Consumer Price Index

Consumer Price Index (CPI)

Measures the overall cost of the goods and services bought by a typical consumer

CPI formula

(Price of basket of goods in current year) / (price of basket in base year) x 100

What five steps are followed to find CPI?

1) Fix the basket

2) Find the prices

3) Compute the baskets cost

4) Choose a base year and compute the index

5) Compute the inflation rate

What is the formula for inflation using CPI?

For inflation rate of year 2:

(CPI year 2) - (CPI year 1) / (CPI year 1) x 100

Core CPI

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

Producer Price Index

Measures the prices of the output of domestic producers

What are the three main problems in measuring CPI?

• substitution bias

• introduction of new goods

• unmeasured quality change

The formula for converting past prices into todays prices

Amount in past year x (price level today / price level in past year)

Indexed

The automatic correction by law or contract of a dollar amount for the effects of inflation

So if inflation rises, things that are indexed will rise too (social security, wages under certain contracts)

Nominal interest rate

The interest rate that measures the change in dollar amounts

Real interest rate

The interest rate adjusted for inflation

Real Rate = nominal rate - inflation rate