3 C H A P T E R C H E C K L I S TWhen you have completed your study of this chapter, you will be able toExplain what the Consumer Price Index (CPI) is and how it is calculated.1Explain the limitations of the CPI as a measure of the cost of living.2Adjust money values for inflation and calculate real wage rates and real interest rates.3
4 7.1 THE CONSUMER PRICE INDEX Consumer Price Index (CPI)A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services.
5 7.1 THE CONSUMER PRICE INDEX Reading the CPI NumbersThe CPI is defined to equal 100 for a period called the reference base period.Reference base periodA period for which the CPI is defined to equal 100. Currently, the reference base period is 19821984.
6 7.1 THE CONSUMER PRICE INDEX In May 2005, the CPI wasThe average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 94.4 percent higher in May 2005 than it was on the average during 19821984.In April 2005, the CPI wasThe average of the prices paid by urban consumers for a fixed market basket of consumer goods and services decreased by 0.2 of a percentage point in May 2005.
7 7.1 THE CONSUMER PRICE INDEX Constructing the CPIThree stages:Selecting the CPI basketConducting the monthly price surveyCalculating the CPI
8 7.1 THE CONSUMER PRICE INDEX The CPI BasketMake 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 current CPI basket is based on information obtained from the Consumer Expenditure Survey conducted during 2001 and 2002.
9 7.1 THE CONSUMER PRICE INDEX Figure 7.1 shows the CPI basket.This shopping cart is filled with the items that an average household buys.Ask your students to make an estimate of their own baskets and compare them with the BLS basket.
11 7.1 THE CONSUMER PRICE INDEX The Monthly Price SurveyEach 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.Surveying college textbook prices might capture the students’ attention. (See the IM for a detailed discussion).
12 7.1 THE CONSUMER PRICE INDEX Calculating the CPIThe 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.
13 7.1 THE CONSUMER PRICE INDEX Table 7.1 shows the consumer price index: a simplified CPI calculation.
14 7.1 THE CONSUMER PRICE INDEX Cost of CPI basket at current period pricesCost of CPI basket at base period pricesx 100CPI =For 2000, the CPI is:= 100$50x 100For 2003, the CPI is:= 140$70$50x 100
15 7.1 THE CONSUMER PRICE INDEX Measuring InflationInflation rateThe percentage change in the price level from one year to the next.CPI in current year CPI in previous yearCPI in previous yearx 100Inflation rate =Emphasize the distinction between the price level and the inflation rate.Do some calculations and have the students do some too.Inflation rate == 16.7 percent140 120120x 100
16 7.1 THE CONSUMER PRICE INDEX Figure 7.2 shows the CPI in part (a) and the inflation rate in part (b).
17 7.1 THE CONSUMER PRICE INDEX In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.
18 7.1 THE CONSUMER PRICE INDEX In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.
20 7.2 THE CPI AND THE COST OF LIVING Cost of living indexA 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 becauseIt does not measure all the components of the cost of livingSome components are not measured exactlySo the CPI is possibly a biased measure.
21 7.2 THE CPI AND THE COST OF LIVING Sources of Bias in the CPIThe potential sources of bias in the CPI areNew goods biasQuality change biasCommodity substitution biasOutlet substitution biasThe IM contains a detailed explanation of how you might illustrate substitution bias.
22 7.2 THE CPI AND THE COST OF LIVING New Goods BiasNew 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 BiasBetter 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.
23 7.2 THE CPI AND THE COST OF LIVING Commodity Substitution BiasIf the price of beef rises faster than the price of chicken, people buy more chicken and less beef.The CPI basket doesn’t change to allow for the effects of substitution between goods.Outlet Substitution BiasIf prices rise more rapidly, people use discount stores more frequently.The CPI basket doesn’t change to allow for the effects of outlet substitution.
24 7.2 THE CPI AND THE COST OF LIVING The Magnitude of the BiasThe 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.
25 7.2 THE CPI AND THE COST OF LIVING Two Consequences of the CPI BiasTwo main consequences of the bias in the CPI areDistortion of private agreementsIncreases in government outlaysDistortion of Private AgreementsMany private agreements, such as wage contracts, are linked to the CPI.If the CPI is biased, these agreements might deliver an outcome different from that intended by the parties.
26 7.2 THE CPI AND THE COST OF LIVING 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 year are $30.90 an hour and $31.83 an hour.The workers’ gain is GM’s loss. With thousands of workers, GM’s loss would be millions of dollars over the 3 years.
27 7.2 THE CPI AND THE COST OF LIVING Increases in Government OutlaysClose to a third of federal government outlays are linked directly to the CPI.The CPI is used to adjust48 million Social Security benefit payments22 million food stamp payments4 million pensions for retired military personnel, federal civil servants, and their surviving spousesthe budget for 27 million school lunches
28 7.2 THE CPI AND THE COST OF LIVING The GDP Deflator: A Better Measure?In principle, the GDP deflator is not subject to the biases of the CPI because it uses the basket of goods and services produced in the current year and the preceding year.In practice, the GDP deflator suffers from some of the CPI’s problems because the Commerce Department does not directly measure the physical quantities of all the goods and services that are produced.
29 7.2 THE CPI AND THE COST OF LIVING Instead, to estimate quantities, the Commerce Department divides expenditures by price indexes.And one of these price indexes is the CPI.So the biased CPI injects a bias into the GDP deflator.
30 7.2 THE CPI AND THE COST OF LIVING Figure 7.3 shows the two measures of inflation in part (a) and the corresponding two measures of the price level in part (b).
31 7.2 THE CPI AND THE COST OF LIVING The two measures of the inflation rate fluctuate together, but the CPI measure rises more rapidly than the GDP deflator measure.But the price levels get farther apart.Both measures probably overstate the inflation rate.
33 7.3 NOMINAL AND REAL VALUES Dollars and Cents at Different DatesTo compare dollar amounts at different dates, we need to know the CPI at those dates.Convert the price of a 2-cent stamp in 1905 into its 2005 equivalent:Price of stamp in 2005 dollars =Spend time helping students appreciate the distinction between real values and nominal values.Price of stamp in 1905 dollarsxCPI in 2005CPI in 1905= 2 cents x195.69.4= 42 cents
34 7.3 NOMINAL AND REAL VALUES Nominal and Real Values in MacroeconomicsMacroeconomics makes a big issue of the distinction between nominal values and real values:Nominal GDP and real GDPNominal wage rate and real wage rateNominal interest rate and real interest rateWe studied the distinction between and calculation of nominal and real GDP in Chapter 20. Here, we’ll look at the other two.
35 7.3 NOMINAL AND REAL VALUES Nominal and Real Wage RatesNominal wage rateThe average hourly wage rate measured in current dollars.Real wage rateThe average hourly wage rate measured in the dollars of a given reference base year.Use the US President example to emphasize the difficulty of holding relevant factors constant to calculate a real wage.
36 7.3 NOMINAL AND REAL VALUES 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 2002CPI in 2002x 100Real wage rate in 2002 =Real wage rate in June 2002 == $8.16$14.68179.9x 100The $8.16 amount is in 19821984 dollars.
37 7.3 NOMINAL AND REAL VALUES Figure 7.4 shows nominal and real wage rates: 1975–2005.The nominal wage rate has increased every year since 1975.The real wage rate increased briefly during the late 1970s, decreased through the mid-1990s, and then increased slightly.
39 7.3 NOMINAL AND REAL VALUES Nominal and Real Interest RatesNominal interest rateThe percentage return on a loan expressed in dollars.Real interest rateThe percentage return on a loan, calculated by purchasing power—the nominal interest rate adjusted for the effects of inflation.Real interest rate = Nominal interest rate – Inflation rate
40 7.3 NOMINAL AND REAL VALUES Figure 7.5 shows real and nominal interest rates: 1965–2005.During the 1970s, the real interest rate became negative.The nominal interest rate increased during the high-inflation 1980s.
42 The CPI in YOUR LifeThink about your student loan—or if you don’t have one, think about Gus’s $80,000 loan.Suppose that the CPI rises by 3 percent a year, each year from now through 2025.How much will a $100 repayment cost you, in 2005 dollars, when you start to pay off your loan in 2015?How much will a $100 repayment cost you, in 2005 dollars, when you make your final payment in 2025?What is the real interest rate that you will have paid?Would you be better off or worse off if the CPI began to rise at 5 percent a year?