EXAM 2 - CH. 11 (Study guide version)

Inflation

An increase in the average levels of prices of goods and services.

Why is inflation an important measure?

is an indicator that measures the growth of the cost of living from time to time

Consumer price index

is a price index that reflects the average price of goods and services that a typical
consumer buys.
• E.g. food, clothing, shelter, transportation and services.

Who surveys for the CPI in the United States?

Bureau of Labor Statistics would track down each month the prices
of these goods and turn them into a single CPI number

Producer price index

A measure of the cost of a basket of goods and services bought by firms

Inflation rate

is the percentage change in the price index (in %) from one period to another.
• Change from month-to-month, or from year-to-year.
• is calculated by comparing Consumer Price Index from different years.

How is CPI calculated?

1. Fix the basket

2. Find the prices

3. Compute the basket’s cost

4. Chose a base year and compute the CPI

5. Compute the inflation rate

What is the meaning of “base year” for CPI calculation

is the year used as a reference point when calculating the Consumer Price Index (CPI).

➡ The CPI in the base year is always set to 100, and all other years are compared to it to measure inflation.

What is the value of CPI in the base year

The value of the CPI in the base year is always 100.

This serves as the reference point for comparing inflation over time

Exports

Goods and services sold to other countries that are produced domestically.

➡ Counted positively in GDP because they reflect domestic production sold abroad.

Imports

Goods and services purchased from other countries and brought into the domestic economy for consumption, resale, or use.

➡ Subtracted in GDP calculations because they are not produced domestically.

GDP deflator

an economic metric that accounts for inflation by converting output measured at current prices into constant-dollar GDP. This specific deflator shows how much a change in the base year's GDP relies upon changes in the price level.

GDP deflator versus CPI

GDP deflator includes all goods and services produced within the country’s borders, while CPI only includes those goods stated to included in the consumer’s basket.

GDP deflator only measures prices of domestically produced goods, while CPI contains imported goods if our consumers typically buy them, as well as domestic goods.

Problems with CPI

1) First, it ignores the consumer’s ability to substitute toward goods that become relatively cheaper over time.

2) Second, CPI ignores the introduction of new goods/outof-use goods.

3) Third, it doesn’t measure the quality /technology of goods and services in the market basket (i.e. it does not measure changes in the effective cost of living or value of your dollar).

Why should we have CPI for different people groups or regions?

buy different goods and services and may experience different price changes.

➡ Having separate CPIs helps measure cost of living more accurately and shape better policy decisions.

Indexation (or converting dollars from one year to another year’s dollars)

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

Nominal interest rate

(i) is the interest rate (in %) that is usually
reported in your bank statement, without any correction for inflation.
• Interest rate not corrected for inflation
• Rate of growth in the dollar value of a deposit or debt

Real interest rate

® is the interest rate corrected for inflation
(in %), measured by the difference between the nominal interest rates and the inflation rate.

Measures the rate of growth in the purchasing power of a deposit or debt
• Also measures the real rate of return of an investment

Relationship between real and nominal interest rate