Chapter 6 (Measuring the Cost of Living) Flashcards
To compare 1957 prices and incomes with 2014 prices and incomes, we need to find some way of turning dollar figures into meaningful measures of purchasing power. That is exactly the job of a statistic called
the consumer price index.
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.
The consumer price index (CPI) is a measure of
the overall cost of the goods and services bought by a typical consumer.
Statistics Canada computes and reports the consumer price index.
Each month
Determine the basket
The first step in computing the consumer price index
is to determine which prices are most important to the typical consumer.
Find the prices.
The second step in computing the consumer price index is to find the price of each of the goods and services in the basket for each point in time.
Compute the basket’s cost.
The third step is to use the data on prices to
calculate the cost of the basket of goods and services at different times.
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
CPI calculation
CPI= [(Price of basket of goods and services in current year)/(Price of basket in base year)] x 100
Compute the inflation rate.
The fifth and final step is to use the consumer price
index to calculate the inflation rate, which is the percentage change in the price index from the preceding period.
CPI approach
πCPI= [(Price of basket current year/base year)-1 ] x 100
GDP deflator approach
πGDP = (Nominal GDP/Real GDP − 1)x100
The excluded components— fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity
transportation, and tobacco products—
account for 19 percent of the CPI basket.
Core inflation is thought to be useful in predicting the
underlying trend of inflation as measured by changes in the consumer price index
the breakdown of consumer spending into the
major categories of goods and services
shelter= 26.8 percent of the typical consumer’s budget. 19.1 percent, is various forms of transportation,
16.4 percent, is food; this includes both food
eaten at home and restaurant meals, Household operations and furnishings 13.1%, 10.9 percent university educational associated fees & recreation, Health and personal care 4.7%, Alcoholic beverages and tobacco products 2.9%
commodity substitution bias (Problem one in measuring cost of living)
When prices change from one year to the next, they do not all change proportionately: Some prices rise
more than others. Consumers respond to these differing price changes by buying less of the goods whose prices have risen by large amounts and by buying more of the goods whose prices have risen less or perhaps even have fallen.
The second problem with the consumer price index is the introduction of new goods
When a new good is introduced, consumers have more variety from which to choose. Greater variety, in turn, makes each dollar more valuable, so consumers need fewer dollars to maintain any given standard of living.
The third problem with the consumer price index is 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. changes in quality remain a problem because quality is so hard to measure.
Bank of Canada in 2012 suggests that the sources of bias identified above, taken together, cause the Canadian CPI to overstate increases in the cost of living by
about 0.5 percentage points per year.
The first difference between GDP and CPI is that the GDP deflator reflects the prices of
all goods and services produced domestically, whereas the consumer price index reflects the prices
of all goods and services bought by consumers
The second and more subtle difference between the GDP deflator and the consumer price index concerns how various prices are weighted to yield a single
number for the overall level of prices.
The consumer price index 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. By contrast, the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. Thus, the group of goods and services used to compute the GDP deflator changes automatically over time
The formula for turning dollar figures from year T into today’s dollars is
Amount in today’s dollars = Amount in year T dollars x (Price level today/Price level in year T)
Statistics Canada gives a CPI of 14.8 for 1957 and 125.2 for the year 2014. (The base year is 2002.) Thus, the overall level of prices rose by a factor of 8.46 (which equals 125.2/14.8). We can use these numbers to measure the 1957 price of gasoline in year 2014 dollars.
1957 gas price in 2014 dollars = 1957 gas price X (CPI in 2014/CPI in 1957) = 9.5 cents X (125.2/14.8) = 80.4 cents. We find that the 1957 price of gasoline is equivalent to a price of 80.4 cents per liter in 2014. This is considerably less than the 2014 price of gas of $1.30 per liter. So, after adjusting for inflation, the price of gas in 2014 is considerably higher than it was 57 years earlier—by about 50 cents per liter. Over this 57-year period, then, the price of gasoline has on average increased somewhat faster than the price of
all other goods and services. The 9.5 was given in the preceding paragraphs.
When some dollar amount is automatically corrected for inflation by law or contract, the amount is said
to be indexed for inflation.
For example, many long-term contracts between firms and unions include partial or complete indexation of the wage to the consumer price index. Such a provision is called a cost-of-living allowance, or COLA. A COLA automatically raises the wage when the consumer price index rises.
These examples show that the higher the rate of inflation, the smaller the increase in Sally’s purchasing power. If the rate of inflation exceeds the rate of interest, her purchasing power actually falls.
And if there is deflation (that is, a negative rate of
inflation), her purchasing power rises by more than the rate of interest.
nominal interest rate
The interest rate that measures the change in dollar amounts
real interest rate
the interest rate corrected for inflation
The nominal interest rate, the real interest rate, and inflation are related
Real interest rate = Nominal interest rate — Inflation rate
The nominal interest rate tells you how fast the
number of dollars in your bank account rises over time
The rate of inflation tells you how fast the
prices of things you want to buy with those dollars are rising
The real interest is the difference between
these two measures; it tells you how fast the purchasing power of your bank account rises over time.
