LectureNotes_ch06_cpi

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Macroeconomics Dr. Saue

Measuring the Cost of Living (ch6)

Inflation is an increase in the ______________________.formula:

Inflation Rate = Price Level 2 Price Level 1 x 100( ) Price Level 1

The inflation rate is the _______________________ in the price level.

Recall: The GDP deflator is one measure of the price level.

GDP Deflators Inflation Rate2005: 100 20052006: 171.4 20062007: 240 2007

Instead of using the GDP Deflator to measure the price level we could use the ____________________.

I. The Consumer Price Index measures changes in the overall cost of the goods and services that a_________________________________ buys.

- Compiled monthly by the Bureau of __________________ Statistics. www.bls.gov

A. How to Calculate:

1. decide on a ______________ of goods2. find _____________ for the goods3. compute the ______________ of the basket4. chose a _________________ and compute the index

1. How is the basket decided?Detailed expenditure information is collected from families and individuals on what they ____________bought.

- Consumer Expenditure Surveys for 2005 and 2006- 7,000 families from around the country provided information each quarter on their spendinghabits- another 7,000 families in each of these years kept diaries listing everything they bought duringa 2-week period

Over the 2 year period, then, expenditure information came from approximately 28,000 weekly diariesand 60,000 quarterly interviews used to determine the importance, or weight, of the more than 200 itemcategories in the CPI index structure.

BLS has classified all expenditure items into more than 200 categories, arranged into_____________major groups:


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The CPI ___________________________ investment items, such as stocks, bonds, real estate, and lifeinsurance.

- These items relate to ____________________ and not to day-to-day consumption expenses.

For each of the more than 200 item categories, using scientific statistical procedures, the Bureau haschosen samples of several hundred specific items within selected business establishments frequented byconsumers to represent the thousands of varieties available in the marketplace.

Ex: In a given supermarket, the Bureau may choose a plastic bag of golden delicious apples,U.S. extra fancy grade, weighing 4.4 pounds to represent theApples category.

2. How are prices collected?Each month, BLS data collectors (called economic assistants) ______________________ thousands ofretail stores, service establishments, rental units, and doctors' offices, all over the US.

- They record the prices of about ____________________ items each month.

3. How is the cost of the basket computed?Example: Suppose the basket contains 4 sodas and 2 hotdogs.

year Psoda Photdog2005 $1 $22006 $2 $32007 $3 $4

Cost of basket:2005:2006:2007:

4. How is the Index computed?Formula for the Index:

CPIyearA = cost of basket in year A x 100cost of basket in base year


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Continuing our example, suppose the base year is 2005.CPI:2005:2006:2007: Note: In the base year, the CPI is always ____.

______________________________________________________________________

B. Using the CPI to calculate inflation

Calculate the inflation rate for December 2010:

Calculate the inflation rate from January 2000 to December 2010:

C. Some Problems with the CPI:

_______________________________: When the price of a good changes, consumers often respondby purchasing a different product in its place.

_______________________________: Because the market basket is not changed constantly, new

goods are often left out of the basket

_______________________________: Attempts are made to adjust for quality changes but qualitychanges are hard to measure.

Most studies indicate that the CPIoverstates the rate of inflation by about _______ percentage point peryear.


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II. The CPI vs the GDP Deflator

Similarity:both try to measure changes in the ____________________

Difference:1) CPI is based on goods that ______________________ but GDP Deflator is based on___________________________ in a nation

2) CPI uses a ___________________ basket but GDP Deflator uses the ___________________that have been produced

III. Other Price Indices

The _____________________________ measures changes in the selling prices received by domestic

producers for their output.-because firms eventually pass on higher costs to consumers in the form of higher prices, the

PPI is believed to be useful in _________________________ in the CPI

- also available by industry or type of good (ex: grocery, medical, electric power)

_______________________ Price Indexes (MXP) measures changes in the prices of nonmilitary goodsand services traded between the U.S. and the rest of the world.

IV. Dollar Figures from Different Times

In order to make a ________________________ comparison of dollar figures over time, you need to____________________________ the effects of inflation.

Formula:$ value in = $ value in x price level in year A

year A year B price level in year B


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Ex: Your father graduated from college and took his first job in 1972. He was paid a salary of$10,000. What is that salary worth in 2008 dollars? In 1972, the CPI was 41.8 and in 2008 the CPIwas 215.3.

Ex: Your friend lives in St. Louis, MO and makes $50,000 a year. Shes received a job offer inHonolulu, HI for $55,000 a year. She knows that you take economics and asks your opinion on thesalary negotiation. You do a little research and find that the CPI in St. Louis is 192.1 and the CPI inHonolulu is 216.6. What do you adviser her?

- How much would she need to keep her purchasing power the same?

When making comparisons, what if you dont adjust dollar figures for inflation?

Domestic Box Office Sales (boxofficemojo.com)Rank Title Studio Lifetime Gross Year

1 Avatar Fox $612,693,000 2009

2 Titanic Par. $600,788,188 1997

3 The Dark Knight WB $533,345,358 2008

4 Star Wars Fox $460,998,007 1977

5 Shrek 2 DW $441,226,247 2004

6 E.T.: The Extra-Terrestrial Uni. $435,110,554 1982

7 Star Wars: Episode I - The Phantom Menace Fox $431,088,301 1999

8 Pirates of the Caribbean: Dead Man's Chest BV $423,315,812 2006

9 Spider-Man Sony $403,706,375 2002

10 Transformers: Revenge of the Fallen P/DW $402,111,870 2009

Rank Title Studio Adjusted Unadjusted Year

1 Gone with the Wind MGM $1,537,559,600 $198,676,459 1939

2 Star Wars Fox $1,355,490,100 $460,998,007 1977

3 The Sound of Music Fox $1,083,781,000 $158,671,368 19654 E.T.: The Extra-Terrestrial Uni. $1,079,511,500 $435,110,554 1982

5 The Ten Commandments Par. $996,910,000 $65,500,000 1956

6 Titanic Par. $976,712,200 $600,788,188 1997

7 Jaws Uni. $974,679,800 $260,000,000 1975

8 Doctor Zhivago MGM $944,670,800 $111,721,910 1965

9 The Exorcist WB $841,427,600 $232,671,011 1973

10 Snow White and the Seven Dwarfs Dis. $829,490,000 $184,925,486 1937

21 Avatar Fox $612,693,000 $612,693,000 2009


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V. Indexation is an _______________________ correction of a dollar amount for the effects ofinflation

- by law or by contract

Many government transfer programs use indexation for benefits.

Many labor contracts include cost of living allowances.

The government also indexes the _______________________ brackets.- If you get a 5% cost of living adjustment, your salary is 5% higher than it was the previousyear.- When your income is higher, you may move to a higher tax bracket.- But your purchasing power hasnt changed!- The government adjusts the tax brackets so this doesnt happen as much.

VI. Real and Nominal Interest Rates

The nominal interestrate is the interest rate _________________.

- the rate you see on your credit card statement- the rate you pay on your car loan

The real interest rate has been _____________________for inflation.

Relationship:nominal = real + inflation

interest rate interest rate rate

Intuition:You deposit $1000 into a bank account that pays you 10% interest. One year later you have $1100.

If inflation that year is:0% then your purchasing power has _______________%2% then your purchasing power has _______________%10% then your purchasing power has ______________%15% then your purchasing power has ______________%

If there is 2% deflation that year, your purchasing power has ___________________%

What matters to you is the __________________________ of your money.

As a borrower, unexpected inflation _____________ you.- get the purchasing power now- pay back the money over time

- inflation means you are paying back less purchasing power


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As a lender, unexpected inflation __________ you.- receive the nominal interest rate- after adjusting for inflation, your real rate is less

_____________________________________________________________________Summary:The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost ofthe same basket in the base year.

The index is used to measure the overall level of prices in the economy.

The percentage change in the consumer price index measures the inflation rate.

The consumer price index is an imperfect measure of the cost of living for three reasons.

Like the consumer price index, the GDP deflator also measures the overall level of prices in theeconomy.

Although the two price indexes usually move together, there are important differences.

Dollar figures from different times do not represent a valid comparison of purchasing power.

Various laws and private contracts use price indexes to correct for the effects of inflation.

A correction for inflation is especially important when looking at data on interest rates.

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