module 21 - inflation

consumer price index (cpi)

fix the basket

finding inflation:

1. fix the basket - bls surveys customers to see which prices are more important

2. fix the prices - bls collects data on the prices of all goods in basket at each point in time

3. compute the basket’s cost - total cost of fixed basket of goods is calculated using the prices

4. choose base year and compute cpi

• inflation yr 2 = (cpi yr 2 - cpi yr 1)/cpi yr 1 × 100

producer price index (ppi)

measure of cost of a basket of goods and services bought by firms. often used in predicting changed in cpi

substitution bias

problem in measuring the cost of living with cpi, where consumers substitute toward goods hat have become relatively less expensive because prices do not change proportionately, leading to an overestimation of cost of living

unmeasured quality change

a problem in measuring the cost of living with cpi, where improvements or declines in quality of goods are difficult to measure and account for

gdp deflator

measure of overall level of prices, calculated as ratio of nominal and real gdp

correcting economic variables

the process of adjusting dollar figures from different times to account for the effects of inflation

• today’s dollar = amount in yr T x (price level today/price level in year T)

indexation

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

cost of living allowance (cola)

an example of indexation, where a dollar amount is automatically adjusted for inflation

nominal interest rates

the interest rate is usually reported, without a correction for the effects of inflation

real interest rate

the interest rate corrected for the effects of inflation

• real = nominal - inflation