Economy Chapter 11

CPI formula

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

Inflation rate formula

Year 2 inflation rate = ((Year 2 CPI - Year 1 CPI)/Year 1 CPI) x 100

Price index formula

Amount in today’s $ = Amount in year T $ x (Price level today/Year t price level)

Real interest rate formula

Real interest rate = Nominal interest rate - Inflation rate

Consumer Price Index (CPI)

Measure of overall cost of goods/services bought by typical consumer

Deflation

Overall price level is falling

Inflation rate

Percentage change in price level from previous period

Core CPI

Measure of overall cost of consumer goods/services excluding food and energy

Producer Price Index (PPI)

Measure of cost of goods/services basket sold by domestic firms

What is substitution bias?

When some prices rise faster than others, consumers substitute to cheaper goods

How does introduction of new goods affect dollars in the economy?

Allows consumers to find products most fit for their needs, making dollars more valuable

How does unmeasured quality change affect dollars in the economy?

improvements in basket quality increase value of each dollar

What do substitution bias, introduction of new goods, and unmeasured quality changes have in common when measuring cost of living?

They make CPI overstate increases in cost of living as CPI uses fixed basket and is hard to measure quality

Calculating CPI: What is fixing the basket?

Determine which prices most important to typical consumer

Calculating CPI: When calculating the cost of the basket, it’s important to focus on…

price changes instead of quantity changes

What are the steps to calculating CPI?

1.) Calculate basket’s cost at diff. times

2.) Choose base year and calculate CPI

3.) Calculate inflation rate