Chapter 24

Question 1

What is one thing that policymakers focus on a lot?

Answer 1

How much prices for goods and services change from year to year
• it:
• is an indication of the overall health of the economy
O tells us whether the purchasing power of money is increasing (can people buy more stuff?)
• helps us predict future behavior of households, firms and the government.

Question 2

What are the two commonly used measures of inflation?

Answer 2

There are two commonly used measures of inflation:
•the GDP deflator (we did this in the last chapter).
•the CPI.

Question 3

What is the consumer price index?

Answer 3

• the most important and most commonly used measure.
• measures the typical consumer’s cost of living
• used to make adjustments to Social Security payments [see, https://www.ssa.gov/policy/docs/ssb/v67n3/67n3p73.html]
rent prices, wages and even US Treasury bonds.
• calculated by a US government office called the Bureau of Labor Statistics -> the “BLS”
• https://www.bls.gov/ - part of the US Department of Labor

Question 4

What are other measures (changes in prices)

Answer 4

But there are other measures:
• the “Personal Consumption Expenditures Price Index” - the PCE.
• the Fed uses this.
• the PCE is a little more precise and more flexible than CPI.
O easier to change expenditure weights (important as people change their behavior and substitute some goods for others).
& more comprehensive coverage of goods and services
• https://www.bea.gov/data/personal-consumption-expenditures-price-index]
• also tinyurl.com/3ybaf9vs (a comparison of CPI and PCE).

Question 5

How do we calculate CPI and then the inflation rate?

Answer 5

There are five steps to calculating CPI and then the inflation rate.
1. Find the “basket” - the collection of things a typical consumer buys regularly.
2. Find the prices of the goods and services in the basket.
3. Compute the total cost of the goods and services in the basket.
4. Choose a base year and compute the index.
5. Compute the inflation rate.

Question 6

Find the basket

Answer 6

The BLS surveys consumers to determine what’s in the typical consumer’s “shopping basket” (we’ll see what’s in it shortly . . . and learn later why this may not reflect people’s current consumption habits).

Question 7

Find the prices

Answer 7

The BLS collects data on the prices of all the goods in the basket

Question 8

Compute the baskets cost

Answer 8

Use the prices to compute the total cost of the goods and services contained in the basket.

Question 9

Choose a base year and compute the index.The CPI in any year equals

Answer 9

cost of basket in current year
—————————————— x 100
cost of basket in base year

Question 10

What’s in the CPI “basket”?

Answer 10

• the CPI represents all goods and services the people
TYPICALLY purchase for consumption.
o they don’t really care about crazy stuff - Rolex watches, for example.

Question 11

What problems are there for CPI

Answer 11

Substitution bias
• over time, some prices rise faster than others.
• consumers substitute toward goods that become relatively cheaper -> this mitigates (reduces) the effects of price increases.
• the CPI misses this substitution because it uses a fixed basket of goods -> it includes the old, pricier stuff, and doesn’t include the new, cheaper stuff. until the BLS can adjust, the CPI overstates increases in the cost of living?.
• who does this help? Who does this hurt?
1 the PCE fixes this.

Question 12

Introduction of new goods

Answer 12

• the introduction of new goods increases variety and allows consumers to find products that more closely meet their needs.
• the same number of dollars buys more happiness > utility increases!
• in effect, a dollar becomes more valuable.
• the CPI misses this effect because, again, it uses a fixed basket of goods (that is, it does not incorporate these new goods promptly).
• in this way, the CPI overstates increases in the cost of living.
• who does this help? Who does this hurt?

Question 13

And finally -> unmeasured quality change

Answer 13

• improvements in the quality of goods in the basket increase the value of each dollar.
• the BLS tries to account for quality changes but probably misses some, as quality and innovation is hard to measure.
• thus, the CPI overstates increases in the cost of living.

Question 14

More problems with CPI

Answer 14

• each of these problems causes the CPI to overstate any cost of living increases.
• the BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year (economists’ best guess].
• this is important because Social Security payments and many contracts have cost of living adjustments (“COLAs”) tied to the CPI.
• this “mistake” helps SSA recipients -> they get more money!

Question 15

The BLS recognizes this and is giving the CPI a makeover!
The changes will

Answer 15

• the changes will:
o shorten the time before the BLS updates the weights in the consumer basket.
o use alternative data sources - big data from big retailers or credit card companies, not just surveys.• the changes will:
• break down CP| numbers by income group
“why? lower income people face higher rates of inflation (for fuel or food, for example) and we should reflect that.
• this would lead to more precise adjustments to Social Security or other benefits.
• acknowledge that people do a lot of buying online, not just in stores.

Question 16

How is the CPI different from the GDP deflator?

Answer 16

Imported consumer goods:
• included in CPI
• excluded from GDP deflator
Capital goods:
“ excluded from CPI
• included in GDP deflator (if produced domestically)

The basket:
• CPI uses fixed basket
• GDP deflator uses basket of currently produced goods & services
This matters if different prices are changing by different amounts.

Question 17

Correcting Variables for Inflation

Answer 17

• inflation makes it harder to compare dollar amounts from different times.
• the CPI helps us make sense of these different amounts.
• researchers and policymakers often use the CPI to convert current-dollar (nominal) figures into constant-dollar (real) figures.
• they can then see how a variable has changed over time after correcting for inflation.
• example: the minimum wage.

Question 18

Correcting Variables for Inflation -> Indexing

Answer 18

A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract.
For example, the increase in the CPI automatically determines:
• the COLA (“Cost Of Living Adjustment”) in many multi-year labor agreements and other kinds of contracts.
• adjustments in Social Security payments and federal income tax brackets.

Question 19

Correcting Variables for Inflation
Nominal Interest Rates

Answer 19

the nominal interest rate:
•the interest rate when it’s not corrected for inflation
•the rate of growth in the dollar value of a deposit or debt
•what you see quoted in the financial press

Question 20

Correcting Variables for Inflation - Real

Answer 20

the real interest rate:
• corrected for inflation
• the rate of growth in the purchasing power of a deposit or debt
• you have to do that math!
Real interest rate =
(nominal interest rate) - (inflation rate)

Question 21

What is “purchasing power”?

Answer 21

• “purchasing power” is the value of a currency expressed in terms of the amount of goods or services that one unit of money can
buy.
• it tells you how much you can buy!
• more precisely, it tells you how much MORE you can buy this year than last year!

• “purchasing power” is the value of a currency based on the amount of goods or services that one unit of money can buy.
“purchasing power” is important because, all else being equal, inflation decreases the amount of goods or services you would be able to purchase.
• put another way, a decline in purchasing power means you need more dollars to buy the same things.

Question 22

Summary

Answer 22

• the Consumer Price Index is the preferred way to measure changes in the cost of living. The CPI tracks the cost of the typical consumer’s “basket” of goods & services.
•the CPI is used to make Cost of Living Adjustments and to correct economic variables for the effects of inflation.
• the real interest rate is corrected for inflation and is computed by subtracting the inflation rate from the nominal interest rate.