Chapter 6 - MEASURING THE COST OF LIVING

Question 1

What is the CPI?

Answer 1

-Overall measure of the cost of the goods and services bought by a typical consumer

-Tries to gauge how much incomes must rise to maintain a constant standard of living

Question 2

How is CPI calculated?

Answer 2

-Every month statistics (Canada) computes and reports the CPI

-Uses data on the prices of more than 600 different goods and services.

Question 3

What are the five steps to computing the CPI and the inflation rate?

Answer 3

1) Determine the basket (quantity important!)

2) Find the prices of each good in each year

3) Compute the basket’s cost

4) Calculate the CPI (CPI (t) / CPI base year), choose a base year

5) Compute the inflation rate

Question 4

How to calculate the inflation rate?

Answer 4

(CPI (year t) - CPI (year t-1))/CPI(year t-1)

Question 5

What is the Core CPI?

Answer 5

Measure of the overall cost of consumer goods and services excluding food and energy.

Question 6

Why does the core CPI reflect the ongoing inflation better?

Answer 6

Due to food and energy prices show substantial short-run volatility.

Question 7

Why is the CPI not a perfect measure of the cost of living?

Answer 7

1. Commodity substitution bias (When prices change from one year to the next year, they do not all change proportionately)
2. Introduction of new goods (When a new good is introduced, consumers have more variety from which to choose)
3. Unmeasured quality change

Question 8

What are the differences between GDP deflator and the CPI?

Answer 8

1. GDP will include the products that are produced within the country.
2. The CPI will include what the typically consumer is buying.
3. For example, helicopters will be included in the GDP but not in the CPI, because that is not what the typical customer buys.
4. Another example, if Volvo rises the prices of its cars: those cars are not included in Canada GDP due to the cars are produced in Sweden. But Canada consumers buy Volvo which is included in a typical consumer’s basket of goods.
5. GDP constant prices, CPI constant quantities.
6. GDP deflator reflects prices of goods and services produced domestically.
7. 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.

Question 9

How to calculate the amount in today’s dollars?

Answer 9

amount in todays dollars = amount in year T dollars * CPI today/CPI in year T

or

amount in todays dollars = amount in year T dollars * price level today/price level in year T

Question 10

What is Indexation?

Answer 10

When some dollars are corrected for changes in the price level by law or contract.

Question 11

What is COLA?

Answer 11

Long-term contracts between firms and unions to increase the wage when the CPI raises.

Question 12

What is nominal interest rate respectively real interest rate?

Answer 12

-Nominal interest rate is the interest rate that is usually reported without a correction for the effects of inflation.

-Real interest rate is the interest rate that is corrected for the effects of inflation.

Real interest rate = nominal rate – inflation