Introduction to Consumer Price Index (CPI) and Inflation

• Explanation of CPI and how it's calculated.
• Comparison of CPI with the GDP deflator.

Yearly Cost Analysis

• Year 1: Original cost of a basket = $500.

• Year 2:

  • Cost for the same basket = $750
  • Price increase = 1.5 times (scale factor).
  • CPI in this year = 150.
  • Inflation calculation: ( \text{Inflation} = \frac{(50)}{500} = 50\% )

• Year 3:

  • Cost calculation:
  • Grapes: 50 units at $8/unit = $400
  • Oranges: 100 units at $6/unit = $600
  • Total cost = $1000.
  • CPI for this year:
  • CPI calculation: ( \text{CPI} = \frac{1000}{500} = 200 )
  • Price index increased by 50 from 150 to 200, which is a ( \frac{50}{150} = 33.3\% ) increase.

Features of CPI Calculation

• CPI maintains the quantity of goods and services constant (fixed basket).
• CPI focuses on measuring cost to maintain the same quality of life.
• Contrasts with GDP deflator, which allows quantities to change.

Effects of Consumption Behavior Changes

• Substitution Bias:
  • CPI does not capture changes in consumer behavior due to price fluctuations (e.g., substitution of cheaper grapes for expensive oranges).
• Actual consumer spending may differ from theoretical CPI-based spending.

Limitations of CPI

• CPI does not consider:
  • New product introductions, impacting purchasing power.
  • Quality improvements which can lead to perceived inflation.
• CPI may overstate the inflation rate because it does not reflect consumption adjustments.

Comparison with Other Indices

• GDP Deflator: Reflects price changes of all goods/services produced domestically.
• PPI (Producer Price Index): Reflects changes in prices of goods/services consumed by producers.

Understanding Price Changes and Dollar Value Over Time

• Inflation can complicate historical financial comparisons (e.g., wages, rent).
• Example:
  • Minimum wage in 1956: $1/hour vs = $11.20 today (adjusted for inflation).
• Importance of indexing dollar values to maintain real purchasing power over time.

Nominal vs. Real Interest Rates

• Nominal Interest Rate: The stated rate that does not consider inflation.
• Real Interest Rate: ( ext{Real Interest Rate} = ext{Nominal Interest Rate} - ext{Inflation Rate} )
  • Illustrates true purchasing power change over time.
• Nominal interest rates do not always correlate with changes in real purchasing power due to inflation.

Conclusion

• Multiple aspects of CPI, inflation, and the value of money are critical for economic understanding.
• Awareness of substitutions and quality improvements helps contextualize CPI's accuracy.
• Awareness of interest rates and inflation informs financial decisions and expectations regarding money's future value.

Quiz Reminder

• A brief quiz is available on Brightspace focusing on the discussed topics with multiple attempts allowed.