Chapter 3 - The CPI and the Cost Of Living PDF

MGT 4073/CFB 1133 MACROECONOMICS  CHAPTER 3: The CPI and the Cost of Living  CHAPTER 3: The CPI and the Cost of Living At the end of this chapter, you should be able to: Interpret the meaning of consumer and producer price index, (CPI) and (PPI). M...

MGT 4073/CFB 1133 MACROECONOMICS  CHAPTER 3: The CPI and the Cost of Living  CHAPTER 3: The CPI and the Cost of Living At the end of this chapter, you should be able to: Interpret the meaning of consumer and producer price index, (CPI) and (PPI). Measure consumer price index (CPI). Identify the problems of measuring consumer price index (CPI). Distinguish between CPI and GDP Deflator  THE CONSUMER PRICE INDEX ▪ Consumer price index (CPI) ▪ Measure of the overall cost of goods and services bought by a typical consumer ▪ Monitor changes in the cost of living over time ▪ 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  How the CPI Is Calculated 1. Fix the basket The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.” 2. Find the prices The BLS collects data on the prices of all the goods in the basket. 3. Compute the basket’s cost Use the prices to compute the total cost of the basket. How the CPI Is Calculated (cont.)  EXAMPLE EXAMPLE 1: Market basket: 10 pizzas, 5 shirts Year Price of Pizza Price of Tshirt Cost of basket 201 $12 $18 2018 $14 $20 2019 $16 $22  Problems with the CPI Substitution Bias Over time, some prices rise faster than others Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. The CPI misses this substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.  Problems with the CPI (cont.) Introduction of New Goods The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. In effect, dollars become more valuable. The CPI misses this effect because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.  Problems with the CPI (cont.) Unmeasured Quality Change Improvements in the quality of goods in the basket increase the value of each dollar. The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. Thus, the CPI overstates increases in the cost of living.  GDP Deflator vs. CPI Imported consumer goods: Included in CPI but excluded from GDP deflator Capital goods: Excluded from CPI but included in GDP deflator (if produced domestically) The basket: – CPI: fixed basket; prices of all goods and services bought by consumers – GDP deflator: prices of all goods and services currently produced domestically  Indexation Indexation A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract. The increase in CPI automatically determines: The COLA in many multi-year labor contracts. Adjustments in Social Security payments and federal income tax brackets.  Real and Nominal Interest Rates The nominal interest rate: Interest rate not corrected for inflation Rate of growth in the dollar value of a deposit or debt The real interest rate: Corrected for inflation Rate of growth in the purchasing power of a deposit or debt Real interest rate = = (nominal interest rate) – (inflation rate) END OF CHAPTER 3 THANK YOU