Chapter 24 Mankiw

Macroeconomics

Consumer Price Index (CPI)

-measures the typical consumer's cost of living
-measure of the overall cost of the goods and services bought by a typical consumer
-the basis of cost of living adjustments (COLAs) in many contracts and in Social Security

How to Calculate CPI

CPI= (cost of basket in current year/cost of basket in base year) x 100

Inflation

increase in overall prices during a given period

Deflation

(opposite of inflation)
decrease in overall prices during a given period

Rate of Inflation

the percentage increase in overall prices during a given period

Rate of Deflation

the percentage decrease in overall prices during a given year

How CPI is Calculated

1) Fix the "basket"
-The Bureau of Labor Statistics (BLS) surveys consumers to determine what is in the typicals consumer's "shopping basket"
2) Find the Prices
-The BLS collects data on the prices of all the goods in the basket
3) Compute the basket's cost
-By keeping the market basket the same, only prices are being allowed to change
-Allows us to isolate the effects of price changes overtime
4) Choose a base year and compute the index
-Percentage change in the price index from the preceding period
100 x (cost of basket in current year)/(cost of basket in base year)

5)Computer the inflation rate
Inflation Rate=
[(CPIyear 2-CPIyear1)/(CPIyear1)] x 100

3 reasons why CPI is an imperfect measue of the cost of living

1) it does take into account consumers' search for cheaper substitutes and ignores their leaning toward goods that become relatively cheaper over time

2) it does not take into account increases in the purchasing power of the dollar due to the introduction of new and better products in the market place

3) it does not take into account unmeasured improvements in the quality of products over time

CPI vs GDP deflator

GDP deflator includes good and services produced by the economy rather than goods and services consumed in the economy
(ex: imported goods and services are included in the CPI but not in the GDP deflator)

CPI uses a fixed basket of consumer products, the GDP deflator automatically changed the composition of products over time as the composition of GDP changed

Equation to change dollar values from one yearto the next

Value in year 2 dollars=
Value in year 1 dollars x (price level in year 2/ price level in year 1)

Nominal Interest Rate

The interest rate is NOT corrected for inflation

the rate of growth in the dollar value of a deposit or debt

Real Interest Rates

Corrected for inflation

the rate of growht in the purchasing power of a deposit or debt

Equation for Nominal Interest Rates

Nominal Interest Rate= Real Interest Rate + inflation premium

Equation for Real Interest Rates

real interest rate = nominal interest rate - inflation premiums

Substitution Bias

PROBLEMS WITH THE CPI:
-Over time, some prices rise faster than others

-Consumers substitute toward goods that become relatively cheaper

-The CPI misses substitution because it uses a fixed basket of goods

-Thus, the CPI overstates increases in the cost of living

Introduction of New Goods

PROBLEMS WITH THE CPI:
-Introduction of new goods increases variety, allows consumers to find products that more closely meet their needs

-In effect, dollars become more valuable

-The CPI misses this effect because it uses a fixed basket of goods

-Thus, the CPI overstates increases in the cost of living

Unmeasured Quality Change

PROBLEMS WITH THE CPI:
-Improvements in the quality of (domestic) goods in the basket increases the value of each dollar

-The BLS tries to account for quality changes but probably misses some, as quality is hard to measure

-Thus, the CPI overstates increases in the cost of living

Problems with the CPI

-Substitution Bias, Introduction of New Goods, and Unmeasured Quality Change all cause the CPI to overstate cost of living increases

-The BLS has made technical adjustments, but the CPI probably overstates inflation by about 0.5%/year

-This is important because Social Security payments and many contracts have COLAs tied to the CPI

Imported Consumer Goods

CPI: Included
GDP deflator: Excluded

Capital Goods

CPI: Excluded
GDP Deflator: Included (if produced domestically)

The Basket

CPI: uses fixed basket
GDP Deflator: uses basket of currently produced goods and service

**This matters if different priced are changing by different amounts

Indexation

A dollar amount is this for inflation if it is automatically corrected for inflation by law or in a contract