Module 2 Flashcards
Market Basket Measure: What is it and What does it measure?
The list includes specific goods and services, in fixed quantities that roughly correspond to a typical consumer’s spending
Measures changes in overall prices based on the fluctuations in certain goods
Goods and quantities MUST be kept constant in order to isolate for changes in prices
How to calculate change year-over-year?
Take the Cost of the item in the second year and subtract the cost from the first year, then divide by the cost of the first year
[($17.87 − $17) / 17] × 100%
Price increase from 2019 to 2020 = 5.1%
Consumer Price Index (CPI)
Measures how much the cost of a market basket has risen or fallen relative to the cost in a base time period or location
Most commonly used tool for tracking price changes in Canada
Which Goods are used for calculating the CPI
Obviously every household has different taste in consumer goods, but the CPI TAKES THE AVERAGE OF PEOPLE LIVING IN URBAN AREAS OF CANADA, and excludes those in the military, rural areas and people in prison and mental hospitals
TWO major complications for calculating cost of living with market basket
Innovation: over time goods improve and become cheaper, making cost of living improve per dollar spent.
A car that costs $20,000 in 2010 will be of much lower quality than a car for $20,000 in 2020. Thus, the cost of living would be cheaper in 2020 because the newer car has more features, better gas mileage and safety for the same price
Substitution: people will naturally buy the goods that have the best value for the best price, and consumers’ shopping baskets are always changing
Inflation rate calculation
Change in CPI year over year
[(CPI Year 2 - CPI Year 1) / CPI Year 1] x 100%
All-items vs. Core inflation rate
All-items: includes all items in the market basket
Core: all items in market basket, excluding food and energy prices due to volatility
Producer Price Index (PPI)
Measures the costs of goods and services purchased by firms. This measure calculates items that would be purchased by businesses, but not consumers (industrial machinery). The PPI usually foreshadows increases or decreases in prices because changing input prices will eventually make it to consumers
Why do we have two different measures of inflation? Why not just use CPI Inflation or GDP Deflator?
- The CPI calculates inflation based on the market basket of goods and services in that country, which keeps the goods and quantities constant when calculating them. The GDP Deflator, on the other hand, calculates inflation using goods and services produced in that country, but does not account for changes in goods, services or quantities.
- The CPI includes prices of imported goods and services, whereas the GDP Deflator only uses domestic goods and services.
- The GDP includes the prices of capital goods (goods used for the production of other goods and services) if they’re produced domestically, and the CPI excludes them
How to calculate the real value of a salary from 1975 in 2022 terms?
Current value = Past value (1975) x (CPI 2022 / CPI 1975)
Current Value = $47,231 x (133.2 / 23.6)
= $266,575
What is indexing a payment? (pension plan or old-age benefits)
Automatically increases payments in relation to the cost of living. All government issued social security benefits are indexed directly to the CPI.
Since inflation would decrease the value of benefits and pensions over time, indexing increases the benefits plans (by a percentage; (MAXIMUM OF 2%/YEAR) to keep the dollar value constant over time
Indexed payments are referred to as Cost-of-Living-Adjustments (COLAs)
Purchasing Power Parity (PPP)
PPP is the idea that price levels in different countries should be the same, once they are converted into a common currency.
This means that the exchange rate between two countries should equal the ratio of the two countries’ price level of a fixed basket of goods and services. For example, a TV in Canada that costs 100$ in CAD should cost 125$ USD in the United States if 1$ CAD = 1.25 USD
Why does PPP almost never hold true?
TRANSACTION COSTS: in theory, we would expect people to buy goods that are cheaper in one country and sell them in another more expensive country to make a profit. However, there are costs to transport goods from one place to another, and there are transaction costs of converting currencies. Though, the price gap between countries is usually larger than would be the transaction costs because people must face opportunity costs on top of transaction costs. It takes time to find buyers for the discounted goods, which causes people to refrain from doing so
NON-TRADEABLE GOOD AND SERVICES: some goods and services simply cannot be bought and sold in different countries, which allows the price discrepancies to stick around. For example, haircuts, apartments and certain consumables (fresh pizza) can’t be bought in one place and sold in the other.
TRADE RESTRICTIONS: international trade isn’t free and there are many tariffs and trade restrictions that make it difficult for country-to-country selling
Purchasing Power Index
Formula used to calculate the difference in prices and incomes between locations
(Supposed Rate - Actual Rate) / Actual Rate
Supposed Rate = Cost in foreign country / cost in base country
Actual Rate = exchange rate from base country’s currency to foreign country’s currency
How to calculate PPP adjusted GDP from country to country
= Nominal GDP per capita Country 1 x [ 1 / (1 - price-level adjustment Country 1) ]
Example: PPP adjusted GDP in Mexico compared to Canada. NOTE goods are 39% more expensive in Canada than Mexico
= $8,903 x [ 1 / (1 - 0.391) ]
= $8,903 x 1.642
= $14,619.05
Meaning the average GDP per capita of a Mexican person would earn $14,619 in Canada
