PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Measuring the Cost of Living 1 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Consumer Price Index Consumer price index (CPI) –Measure of the overall level of prices –Measure of the overall cost of goods and services bought by a typical consumer –Released monthly by Bureau of Labor Statistics which part of Dept of Labor 2 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Calculating CPI 1.Fix the basket so that the most important prices of goods bought by consumers is weighted more. The basket should represent goods and services purchased by the typical consumer. 2.Find the prices at each point in time 3.Compute the basket’s cost keeping the quantities in the basket constant over time 3 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Calculating CPI 4 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 1 5 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

Table 1 6 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

The Consumer Price Index Inflation rate –Percentage change in monthly CPI from the preceding month –Calculates how quickly the cost of living for the typical consumer is rising Producer price index, PPI –Measure of the cost of a basket of goods and services bought by firms –These costs are eventually going to be passed onto consumers in the form of higher prices –Changes in PPI are often thought to be useful in predicting changes in CPI 7 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 8 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Typical Basket of Goods and Services This figure shows how the typical consumer divides spending among various categories of goods and services. The Bureau of Labor Statistics calls each percentage the “relative importance” of the category.

The Consumer Price Index Problems in measuring the cost of living –Substitution bias Prices do not change proportionately Consumers substitute toward goods that have become relatively less expensive so the basket is not truly fixed. –Year 1: Apples are less than pears so people buy more apples. CPI is computed with more apples –Year 2: Apples are more than pears so people buy more pears. CPI is still calculated with more apples. –The result is that CPI will show a large cost of living increase than consumers actually experience 9 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Consumer Price Index Problems in measuring the cost of living –Introduction of new goods As new goods are introduced and substitutes are available, each $1 that the consumer has can go further –When the vcr was introduced, it was a substitute for movie theatres. This reduced consumer cost to watch movies. The change did not show in CPI until BLS changed basket. –Unmeasured quality change As the quality of goods improves over time, each $1 goes further 10 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

GDP versus CPI Difference between GDP and CPI –GDP measures goods and services produced domestically –CPI measures the prices of all goods and services bought by consumers A plane made by Boeing and sold to U.S. military will show up in GDP but not CPI If Volvo, a foreign producer of cars, increases its prices, it will show up in CPI but not GDP Historically, oil prices have had a larger impact on CPI than GDP because most oil has been produced outside the U.S. 11 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

GDP deflator versus CPI GDP deflator –Ratio of nominal GDP to real GDP –Reflects prices of all goods & services produced domestically CPI –Ratio of price increase to base year prices –Reflects change in prices of goods & services bought by consumers 12 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 13 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Two Measures of Inflation This figure shows the inflation rate—the percentage change in the level of prices— as measured by the GDP deflator and the consumer price index using annual data since Notice that the two measures of inflation generally move together.

Correcting Economic Variables 14 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Correcting Economic Variables Indexation –Automatic correction by law or contract of a dollar amount for the effects of inflation Social Security gives an annual COLA (Cost of Living Allowance) adjustment Long term contracts such as a 10 year infrastructure project will often have adjustments for inflation 15 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real and Nominal Interest Rates Interest Rate = Cost of $’s Future $’s have a different value than today’s $’s –If a person deposits $1000 into that bank at 10% interest, then after 1 year is $1100 worth more than the original $1000? If inflation was less than 10%, then the $1100 is worth more; it will buy more If inflation was more than 10%, then the $1100 is worth less than the original $1000; it will not buy as much Nominal interest rate –Interest rate as usually reported without a correction for the effects of inflation Real interest rate –Interest rate corrected for the effects of inflation = Nominal interest rate – Inflation rate 16 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Real and Nominal Interest Rates Interest Rate = Cost of $’s Future $’s have a different value than today’s $’s –Nominal interest rate is the interest rate as usually reported without a correction for the effects of inflation –Real interest rate is the interest rate corrected for the effects of inflation Real Interest Rate = Nominal interest rate – Inflation rate 17 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest rates in the U.S. Economy Nominal interest rate –Almost always exceeds the real interest rate (2009) –U.S. economy has experienced rising consumer prices in every year Inflation is variable –Real and nominal interest rates do not always move together (1960’s-1970’s) Periods of deflation –Real interest rate exceeds the nominal interest rate (2009) 18 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 3 19 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Real and Nominal Interest Rates This figure shows nominal and real interest rates using annual data since The nominal interest rate is the rate on a 3-month Treasury bill. The real interest rate is the nominal interest rate minus the inflation rate as measured by the consumer price index. Notice that nominal and real interest rates often do not move together.