Econ Chapter 25: Understanding the Consumer Price Index

Consumer Price Index (CPI)

Measures the overall cost of goods and services a typical consumer buys.

CPI Usage

Used to monitor changes in the cost of living.

CPI Rises

The typical family has to spend more money to maintain the same standard of living.

Inflation

Describes a situation in which the overall price level is rising.

Deflation

Describes the overall price level is falling.

Department Computing CPI

The Bureau of Statistics (BLS) is part of the Department of Labor.

CPI vs. GDP Deflator

The CPI reflects the prices of goods and services typically bought by consumers, making it a better measure of the cost of living than the broader GDP deflator.

First Step in Calculating CPI

Fixing the basket.

Second Step in Calculating CPI

Finding the prices.

Third Step in Calculating CPI

Compute the Basket's Cost.

Fourth Step in Calculating CPI

Choose a base year and compute the index.

Purpose of Calculating CPI

Determines how quickly the cost of living for the typical consumer is rising.

Core CPI

A measure of the overall cost of consumer goods and services excluding food and energy.

Producer Price Index

When the BLS calculates the prices of the output of domestic producers.

Problems with CPI

Substitution bias, introduction of new goods, and unmeasured quality change.

Substitution Bias

The CPI doesn't adjust when people switch to cheaper alternatives, so it can make inflation seem higher than it really is.

Introduction of New Goods Bias

The CPI takes time to include new goods, which can make it seem like prices are rising faster than they are.

Unmeasured Quality Change

When products improve or don't improve, the CPI may miss this, making it seem like the cost of living is rising more than it is.

CPI vs. GDP Deflator: Fixed vs. Changing Basket

The CPI uses a fixed basket of goods compared to the prices of the basket in the base year.

CPI vs. GDP Deflator: Imported Goods

The CPI includes imported goods consumed by households, while the GDP Deflator excludes imports.

Largest Component of CPI Basket

Housing.

Nominal Interest Rate

The interest rate usually reported without a correction for the effects of inflation.

Real Interest Rate

The interest rate corrected for the effects of inflation.

Difference between Nominal and Real Interest Rate

The nominal interest rate shows how fast the balance grows, while the real interest rate shows how much the purchasing power actually increases.

Real Interest Rate Calculation

Real Interest Rate = Nominal Interest Rate − Inflation Rate.

Example of Real Interest Rate

If nominal interest rate is 5% and inflation rate is 2%, then real interest rate is 3%.

Nominal Interest Rate Example

If you deposit $2,000 and have $2,100 a year later, the nominal interest rate is 5%.

Real Interest Rate Example

If CPI rose from 200 to 204, the real interest rate is 3%.