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Measuring the Cost of Living Chapter 11 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of.

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Presentation on theme: "Measuring the Cost of Living Chapter 11 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of."— Presentation transcript:

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2 Measuring the Cost of Living Chapter 11 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

3 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring the Cost of Living u Inflation refers to a situation in which the economy’s overall price level is rising. u The inflation rate is the percentage change in the price level from the previous period.

4 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Using Price Indexes u Because inflation may overstate the value of our GDP we need to make adjustments accordingly. u Price indexes are the way we adjust nominal GDP (the value of GDP in current dollars) to real GDP (the value of GDP in constant dollars)

5 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. GDP Deflator: A measure of the price level The GDP deflator is calculated as follows: The GDP deflator allows us to distinguish between nominal GDP, which measures prices and quantities, and real GDP, which measures just quantities.

6 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Consumer Price Index u The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. u The Bureau of Labor Statistics reports the CPI each month. www.bls.gov u It is used to monitor changes in the cost of living over time.

7 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The GDP Deflator versus the Consumer Price Index u The GDP deflator reflects the prices of all goods and services produced domestically, whereas... u …the consumer price index reflects the prices of all goods and services bought by consumers.

8 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 1965 Percent per Year 15 10 5 0 197019751980198519901995 2000 CPI Two Measures of Inflation GDP deflator

9 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Other Price Indexes u The BLS calculates other prices indexes: u The index for different regions within the country. u The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

10 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How the Consumer Price Index Is Constructed u Fix the Basket: Determine what prices are most important to the typical consumer. u Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. u Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

11 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How the Consumer Price Index Is Calculated u Choose a Base Year and Compute the Index: u Designate one year as the base year, making it the benchmark against which other years are compared. u Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. Current prices x 100 = CPI Base prices

12 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Inflation Rate u Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

13 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Causes of inflation u Demand Pull Theory – demand for goods & services exceeds existing supply. One reason for this may be too much money in circulation. u Cost Push Theory- producers raise prices in order to meet increased costs. This is also known as supply shocks (supply curve shifts left).

14 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Demand-pullCost-push or Supply Shock PRICELEVELPRICELEVEL PRICELEVELPRICELEVEL REAL GDP AS AD 1 AD2 AS 2 AS1 AD

15 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Effects of Inflation Interest Rates: Interest represents a payment in the future for a transfer of money in the past. When you save or loan someone money you expect a return on that money (interest). Inflation affects the future value of our money.

16 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Real and Nominal Interest Rates u The nominal interest rate is the interest rate not corrected for inflation. u It is the stated interest rate that a bank pays. u The real interest rate is the nominal interest rate that is corrected for inflation. When evaluating your return you need to focus on the real interest rate Real interest rate = (Nominal interest rate – Inflation rate)

17 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Real and Nominal Interest Rates u You borrowed $1,000 for one year. u Nominal interest rate was 15%. u During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5%

18 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Anticipated and Unanticipated Inflation u If a bank anticipates inflation they will set the nominal rate high enough to insure a return on any loans they make and inflation will not harm them. u If inflation is unanticipated then the interest rate will not be set high enough and the bank (savers) will lose money.

19 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 1965 Interest Rates (percent per year) 15 10 5 0 -5 197019751980198519901995 1998 Nominal interest rate Real interest rate Real and Nominal Interest Rates

20 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Who’s Hurt? Who’s Helped? By Unantipated Inflation You’re hurt if you are a u Creditor – the money you loan out is worth less when its paid back u Saver – inflation rates are normally higher than interest rates u Fixed income receiver- a constant income will buy less. You’re helped if you are a u Borrower- the money you are repaying is worth less u Flexible income earner- äif your income is tied to profits you will earn more äIf your income is adjusted for inflation you will earn more (COLA) u Payer of fixed amounts


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