Macro lecture 2

Overview of CPI (Consumer Price Index)

• The Consumer Price Index (CPI) is often reported in the financial news and has gained more attention post-COVID.

• Before COVID, inflation was relatively low and people were concerned over minor increases (e.g., 0.03%).

• CPI measures the overall cost of goods and services purchased by consumers, which include necessities and discretionary items.

Definitions

• Necessities: Essential goods/services for daily living (food, gas, personal care).

• Discretionary: Non-essential goods/services (concert tickets, luxury items).

CPI Calculation

• Calculated by taking the price of a basket of goods/services in the current year and dividing it by the price in a base year:

  • Example: CPI in 2024 is calculated using prices from a chosen base year (e.g., 2023).

  • The formula is: ( \text{CPI} = \left( \frac{\text{Price of basket current year}}{\text{Price of basket base year}} \right) \times 100 )

• Inflation rate = Percentage change in CPI from one period to another:

  • Formula: ( \text{Inflation Rate} = \left( \frac{\text{CPI current year} - \text{CPI previous year}}{\text{CPI previous year}} \right) \times 100 )

Types of CPI

Core CPI

• Excludes volatile items (food and energy) to provide a clearer picture of underlying inflation trends.

• Helps to identify inflation trends that are less affected by short term fluctuations in food and energy prices.

PPI (Producer Price Index)

• Measures the cost of goods/services bought by firms as opposed to consumers.

• Used to understand inflation through the producer's perspective, indicating inflation pressure from the supply side.

Sticky Prices

• Some prices are "sticky," meaning they don't change easily in response to supply or demand fluctuations (e.g., wages).

• Price rigidity can lead to prolonged periods of inflation or deflation depending on macroeconomic conditions.

CPI Components

Main Components of CPI Basket

• Housing: Largest share, includes rent, mortgage payments.

• Transportation: Costs associated with commuting (gas, taxis).

• Food and Beverages: Groceries and dining out.

• Medical Care: Health expenses that consumers incur.

Issues with CPI

1. Substitution Bias: Doesn’t consider consumers switching to cheaper alternatives when prices of goods rise.

2. Introduction of New Goods: CPI may underestimate inflation when new products are introduced or industries evolve.

3. Unmeasured Quality Change: Fails to account for improvements in product quality that enhance value (e.g., tech devices).

Comparisons with Other Measures

GDP Deflator vs. CPI

• GDP Deflator: Reflects the price level of all domestically produced goods and services, not just consumer purchases.

• CPI: Focuses solely on consumer purchasing behavior with a fixed basket of goods.

Economic Trends and Consumer Behavior

Historical Context

• Inflation trends can now be observed linked to significant events (e.g., 1970s stagflation, COVID impacts).

• Consumer expectations and sentiment can drive spending behavior; fearful consumers often cut spending, which can lead to recessionary trends.

Impact of Inflation on Wages

• Throughout economic history, wage adjustments often align with inflation rates to maintain purchasing power.

• Issues such as inflationary pressures require businesses to balance wage increases with overall profitability.

Summary of Concepts

• Real vs Nominal Interest Rates: Real interest rate accounts for inflation while nominal does not. Formula: ( \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} )

• Indexation: Adjustment of wages or payments (e.g., Social Security) to counteract inflation effects, ensuring real value is preserved over time.

Market Dynamics

• Economic cycles can induce volatility in prices, leading to inflationary spikes or periods of deflation.

• Demand scenarios affect prices significantly (e.g., supply chain constraints and commodity price fluctuations).

Homework and Future Learning

• Quiz preparation emphasized; resources and eligibility for homework submission discussed.

• Next classes will link these foundational concepts to monetary policy and inflation's broader economic roles.