1. Welcome To Macroeconomics Econ 2301 Dr. Jacobson Mr. Stuckey Chapter 7 Chapter 7

2. Chapter 7 GDP and CPI: Tracking the Macroeconomy

3. In Chapter 7 We Look at How Economists Use the GDP To Measure the Quantity of Goods and Services An Economy Produces.

4. In This Chapter We Will Look At How Economists Measure The Overall Cost of Living. This is Done Through a Statistic Called the Consumer Price Index (CPI).

5. The Consumer Price Index (CPI) is Used to Monitor Changes in The Cost of Living Over Time.

6. Remember When I Said the GDP Deflator Was One Way to Measure Inflation. This Occurred Because (If You Remember) Only Two Items Can Cause the GDP to Increase: Prices or Production.

7. In Looking at the GDP We Calculated Both The Nominal and Real GDP. The Real GDP Eliminated Price Increases and Gave Us An Increase (or Decrease) in Production For the Period.

8. From There We Calculated The GDP Deflator That Eliminated an Increase in Production to Give Us an Increase in Prices For the Products During This Period of Time. This We Called This Increase the Rate of Inflation.

9. In Essence the Consumer Price Index (CPI) is Just Another Way of Computing the Rate of Inflation.

10. The Consumer Price Index (CPI) Dates Back to 1890 and is the Oldest Continuous Statistical Series Published By the Bureau of Labor Statistics. It is Based on Approximately 3400 Commodity Prices.

11. Consumer Price Index (CPI) The Consumer Price Index is a Measure of the Overall Cost of the Goods and Services Bought by a Typical Consumer.

12. Consumer Price Index A Price Index That Measures The Cost of A Fixed Basket of Consumer Goods in Which the Weight Assigned to Each Commodity is the Share of Expenditures On That Commodity By Urban Consumers.

13. The Consumer Price Index (CPI) is Calculated Monthly By the Bureau of Labor Statistics (BLS) (Which is Part of the Department of Labor).

14. Calculating the CPI 1.Fix the Basket. 2.Find the Prices. 3.Compute The Basket’s Cost. 4.Choose a Base Year and Compute the Index. 5.Compute the Inflation Rate.

15. 1.Fix The Basket. Determine Which Prices Are Important to the Typical Consumer. This is Done By Surveying Consumers and Finding The Basket of Goods and Services, The Typical Consumer Buys.

16. A 2001 Source Indicates that The Standard Market Basket Consisted of 365 Separate Classes of Good and Services That Were Collected From 23,000 Establishments in 87 Areas of The Country.

17. 2.Find The Prices. Find the Prices For Each of the Goods and Services In the Basket For Each Point in Time.

18. 3.Compute the Basket’s Cost. Use the Data on Prices to Calculate the Cost of the Basket of Goods and Services At Different Times.

19. 4.Choose a Base Year and Compute the Index. Designate One Year As the Base Year, Which is the Benchmark Against Which Other Years Are Compared. Again, as With the GDP the Earliest Year is Usually Designated as the Base Year.

20. Once the Base Year is Chosen, the Index is Calculated as Follows: Price of Basket of Goods and Services Consumer = --------------------- X 100 Price Index Price of Basket in Base Year Price of Basket of Goods and Services Consumer = --------------------- X 100 Price Index Price of Basket in Base Year

21. 5.Compute the Inflation Rate. Using the Consumer Price Index to Calculate the Inflation Rate. The Inflation Rate is the Percentage Change in the Price Index From the Preceding Period.

22. The Inflation Rate Between Two Years is Calculated as Follows: CPI In CPI In CPI In CPI In Inflation Rate in Year 2 – in Year 1 In = X100 Year 2 CPI in Year 1

23. Example: Step 1: Survey Consumers to Determine a Fixed Basket of Goods. Basket = 4 Hot Dogs, 2 Hamburgers

24. Step 2: Find the Price of Each Good in Each Year. Price of Price of Year Hot Dogs Hamburgers 2005 $1 $2 2006 2 3 2007 3 4

25. Step 3: Compute the Cost of the Basket of Goods in Each Year. 2005 ($1/HD X 4HD) + ($2/HB X 2 HB) = $8 Per Basket 2006 ($2/HD X 4HD) + ($3/HB X 2 HB) = $14 Per Basket 2007 ($3/HD X 4HD) + ($4/HB X 2 HB) = $20 Per Basket

26. Step 4: Choose One Year As a Base Year (2005) and Compute the Consumer Price Index For Each Year. 2005* ($8/$8) X 100 = 100 2006 ($14/$8) X 100 = 175 2007 ($20/$8) X 100 = 250 * Note the Base Year By Definition Will Always Be 100

27. Step 5: Use the Consumer Price Index to Compute the Inflation Rate From Previous Year. 2006 (175 - 100)/ 100 X 100 = 75% 2007 (250 - 175)/ 175 X 100 = 43% 2005/7 (250 - 100)/ 100 X 100 = 150%

28. Other Indexes: Producer Price Index (PPI) The Producer Price Index Measures the Cost of a Basket of Goods and Services Bought By Firms Rather Than Consumers.

29. Other Indexes: The Bureau of Labor Statistics Also Calculates the CPI for Specific Metropolitan Areas Such as Boston, New York and Los Angeles. In addition it Calculates Some Narrow Categories Such As Food Clothing, and Energy.

30. Problems With the CPI 1.Substitution Bias. 2.Introduction of New Goods. 3.Unmeasured Quality Change.

31. 1. Substitution Bias: When Prices Change From One Year to the Next, They Do Not all change Proportionately: Some Prices Rise More Than Others. Consumers Respond By Buying More or Less of the Product.

32. 2.The Introduction of New Goods. When a New Good is Introduced, Consumers Have More Variety From Which to Choose, and This in Turn Reduces the Cost of Maintaining the Same Level of Economic Well-being.

33. 3.Unmeasured Quality Change: If the Quality of a Good Deteriorates From One Year to the Next, The Value of a Dollar Falls, Even if the Price of the Good Stay the Same, Because You Are Getting a Lesser Good For The Same Amount of Money.

34. The Bureau of Labor Statistics Has Acknowledged Problems in Their Calculations and Have Made Some Adjustments to their Method of Calculations Over the Years.

35. GDP Deflator Vs. The CPI 1. The First Difference is That 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 Services Bought by Consumers.

36. 2. The Next Difference is How Prices Are Weighted By the CPI. The CPI 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 of Goods.

37. 2. Cont. By Contrast, the GDP Deflator Compares the Price of Currently Produced Goods and Services to the Price of the Same Goods and Services in the Base Year.

38. Important Note: Therefore the Group of Goods and Services Used to Compute the GDP Deflator Changes Automatically Over Time and the CPI Basket Does Not.

39. Comparing Dollar Figures At Different Points in Time. What Would an Item Cost Today Verses That Same Item Purchased at Some Point in the Past?

40. The Formula For Turning Dollar Figures From Year (T) Into Today’s Dollars is As Follows: Price Level Price Level Amount In Amount in Today Today’s Dollars = Year (T) Dollars X Price Level Price Level In Year (T) In Year (T)

41. Babe Ruth’s Salary Babe Ruth’s Salary in 1931 Was $80,000. CPI For 1931 Was 15.2 CPI For 2005 Was 195 Using the Formula We Get: Salary in Salary In Price Level In 2005 2005 Dollars = 1931 Dollars X Price Level in 1931 Price Level in 1931

42. Babe Ruth’s Salary 195 195 Salary in 2005 Dollars = $80,000 X 15.2 15.2 Salary in 2005 Dollars = $1,026,316

43. Indexation Price Indexes Are Used to Correct For the Effects of Inflation When comparing Dollar Figures From Different Times. When Some Dollar Amount is Automatically Corrected For Inflation By Law or Contract, the Amount is Said to Be Indexed for Inflation Price Indexes Are Used to Correct For the Effects of Inflation When comparing Dollar Figures From Different Times. When Some Dollar Amount is Automatically Corrected For Inflation By Law or Contract, the Amount is Said to Be Indexed for Inflation

44. Indexation- Indexation is the Automatic Correction of a Dollar Amount for the Effects of Inflation By Law or Contract. Examples: Cost-of-Living Allowance (COLA) Social Security

45. Another Definition: Indexing or Indexation is a Mechanism By Which Wages, Prices and Contracts Are Partially or Wholly Adjusted for Changes in the General Price Level.

46. Real and Nominal Interest Rates 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.

47. Calculation of Real Interest Rate Real Nominal Interest = Interest - Inflation Rate Rate Rate Rate Rate Rate

48. Questions ?

49. Quick Write Do You Think That the Consumer Price Index (CPI) is a Good Measure of the Goods and Services Bought by Consumers? Why or Why Not? Do You Think That the Consumer Price Index (CPI) is a Good Measure of the Goods and Services Bought by Consumers? Why or Why Not?