1、 2007 Thomson South-Western 2007 Thomson South-WesternMeasuring the Cost of Living Inflation refers to a situation in which the economys overall price level is rising. The inflation rate is the percentage change in the price level from the previous period. 2007 Thomson South-WesternTHE CONSUMER PRIC

2、E INDEX The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. The Bureau of Labor Statistics reports the CPI each month. It is used to monitor changes in the cost of living over time. 2007 Thomson South-WesternTHE CONSUMER PRICE INDEX

3、When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. 2007 Thomson South-WesternHow the Consumer Price Index Is Calculated1. Fix the basket. Determine what prices are most important to the typical consumer. The Bureau of Labor Statistics (BLS) iden

4、tifies a market basket of goods and services the typical consumer buys. The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services. 2007 Thomson South-WesternHow the Consumer Price Index Is Calculated2. Find the prices. Find the prices of each of the good

5、s and services in the basket for each point in time.3. Compute the baskets cost. Use the data on prices to calculate the cost of the basket of goods and services at different times. 2007 Thomson South-WesternHow the Consumer Price Index Is Calculated4. Choose a base year and compute the index. Desig

6、nate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. 100year basein basket of Priceservices and goods ofbasket of Priceindex priceConsume

7、r 2007 Thomson South-WesternHow the Consumer Price Index Is Calculated5. Compute the inflation rate. The inflation rate is the percentage change in the price index from the preceding period. 2007 Thomson South-WesternHow the Consumer Price Index Is Calculated The inflation rate is calculated as foll

8、ows:CPI in Year 2CPI in Year 1Inflation Rate in Year 2=100CPI in Year 1 2007 Thomson South-WesternTable 1 Calculating the Consumer Price Index and the Inflation Rate: An Example 2007 Thomson South-WesternTable 1 Calculating the Consumer Price Index and the Inflation Rate: An Example 2007 Thomson Sou

9、th-WesternHow the Consumer Price Index Is Calculated Calculating the Consumer Price Index and the Inflation Rate: Another Example Base Year is 2002. Basket of goods in 2002 costs $1,200. The same basket in 2004 costs $1,236. CPI = ($1,236/$1,200) 100 = 103. Prices increased 3 percent between 2002 an

10、d 2004. 2007 Thomson South-WesternFYI: What Is in the CPIs Basket?17%Transportation15%Food and beveragesMedical care6%Recreation6%Apparel4%Other goodsand services4%42%Housing6%Education and communication 2007 Thomson South-WesternProblems in Measuring the Cost of Living The CPI is an accurate measur

11、e of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. Substitution bias Introduction of new goods Unmeasured quality changes 2007 Thomson South-WesternProblems in Measuring the Cost of Living Substitution Bias The basket does not change to re

12、flect consumer reaction to changes in relative prices. Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution. 2007 Thomson South-WesternProblems in Measuring the Cost of Living Introd

13、uction of New Goods The basket does not reflect the change in purchasing power brought on by the introduction of new products. New products result in greater variety, which in turn makes each dollar more valuable. Consumers need fewer dollars to maintain any given standard of living. 2007 Thomson So

14、uth-WesternProblems in Measuring the Cost of Living Unmeasured Quality Changes If the quality of a good rises from one year to the next, the value of a dollar 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 a dollar falls, e

15、ven if the price of the good stays the same. The BLS tries to adjust the price for constant quality, but such differences are hard to measure. 2007 Thomson South-WesternProblems in Measuring the Cost of Living The substitution bias, introduction of new goods, and unmeasured quality changes cause the

16、 CPI to overstate the true cost of living. The issue 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. 2007 Thomson South-WesternThe GDP Deflator versus the Consumer Price

17、 Index The GDP deflator is calculated as follows:GDP deflator =Nominal GDPReal GDP100 2007 Thomson South-WesternThe GDP Deflator versus the Consumer Price Index The BLS calculates other prices indexes: The index for different regions within the country. The producer price index, which measures the c

18、ost of a basket of goods and services bought by firms rather than consumers. 2007 Thomson South-WesternThe GDP Deflator versus the Consumer Price Index Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. There are two importa

19、nt differences between the indexes that can cause them to diverge. 2007 Thomson South-WesternThe GDP Deflator versus the Consumer Price Index The GDP deflator reflects the prices of all goods and services produced domestically, whereas. the consumer price index reflects the prices of all goods and s

20、ervices bought by consumers. 2007 Thomson South-WesternThe GDP Deflator versus the Consumer Price Index The consumer price index 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 BLS change the basket). whereas the GDP

21、deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. 2007 Thomson South-WesternFigure 2 Two Measures of Inflation1965Percentper Year15CPIGDP deflator105019701975198019851990200019952005 2007 Thomson South-WesternCORRECTING

22、 ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times. 2007 Thomson South-WesternDollar Figures from Different Times Do the following to convert dollar values from year T into todays dollars:

23、Amount intodays dollarsAmount in year Ts dollarsPrice level todayPrice level in year T 2007 Thomson South-WesternDollar Figures from Different Times Do the following to convert (inflate) Babe Ruths wages in 1931 to dollars in 2005:SalarySalaryPrice level in 2005Price level in 193120051931$80,.$00019

24、51521,026,316 2007 Thomson South-WesternIndexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. 2007 Thomson South-WesternTable 2 The Most Popular Movies of All Times, Inflation Adjusted 2007 Thomson South-Wester

25、nReal and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past. 2007 Thomson South-WesternReal and Nominal Interest Rates The nominal interest rate is the interest rate usually reported and not corrected for inflation. It is the interest rate that a

26、bank pays. The real interest rate is the interest rate that is corrected for the effects of inflation. 2007 Thomson South-WesternReal and Nominal Interest Rates You borrowed $1,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%. Real interest rate = Nominal interest r

27、ate Inflation = 15% 10% = 5% 2007 Thomson South-WesternFigure 3 Real and Nominal Interest Rates1965Interest Rates(percentper year)15%Real interest rate1050519701975 1980 1985 1990 1995 2000 2005Nominal interest rateSummary 2007 Thomson South-Western The consumer price index shows the cost of a baske

28、t 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.Summary 2007 Thomson South-Western The consumer price index is an imperfect measure of the cost of livi