Measuring the Cost of Living Flashcards
Consumer price index (CPI)
Measure of the overall cost of the goods and services bought by a typical consumer
Calculated by fixing a basket, finding the prices in the basket at each point in time, computing the basket’s cost, and choosing a base year and computing the index
CPI=Price of basket goods and services in current year/Price of basket in base year * 100
Because of measurement problems, the CPI overstates true inflation.
Inflation rate
Percentage change in the price index from the preceding period
Inflation rate in year 2 = CPI in y2 - CPI y1/CPI y1 * 100
Producer Price index
A measure of the cost of a basket of goods and services bought by firms
Problems in measuring the cost of living: Substitution bias
When prices change from one year to the next, they don’t change all proportionate. The CPI overstates the increase in the cost of living form one year to the next
Problems in measuring the cost of living: Introduction of new goods
The CPI is based on a fixed basket of goods and services, so it doesn’t reflect the increase in the value of the dollar that arises from the introduction of new goods.
Problems in measuring the cost of living: Unmeasured quality change
Quality is hard to measure. Despite BLS trying to adjust the price of the good to account for the quality change, it remains a problem
GDP deflator vs Consumer Price Index
Both used to gauge how quickly prices are rising.
GDP deflator: ratio of nominal GDP to real GDP, all goods and services produced domestically, compares the price of currently produced goods and services to to the price of the same goods and services in the base year. The group of goods and services used to compute the GDP deflator changes automatically over time.
CPI: reflects all goods bought by consumers (not just produced domestically), compares the price of a fixed basket of goods and services to the price of the basket in the base year (basket is not changed very often).
Dollar figures from different times
Amount in today’s dollars=Amount in year t dollars * (price level today/price level in year T)
Indexation
Automatic correction by law or contract of a dollar amount for the effects of inflation.
eg: Cost of living allowance (COLA). Automatically raises wage when the CPI rises.
Social security benefits, the brackets of federal income tax
Purchasing power
amount of goods and services a person can buy
If rate of inflation exceeds the rate of interest
purchasing power falls
Nominal interest rate
interest rate as usually reported without a correction for the effects of inflation. Tells you how fast the number of dollars in your bank account raises over time.
Based largely on 3-month Treasury bills
Real interest rate
the interest rate corrected for the effects of inflation. Tells you how fast the purchasing power of your bank account rises over time.
Formula for real interest rate
Real interest rate=Nominal Interest rate-inflation rate
who loses when inflation goes down?
borrowers
