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© 2007 Thomson South-Western

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1 Measuring the Cost of Living Inflation refers to a situation in which the economy’s price level is rising. The inflation rate is the rate of change in the price level from the previous period (month or year).

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2 THE CONSUMER PRICE INDEX The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. CPI is one way of measuring the price level. It is used to monitor changes in the cost of living over time.

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3 THE CONSUMER PRICE INDEX When the CPI increases, the average family has to spend more money to maintain the same standard of living.

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4 How the CPI Is Calculated 1. Fix the basket. Determine the quantity of each good that the average consumer buys. Identify a basket of goods and services the typical consumer buys. Conduct monthly consumer surveys to determine the quantities of those goods and services.

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5 How the CPI Is Calculated 2. Find the prices. Find the prices of each of the goods and services in the basket for each period (month or year). 3. Calculate the cost of the basket. Use the data on prices to calculate the cost of the basket of goods and services at each period.

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6 How the CPI Is Calculated 4. Choose a base year and compute the index. Choose one year as the base year, so that we can compare across years more clearly. Compute the index by dividing the cost of the basket in one year by the cost of the basket in the base year and multiplying by 100.

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7 How the CPI Is Calculated 5. Calculate the inflation rate. The inflation rate is the rate of change in the consumer price index between years (or months).

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8 How the CPI Is Calculated The inflation rate is calculated as follows:

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9 Table 1: Calculating the Consumer Price Index and the Inflation Rate: An Example

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10 Table 1: Calculating the Consumer Price Index and the Inflation Rate: An Example

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11 How the CPI 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 YTL. The same basket in 2004 costs 1,236 YTL. CPI = (1,236/1,200) 100 = 103. Prices increased by 3 percent between 2002 and 2004. (Remember that base year CPI is always 100)

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12 What Is in the CPI’s Basket? (US data) 17% Transportation 15% Food and beverages Medical care 6% Recreation 6% Apparel 4% Other goods and services 4% 42% Housing 6% Education and communication

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13 CPI in Turkey

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14 Problems in Measuring the Cost of Living The CPI is a good but not a perfect measure of the cost of living because it fixes the basket. Problems include: Substitution bias (overestimates inflation) Introduction of new goods Unmeasured quality changes

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15 Problems in Measuring the Cost of Living Substitution Bias The basket does not change to reflect consumer’s reaction to changes in relative prices. Consumers substitute away from goods that have become relatively more expensive toward goods that have become cheaper. Think about benzene (gasoline) and LPG. But CPI ignores this consumer reaction. Therefore the index overestimates the actual inflation rate by not considering the substitution effect.

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16 Problems in Measuring the Cost of Living Introduction of New Goods The basket does not reflect the change in purchasing power brought on by the introduction of new products. Think about a new Nokia cell phone coming to Turkey in March. Increases standard of living. But the CPI basket is fixed, ignores new products. New products result in greater variety, which in turn makes each YTL more valuable. Consumers need fewer liras to maintain the same standard of living.

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17 Problems in Measuring the Cost of Living Unmeasured Quality Changes If the quality of the same good rises from one year to the next, and its price does not change, the value of one YTL rises, Ex1: Airbags became standard in cars, but assume that price of a car did not increase much. Ex2: Cell phones developed a lot in last 10 years but prices did not increase as much. TURKSTAT tries to adjust the price for constant quality, but it is hard to measure quality.

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18 Problems in Measuring the Cost of Living The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overestimate 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. (indexing) The CPI overestimates inflation by about 1 percentage point per year.

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19 Other Indices: Indices for different regions within the country, such as Istanbul, Ankara, etc. For various categories of goods such as food, energy, housing etc. The producer price index (PPI), which measures the cost of a basket of goods and services bought by firms rather than consumers. PPI is used for predicting future CPI inflation. Wholesale Price Index (WPI)

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20 WPI in TR

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21 The GDP Deflator versus the CPI The GDP deflator is calculated as follows:

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22 The GDP Deflator versus the CPI Economists and policymakers monitor both the GDP deflator and CPI to measure how quickly prices are rising. There are two important differences between GDP deflator and CPI.

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23 The GDP Deflator versus the CPI GDP deflator measures the prices of all goods and services produced in this country, whereas... …the CPI reflects the prices of all goods and services purchased by the average consumer. So CPI includes prices of imported goods, such as oil, natural gas, imported cars, etc. (deflator does not) Does CPI include prices of military equipment produced by Aselsan in Turkey? Does GDP Deflator include it?

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24 Figure 2: Two Measures of Inflation in US 1965 Percent per Year 15 CPI GDP deflator 10 5 0 1970197519801985199020001995 2005

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25 Figure 3: Two Measures of Inflation in TR

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26 Correcting Economic Variables For The Effects Of Inflation Real value of 1 lira is different across time due to inflation. Price indices are used to correct for the effects of inflation when comparing lira figures from different times.

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27 Lira Figures from Different Times Do the following to convert lira values from time T into today’s liras: Amount in today’s liras Amount in time T’s liras Price level today Price level in time T X

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28 TL Figures from Different Times Let us convert Adrian Ilie’s transfer payment to Beşiktaş, 234 000 liras in January 2004 into liras of January 2008:

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29 Indexation When some TL amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation.

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30 Table 2 The Most Popular Movies of All Times, Adjusted for Inflation

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31 Real and Nominal Interest Rates Interest rate is the cost of borrowing money (credit) for a specified period of time. It is the cost of renting money for a month or year.

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32 Real and Nominal Interest Rates The nominal interest rate is the interest rate usually quoted in the banking system and not corrected for inflation. It is the interest rate that a bank pays. Ex: Suppose the bank pays 15% annual interest rate on 100 YTL you deposit now. Then you will receive 100 YTL as principal + 15 YTL as interest payment one year from now. Are you 15% richer in terms of goods & services you can buy? No. Because there is inflation.

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33 Real and Nominal Interest Rates The real interest rate is the interest rate that is corrected for the effects of inflation. It measures real return on your deposit. You deposited 100 YTL for one year. Annual nominal interest rate is 15%. Suppose during the next year, people expect that inflation will be 8%.

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34 Real and Nominal Interest Rates Then Fisher Equation says that: Real Interest Rate = 15% – 8% = 7% You will receive 115 YTL next year, but this will buy only 107 liras worth of goods & services. You are 7% richer in real terms. You will have 7% more purchasing power.

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35 Unexpected Inflation If actual inflation turns out to be greater than expected inflation, then lenders (depositors) lose and borrowers gain. If actual inflation becomes 15% instead of 8%, then your real return on your deposit becomes 0%, not 7%. You (lender) lose and bank (borrower) gains.

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36 Real and Nominal Interest Rates in TR

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37 Figure 3 Real and Nominal Interest Rates (US) 1965 Interest Rates (percent per year) 15% Real interest rate 10 5 0 5 19701975198019851990199520002005 Nominal interest rate

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38 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. CPI is used to measure the price level in the economy. The percentage change in the CPI measures the inflation rate. Summary

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39 The GDP deflator differs from the CPI because deflator considers goods and services produced but CPI considers goods and services consumed. In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes. Summary

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40 Lira figures from different points in time do not represent a correct comparison of purchasing power. Fisher equation says that the real interest rate equals the nominal interest rate minus the rate of inflation. Summary

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