought by consumers.
• The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the government change the basket).
• The GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

Correcting Economic Variables for the Effects of Inflation

• Price indexes are used to correct for the effects of inflation when comparing given amounts of money from different times.

Salary2004 = Salary1968 (Price level in 2004 / Price level in 1968)

• Indexation is when some money amount is automatically corrected for inflation by law or contract.

Real and Nominal Interest Rates

• Interest represents a payment in the future for a transfer of money in the past.
• The nominal interest rate is the interest rate usually reported and not corrected for inflation, such as what a bank pays.
• The real interest rate is the interest rate that is corrected for the effects of inflation.
• Real interest rate = Nominal interest rate – Inflation

Summary Points From Text

• The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year.
• The index is used to measure the overall level of prices in the economy.
• The percentage change in the CPI measures the inflation rate.
• The consumer price index is an imperfect measure of the cost of living because of substitution bias, new goods, and unmeasured changes in quality.
• The GDP deflator and CPI differ because the GDP includes goods and services produced rather than goods and services consumed.
• The GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes, unlike the fixed basket of goods used by the CPI.
• Money values from different points in time do not represent a valid comparison of purchasing power.
• Laws and contracts use price indexes to correct for the effects of inflation.
• The real interest rate equals the nominal interest rate minus the rate of inflation.