Chapter 6 Flashcards
Measuring the Cost of Living
The consumer price index is used to monitor changes in the cost of living over time.
When the consumer price index rises, the typical family has to spend more dollars to maintain the same standard of living.
Economists use the term inflation to describe a situation in which the economy’s overall price level is rising.
The inflation rate is the percentage change in the price level from the previous period.
consumer price index (CPI)
Consumer price index (CPI) is the overall measure of the cost of the goods and services bought by a typical consumer.
How the Consumer Price Index Is Calculated
Every month, Statistics Canada computes and reports the CPI.
It uses data on the prices of more than 600 different goods and services.
To see how these statistics are constructed, a simple economy with two goods is used: hot dogs and hamburgers.
If a price level falls, it raises the power of the dollar, if price level rises it lowers the poer of the dollar
Five steps to computing the CPI and the inflation rate (Step 1 to 3)
- Determine the basket to determine which prices are most important to the typical consumer.
- Find the prices of each of the goods and services in the basket for each point in time.
- Compute the basket’s cost at different times.
Five steps to computing the CPI and the inflation rate (Step 4 & 5)
- Choose a base year and compute the index. The fourth step is to designate one year as the base year, which is the benchmark against which other years are compared. (The choice of a base year is arbitrary, as the index is used to measure changes in the cost of living.)
Formula: CPI = ((Price of basket of goods/services in current year)/(Price of basket in base year))* 100 - Compute the inflation rate. The fifth and final step is to use the CPI to calculate the inflation rate, which is the percentage change in the price index from the preceding period.
Formula: Inflation Rate in Yr 2 = ((CPI in year 2 - CPI in year 1) / (CPI in Yr 1)) * 100
CPI Continued
Statistics Canada calculates several other price indexes.
* For each province and territory and for 19 cities across Canada.
* For some narrow categories of goods and services (such as food, clothing, and shelter).
“CORE” INFLATION: a measure of the underlying trend in inflation. It is thought to be useful in predicting the underlying trend of inflation as measured by changes in the consumer price index. Food and energy prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly.
What Is in the CPI’s Basket?
Order from most to least:
1. Shelter 27.4%
2. Transportation 20.0%
3. Food 16.5%
Problems in Measuring the Cost of Living
The CPI is not a perfect measure of the cost of living.
- Commodity substitution bias: Consumers substitute toward goods that have become relatively less expensive. If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution and, therefore, overstates the increase in the cost of living from one year to the next.
- Introduction of new goods: The CPI is based on a fixed basket of goods and services, it does not reflect the increase in the value of the dollar that arises from the introduction of new goods.
- Unmeasured quality change: If the quality of a good deteriorates from one year to the next, the value of a dollar falls, even if the price of the good stays the same. Similarly, if the quality rises from one year to the next, the value of a dollar rises. Statistics Canada does its best to account for quality change.
Taken together, these sources of bias cause the CPI to overstate the cost of living by 0.5 percentage points per year according to the Bank of Canada.
20 Years of Price Changes in Canada Graph
This figure shows how the price of a select group of goods and hourly earnings have changed over 20 years.
Top 3:
Booze, Tobacco, Weed +120%
Average Hourly Earnings +65%
Food +60%
The GDP Deflator versus the Consumer Price Index
Economists and policymakers monitor both the GDP deflator and the CPI to gauge how quickly prices are rising.
*Usually, these two statistics tell a similar story.
Two important differences can cause them to diverge:
*The GDP deflator reflects prices of goods and services produced domestically, whereas the CPI reflects the prices of all goods (domestic and imported) and services bought by consumers.
*The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year. Statistics Canada changes the basket of goods every two years. The GDP deflator compares the price of currently produced goods and services with the price of the same goods and services produced during the base year.
Two Measures of Inflation
This figure shows the inflation rate—the percentage change in the level of prices—as measured by the GDP deflator and the consumer price index using annual data since 1965. Notice that the two measures of inflation generally move together. They both show the price level in the economy.
CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION
The purpose of measuring the overall level of prices in the economy is to permit comparison between dollar figures from different points in time.
Dollar Figures from Different Times
Was the 1957 price of 9.5 cents per litre high or low compared with the 2021 price of gas ($1.30 per litre)?
To compare the 1957 price of gas with the 2021 price, we need to inflate the price of 9.5 cents per litre to turn 1957 dollars into 2021 dollars.
Amount in today’s dollars = Amount in year T dollars * (CPI today/CPI in year T)
CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION (Pt.2)
INDEXATION: the automatic correction of a dollar amount for the effects of inflation by law or contract
COLA (cost-of-living allowance) automatically raises the wage when the CPI raises
Real and Nominal Interest Rates
Interest rates involve comparing amounts of money at different points in time.
To fully understand interest rates, knowing how to correct for the effects of inflation is important.
- Suppose you make a deposit of $1000 in a bank account that pays interest at a rate of 10 percent per year.
- After one year, that bank account now contains $1100 (= principal of $1000 + interest of $100).
- Are you actually wealthier after one year?
