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How do we measure the changing value of money? Transformers: Revenge of the Fallen earned $400 million at the box office. Gone with the Wind earned $200 million. Which movie really had the larger box office revenues?

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© 2011 Pearson Education The CPI and the Cost of Living 7 When you have completed your study of this chapter, you will be able to 1 Explain what the Consumer Price Index (CPI) is and how it is calculated. 2 Explain the limitations of the CPI and describe other measures of the price level. 3 Adjust money values for inflation and calculate real wage rates and real interest rates. CHAPTER CHECKLIST

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7.1 THE CONSUMER PRICE INDEX Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. The BLS calculates the CPI every month. We can use these numbers to compare what a fixed basket of goods costs this month with what it cost in some previous month.

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7.1 THE CONSUMER PRICE INDEX Reading the CPI Numbers The CPI is defined to equal 100 for a period called the reference base period. Reference base period is a period for which the CPI is defined to equal 100. Currently, the reference base period is 1982 1984.

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7.1 THE CONSUMER PRICE INDEX In June 2009, the CPI was 214.5. The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 114.5 percent higher in June 2009 than it was on the average during 1982 1984. In May 2009, the CPI was 212.9. The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services increased by 1.6 of a percentage point in June 2009.

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7.1 THE CONSUMER PRICE INDEX Constructing the CPI Three stages: Selecting the CPI basket Conducting the monthly price survey Calculating the CPI

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7.1 THE CONSUMER PRICE INDEX The CPI Basket Make the relative importance of the items in the CPI basket the same as in the budget of an average urban household. The CPI is calculated each month, but the CPI basket is not updated each month. The CPI basket in 2009 is based on information obtained from the Consumer Expenditure Surveys conducted during 2005 and 2006.

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7.1 THE CONSUMER PRICE INDEX Figure 7.1 shows the CPI basket at the end of 2008. This shopping cart is filled with the items that an average household buys.

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7.1 THE CONSUMER PRICE INDEX The Monthly Price Survey Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas. Because the CPI measures price changes, it is important that the prices recorded refer to exactly the same items.

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7.1 THE CONSUMER PRICE INDEX Calculating the CPI The CPI calculation has three steps: Find the cost of the CPI basket at base period prices. Find the cost of the CPI basket at current period prices. Calculate the CPI for the base period and the current period. Table 7.1 on the next slide shows a simplified CPI calculation in which we assume a base period of 2005.

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7.1 THE CONSUMER PRICE INDEX

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CPI = Cost of CPI basket at current period prices Cost of CPI basket at base period prices x 100 For 2005, the CPI is: = 100 $50 x 100 For 2010, the CPI is: = 140 $70 $50 x 100

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7.1 THE CONSUMER PRICE INDEX Measuring Inflation Inflation rate is the percentage change in the price level from one year to the next. Inflation rate = = 16.7 percent 140 120 120 x 100 CPI in current year CPI in previous year CPI in previous year x 100 Inflation rate =

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7.1 THE CONSUMER PRICE INDEX Figure 7.2 shows the CPI in part (a) and the inflation rate in part (b).

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7.1 THE CONSUMER PRICE INDEX 1. The price level has rising rapidly in the 1980s and the inflation rate was high.

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7.1 THE CONSUMER PRICE INDEX 2. The price level was rising slowly during the 1990s and 2000s and the inflation rate was low.

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7.1 THE CONSUMER PRICE INDEX 3. In 2009, the price level fell and the inflation rate was negative.

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7.2 THE CPI AND OTHER PRICE LEVEL MEASURES Cost of living index is a measure of changes in the amount of money that people would need to spend to achieve a given standard of living. The CPI does not measure the cost of living because It does not measure all the components of the cost of living Some components are not measured exactly So the CPI is possibly a biased measure.

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Sources of Bias in the CPI The potential sources of bias in the CPI are New goods bias Quality change bias Commodity substitution bias Outlet substitution bias 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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New Goods Bias New goods do a better job than the old goods that they replace, but cost more. The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate. Quality Change Bias Better cars and televisions cost more than the versions they replace. A price rise that is a payment for improved quality is not inflation but might get measured as inflation. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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Commodity Substitution Bias If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. The CPI basket doesnt change to allow for the effects of substitution between goods. Outlet Substitution Bias If prices rise more rapidly, people use discount stores more frequently. The CPI basket doesnt change to allow for the effects of outlet substitution. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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The Magnitude of the Bias The Boskin Commission estimated the bias to be 1.1 percentage points per year. If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year. To reduce the bias, the BLS has decided to increase the frequency of its Consumer Expenditure Survey and revise the CPI basket every two years. When the BLS revises the CPI basket, the reference base period does not change. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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Two Consequences of the CPI Bias Two main consequences of the bias in the CPI are Distortion of private contracts Increases in government outlays and decreases in taxes Distortion of Private Contracts Many wage contracts are linked to the CPI. If the CPI is biased, these contracts might deliver an outcome different from that intended by the parties. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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Suppose that the UAW and GM sign a 3-year wage deal: In the first year, the wage will be $30 an hour and will rise by the inflation rate in the next two years. If the inflation rate is 5 percent a year, the wage rises to $31.50 an hour in the second year and $33.08 an hour in the third year. But if the actual inflation rate is 2 percent a year, the intended wages in the second and third years are $30.90 an hour and $31.83 an hour. The workers gain is GMs loss. With thousands of workers, GMs loss would be millions of dollars over the 3 years. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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Increases in Government Outlays and Decreases in Taxes Close to a third of federal government outlays are linked directly to the CPI. The CPI is used to adjust 49 million Social Security benefit payments 27 million food stamp payments 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses the budget for 3 million school lunches 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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The CPI is used to adjust the income levels at which higher tax rates apply. Because tax rates on large incomes are higher than those on small incomes as incomes rise, the burden of taxes would rise relentlessly if these adjustments were not made. To the extent that the CPI is biased upward, the tax adjustments over-compensate for rising prices and decrease the amount paid in taxes. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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Alternative Measures of the Price Level Several alternative measures of the price level are available. Here we look at GDP price index Personal consumption expenditures (PCE) price index PCE price index excluding food and energy 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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GDP Price Index The GDP price index is an average of current prices of all the goods and services included in GDP expressed as a percentage of base-year prices. GDP price index = (Nominal GDP Real GDP) 100. The GDP price index is a measure of the price level. The percentage change in the GDP price index is a measure of the inflation rate. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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Two differences between the GDP price index and the CPI result in different estimates of the price level and inflation rate. 1.The GDP price index uses the prices of all the goods and services in GDP. The CPI uses prices of consumption goods and services. 2.The GDP price index weights each item using information about current as well as past quantities. In contrast, the CPI weights each item using information from a past Consumer Expenditure Survey. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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Because the GDP price index uses information on current year quantities, it includes new goods and quality improvements and even allows for substitution effects of both commodities and retail outlets. So in principle, the GDP price index is not subject to the biases of the CPI. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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PCE Price Index The PCE price index is an average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices. The PCE price index, like the GDP price index, uses current information on quantities and prices and to some degree overcomes the sources of bias in the CPI. Because it focuses on consumption expenditure, it a possible measure of the cost of living. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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PCE Price Index Excluding Food and Energy Food and energy prices fluctuate much more than other prices, so their changes can obscure the underlying trends in prices. By excluding these highly variable items, the underlying price level and inflation trends can be seen more clearly. The percentage change in the PCE price index excluding food and energy is called the core inflation rate. 7.2 THE CPI AND OTHER PRICE LEVEL MEASURES

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7.2 THE CPI AND OTHER … Figure 7.3 shows the three measures of the price level and their inflation rates. The three measures of the inflation rate fluctuate together, but the CPI inflation rate is higher than the other two measures. The core inflation rate fluctuates less than the other two measures.

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7.2 THE CPI AND OTHER … Part (b) shows the three measures of the price level. The CPI increases more quickly than the two PCE measures. The path of the CPI shows the bias in the CPI as a measure of the price level.

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7.3 NOMINAL AND REAL VALUES Dollars and Cents at Different Dates To compare dollar amounts at different dates, we need to know the CPI at those dates. Convert the price of a 2¢ stamp in 1909 into its 2009 equivalent: Price of stamp in 2009 dollars = = 2¢ x 214.5 9.6 = 44.69¢ Price of stamp in 1909 dollarsx CPI in 2009 CPI in 1909

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We measure the changing value of money by using a price index. The most common price index is the CPI. Because the CPI is biased, we supplement it with other indexes and other information. By using a price index, we can calculate the amount that a movie really earns at the box office. How Do We Measure the Changing Value of Money? EYE on the VALUE OF MONEY

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Gone with the Wind was made in 1939 and rereleased in nine subsequent years. By 2009, it had earned a total box office revenue of $198,676,459 (almost $200 million) in the United States. Transformers: Revenge of the Fallen was released in 2009. During the summer of 2009, it earned $397,470,858 (almost $400 million). Which movie earned the more box office revenue? How Do We Measure the Changing Value of Money? EYE on the VALUE OF MONEY

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To convert the Gone with the Wind revenues into 2009 dollars, … multiply the dollars received each year by the 2009 CPI and divide by the CPI for the year in which the dollars were earned. Box-Office Mojo has done such a calculation, but rather than use the CPI, it used the average prices of movie tickets. According to Box-Office Mojo, valuing the tickets for Gone with the Wind at 2009 movie-ticket prices, it has earned $1,450,680,400, or $1,451million, about 3.6 times Transformers revenue. How Do We Measure the Changing Value of Money? EYE on the VALUE OF MONEY

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Because Box-Office Mojo uses average ticket prices, the real variable that it compares is the number of tickets sold. The average ticket price in 2009 was $7.18, so 202 million movie-goers have seen Gone with the Wind and 55 million have seen Transformers: Revenge of the Fallen. How Do We Measure the Changing Value of Money? EYE on the VALUE OF MONEY

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7.3 NOMINAL AND REAL VALUES Nominal and Real Values in Macroeconomics Macroeconomics makes a big issue of the distinction between nominal values and real values: Nominal GDP and real GDP Nominal wage rate and real wage rate Nominal interest rate and real interest rate We studied the distinction between and calculation of nominal and real GDP in Chapter 20. Here, well look at the other two.

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7.3 NOMINAL AND REAL VALUES Nominal and Real Wage Rates Nominal wage rate is the average hourly wage rate measured in current dollars. Real wage rate is the average hourly wage rate measured in the dollars of a given reference base year.

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7.3 NOMINAL AND REAL VALUES Real wage rate in 2008 = = $8.36 $18.00 215.3 x 100 To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100. That is, Nominal wage rate in 2008 CPI in 2008 x 100 Real wage rate in 2008 = The $8.36 amount is in 1982 1984 dollars.

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7.3 NOMINAL AND REAL VALUES Figure 7.4 shows nominal and real wage rates: 1984 to 2008. Despite the increase in the nominal wage rate every year. Since 1984, the real wage rate barely changed,

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7.3 NOMINAL AND REAL VALUES Nominal and Real Interest Rates Nominal interest rate is the dollar amount of interest expressed as a percentage of the amount loaned. Real interest rate is the goods and services forgone in interest expressed as a percentage of the amount loaned. Real interest rate = Nominal interest rate – Inflation rate.

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7.3 NOMINAL AND REAL VALUES Figure 7.5 shows real and nominal interest rates: 1968 to 2008. The nominal interest rate increased during the high-inflation 1980s. During the 1970s, the real interest rate became negative.

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Section 5.3: Inflation and the Consumer Price Index.

Section 5.3: Inflation and the Consumer Price Index.

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