ECON 202 Chapter 11: Measuring the Cost of Living (CPI, Inflation, and the GDP Deflator)

Flashcards cover the CPI calculation, core CPI, PPI, biases in CPI, CPI vs GDP deflator, adjusting dollars for inflation, real vs nominal interest rates, indexation, and example problems from the lecture notes.

What is the Consumer Price Index (CPI)?

A measure of the overall cost of goods and services bought by a typical consumer; used to monitor changes in the cost of living over time.

What is Core CPI?

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

What is the Producer Price Index (PPI)?

A measure of the cost of a basket of goods and services sold by domestic firms.

How is the CPI calculated?

Fix the basket, find the prices, and compute the basket’s cost.

How is the CPI expressed in a base year and current year?

CPI = (Basket’s cost in current year / Basket’s cost in base year) × 100.

How is the inflation rate derived from the CPI?

Inflation rate = [(CPI this year − CPI last year) / CPI last year] × 100.

What is substitution bias in the CPI?

Because the CPI uses a fixed basket, it misses consumers substituting toward cheaper goods, overestimating true cost of living.

What is the New Goods bias in the CPI?

New goods increase variety and value; the fixed basket misses this, causing the CPI to overstate inflation.

What is the Unmeasured Quality Change bias in the CPI?

Improvements in quality raise value; if not fully measured, the CPI overstates inflation.

How does the CPI differ from the GDP deflator regarding imports?

Imported consumer goods are included in the CPI but excluded from the GDP deflator.

How does the CPI differ from the GDP deflator regarding capital goods?

Capital goods are excluded from the CPI but included in the GDP deflator (if domestically produced).

What is the difference between fixed basket and changing basket in CPI vs GDP deflator?

CPI uses a fixed basket; the GDP deflator uses prices of all goods/services produced domestically and allows the basket to change over time.

What is indexation?

Automatic correction of a dollar amount for inflation, used in COLAs, Social Security, and some tax brackets.

What is the difference between nominal and real interest rates?

Nominal interest rate is not adjusted for inflation; real interest rate is adjusted for inflation (real = nominal − inflation).

How do you compute the real interest rate from a nominal rate and inflation?

Real interest rate = Nominal rate − Inflation rate.

What is the formula to express past dollars in today’s dollars?

Amount today = Amount in year T × (Price level today / Price level in year T).

Why convert tuition figures to 2022 dollars when comparing 1990 and 2022?

To express past amounts in real terms (2022 dollars) for a fair comparison of real increases.

What is the Great-grandpa salary example result for converting 1963 $310/month to 2022 dollars?

Approximately $2,932.46 in 2022 dollars using CPI 1963 = 30.9 and 2022 = 292.3.

What happens to the CPI and GDP deflator when muffins prices rise?

Both the CPI and the GDP deflator rise.

What happens to the GDP deflator vs. the CPI when Caterpillar raises the price of domestically produced tractors?

GDP deflator rises; the CPI does not.

What happens to the CPI vs. GDP deflator when Armani raises the price of Italian jeans in the U.S.?

The CPI rises; the GDP deflator does not.

What are the three main reasons the CPI is considered imperfect?

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

What does the CPI measure relative to the base year?

The cost of a basket of goods and services relative to the cost of the same basket in the base year.

What is the relationship between the CPI and the inflation rate?

The percentage change in the CPI from one period to the next is the inflation rate.

What is the difference between the CPI and the GDP deflator in terms of what they reflect?

CPI reflects prices of goods and services bought by consumers (fixed basket); GDP deflator reflects prices of all domestically produced goods and services (basket changes over time).

If the typical consumer's basket costs $150 in the base year, $180 in Year 1, and $195 in Year 2, calculate the CPI for Year 1 and Year 2. Then, calculate the inflation rate between Year 1 and Year 2.

The CPI for Year 1 is 120 (calculated as 180/150 x 100), and for Year 2, it is 130 (calculated as 195/150 x 100). The inflation rate between Year 1 and Year 2 is approximately 8.33% (calculated as (130-120)/120 x 100).

Suppose the nominal interest rate on a savings account is 5% and the inflation rate is 2.5%. What is the real interest rate?

The real interest rate is the nominal interest rate adjusted for inflation, which can be calculated as 5% - 2.5% = 2.5%. This rate reflects the true increase in purchasing power.

A house was bought for $100,000 in 1995. If the CPI in 1995 was 152.4 and the CPI in 2023 is 304.7, what is the equivalent value of that house in 2023 dollars

Using the CPI to adjust for inflation, the equivalent value of the house in 2023 dollars is calculated as $100,000 × (304.7 / 152.4) = $199,440.57.

When a new smartphone model is released with significantly enhanced features at a similar price to the old model, which CPI bias would likely lead to an overstatement of inflation?

Unmeasured Quality Change bias. The improved quality for the same price isn't fully captured, making it seem like the cost of living (or technology) hasn't improved as much as it has, thereby overstating inflation.This occurs because the CPI does not account for the changes in quality of goods.

If the price of crude oil, which is entirely imported, increases significantly, how would this affect the U.S. CPI and the U.S. GDP deflator?

The U.S. CPI would rise because imported consumer goods (like gasoline derived from crude oil) are included in the consumer's basket. The U.S. GDP deflator would not be directly affected, as it only includes domestically produced goods and services.