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Foundations of Macroeconomics 8th Edition Bade Solutions Manual
Foundations of Macroeconomics 8th Edition Bade Solutions Manual
Foundations of Macroeconomics 8th Edition Bade Solutions Manual
CHAPTER OUTLINE
the Cost
of Living
1. Explain what the Consumer Price Index (CPI) is and how it is calculated.
A. Reading the CPI Numbers
7
B. Constructing the CPI
C. The CPI Market Basket
D. The Monthly Price Survey
E. Calculating the CPI
F. Measuring Inflation and Deflation
G. The Price Level, Inflation, and Deflation in the United States
2. Explain the limitations of the CPI and describe other measures of the
price level.
A. Sources of Bias in the CPI
1. New Goods Bias
2. Quality Change Bias
3. Commodity Substitution Bias
4. Outlet Substitution Bias
B. The Magnitude of the Bias
C. Two Consequences of the CPI Bias
1. Distortion of Private Contracts
2. Increases in Government Outlays and Decreases in Taxes
D. Alternative Consumer Price Indexes
1. Chained Consumer Price Index (C-CPI)
2. Personal Consumption Expenditures Price Index (PCEPI)
3. PCEPI Excluding Food and Energy
3. Adjust money values for inflation and calculate real wage rates and real
interest rates.
A. Dollars and Cents at Different Dates
B. Nominal and Real Values in Macroeconomics
C. Nominal GDP and Real GDP
D. Nominal Wage Rate and Real Wage Rate
E. Nominal Interest Rate and Real Interest Rate
◼ Where We Are
In Chapter 7, we explain what the Consumer Price Index
(CPI) is and how it is calculated. We examine the limitations
of the CPI as a measure of the cost of living. Next we look at
alternative measures of the price level: the chained CPI, the
PCE price index, and the PCE price index excluding food
and energy. Finally we show how to adjust money values for
inflation and calculate real wage rates and real interest rates.
IN THE CLASSROOM
Class Activities: Ask your students to match their expenditure patterns with those in the CPI
basket displayed below. The table presents a list of items and what the Bureau of Labor Sta-
tistics reported as the average expenditure in a typical market basket of goods for 2016. List
the categories and leave the percentages blank. Next, ask your students to write down their
own personal percentage expenditures for the list you have provided them. Remind them
that they should make estimates of what percentage each item represents in terms of their
annual income. After a couple of minutes or so, reveal the actual weights that the BLS report-
ed for 2016. Then ask your students to place a check mark against each expenditure category
in which he or she observes a substantial difference in relative weightings. In addition, you
also can ask them to reveal if there are any items that are on their personal list that did not
make it on the BLS list. The point of this activity is to demonstrate that although the CPI is a
statistically sound measure of the average change in the cost of a bundle of goods; it does not
measure each and every individual person’s average change in cost.
Indeed, there is at least one item on this list that has a markedly different weight of im-
portance than the figure that your students assigned to it. That item is education. Many stu-
dents who are working their way through college are probably also paying their own tuition.
It is likely that the percentage in this category is much higher than the BLS reported figure.
This activity can be combined with the Eye on Your Life discussed at the end of this chapter.
CHAPTER LECTURE
Lecture Launcher: Students might get the wrong idea in believing that the BLS blindly measures
exactly the same quantities of goods from year to year. While true in general, it does smooth
over some important details that are worth mentioning. One of them you could use for illus-
tration in class is the treatment of college textbooks. Below is an example:
College textbooks have a relatively high number of replacements (which occur when the
book that has been followed is no longer sold in the outlet) and in many cases the replace-
ment is not comparable to its predecessor. For example, over the one year time period from
June 1998 to May 1999, the CPI priced a total of 948 quotes for the College textbook category.
From this full year of quotes, 113 quotes (12 percent) were replacements. Of the 113 replace-
ments, 40 quotes (35 percent) were deemed to be either comparable or able to be quality ad-
justed, and thus could be used in the CPI. The remaining 73 quotes (65 percent) were not
comparable, and were deemed to be eligible for other processing where estimated price
change is used based on price movement of comparable replacement items. Ultimately, this
meant that 1 out of every 13 priced quotes in this item category over the course of a year were
non-comparable replacements. These figures led to the conclusion that College textbooks
more than qualified as a candidate for hedonic regression analysis.1
While you probably won’t want to get into the business of what a hedonic regression analysis
is, you might still find the passage useful in demonstrating that the BLS goes to great pains to
try to get the CPI right.
1Reese, Mike, “Hedonic Quality Adjustment Methods for College Textbook in the U.S. CPI.”
❑ Land Mine: Be careful to explain the difference between calculating the CPI and calculating
the inflation rate. Students easily confuse the two!
• Quality Change Bias: Sometimes price increases reflect quality improvements (safer
cars, improved health care) and should not be counted as part of inflation.
• Commodity Substitution Bias: Consumers substitute away from goods and services
with large relative price increases.
• Outlet Substitution Bias: When prices rise, people use discount stores more frequently
and convenience stores less frequently.
The Magnitude and Consequences of the Bias
• The Boskin Commission in 1996 estimated the bias overstates the inflation rate by about
1.1 percentage points a year.
• Many contracts and payments are indexed to the CPI. If the CPI is biased, then these con-
tracts are distorted because they incorrectly account for inflation.
• Many government outlays, such as Social Security payments, are linked to the CPI. If the
CPI is biased upward, then government outlays increase more than what is required to
offset inflation. Taxes are also indexed to the CPI so that the incomes for which tax rates
rise are adjusted to take account of inflation. The upward bias means that adjustments
are biased upward so that the government collects less tax revenues.
• To reduce the bias, the BLS has decided to undertake consumer spending surveys more
frequently.
In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent
amounts to close to a trillion dollars in additional expenditures over a decade. Politically, it is
hard to adjust Social Security payments for the bias, so the current plan is to reduce the meas-
urement bias in the CPI, for instance by revising the basket more frequently to reflect new goods
and substitution changes.
Students (and the media) often don’t understand why core inflation is a useful measure-
ment and assume it is a way for the government or economists to trick people into think-
ing inflation is not as high by removing food and energy prices, which obviously do play
a role in people’s expenditures. It is important to identify that food and energy prices can
be extremely volatile, especially as a function of weather and global politics. Not only
does this volatility complicate the analysis of other price changes, but from a policy per-
spective core inflation measurements may serve as a better guide than overall inflation.
Food and energy price changes that are the result of changes in weather and global poli-
tics are largely outside of the influence of policies. Therefore, it may make sense to ignore
them and focus on core inflation when designing policies, since it’s that underlying infla-
tion that may be a reflection of the functioning of the economy and economic policies, as
opposed to external factors which cannot be controlled. This is why policymakers (espe-
cially the Federal Reserve) may focus more on core inflation when designing policies.
• Over time, all of the indices move up and down in similar ways, but the previously dis-
cussed biases cause the CPI to rise slightly more rapidly than the C-CPI and PCEPI (and
PCEPI excluding food and energy rises slightly less rapidly).
Real values seem to cause students confusion. Reiterate why we calculate real values and that the
calculation of the real wage is just like the calculation of real GDP, only using a different set of
variables. It may be helpful to show the real calculations side-by-side by writing out (real wage) =
(nominal wage) (CPI) and real GDP = (nominal GDP) (GDP deflator). In other words, show
your students the same general formula—real variable equals nominal variable divided by the
price level—applies to all real variables except, of course, the real interest rate.
• The real wage rate is the quantity of goods and services that an hour’s work can buy.
• Between 1980 and 2015 the nominal wage rate approximately tripled but the real
wage rate stayed roughly constant because the increase in the nominal wage rate just
kept up with inflation.
Ask students to think about whether it is the real wage or the nominal wage that matters to them.
You may want to use a numerical example to illustrate how an increase in prices without an in-
crease in the nominal wage will reduce the amount of goods and services a student can buy. This
procedure will help to cement the idea of the real wage.
To be sure that your students understand that the real interest rate is similar to the real wage rate
and real GDP insofar as it’s in real terms, mention that the calculation of the real interest rate also
“deflates” the nominal interest rate. However, because the numbers are already percentages, we
must subtract the percentage change in prices (the inflation rate) rather than divide by the price
level.
they enjoyed or the 50-cent movies they went to. Advise your students that when
people often complain about the rising price of something they are nearly always
speaking of nominal prices, not real prices. So, in today’s dollars, how much was
that famous nickel Coca-Cola we’ve heard so much about? If we use 1939 as the
starting year, a $.05 Coca-Cola would be the equivalent of paying $.87 in 2016 –
which for a 12oz can purchased from a grocery store, would be a bit on the high
side (especially if considering the per unit price of purchasing in bulk). What
about a $.50 movie? A $.50 cent movie in 1939 (the year Gone with the Wind was
first released), would be $8.66 in 2016 – which is exactly the same as the estimat-
ed 2016 average ticket price. You might want to stress the opportunity cost ele-
ment here. That is, if the price of a particular good is rising at a slower rate than
other the prices of other goods, then the opportunity cost of acquiring that item
has actually fallen. Perhaps the good ‘ole days weren’t as good as we’ve heard!
◼ A Student’s CPI
This Eye discusses how the CPI is not necessarily a reflection of how all consum-
ers experience inflation. You can integrate the class activity previously suggested
with this Eye. How does their personal market basket compare to that of the av-
erage American household? How does it compare to the student’s basket of
goods created in this Eye? How might the market basket of a group near the op-
posite end of the age scale – senior citizens – compare to the student market bas-
ket and the average market basket used by the CPI? Given that college students
and seniors may rely on more fixed incomes than most groups (financial aid and
Social Security, respectively), why do these price trends pose more of a problem
for these groups? Why might using CPI measurements for different groups (a
student CPI, a senior CPI, etc) instead of just the general CPI be useful for target-
ed income assistance programs like financial aid and Social Security? How does
the fact that the CPI tends to overstate the actual rate of inflation complicate this
analysis?
◼ Questions
◼ Checkpoint 7.1 The Consumer Price Index
1 A Consumer Expenditure Survey in the city of Firestorm shows that people
consume only firecrackers and bandages. In 2010, the year of the survey
and also the reference base year, the average household spent $100 on fire-
crackers and $10 on bandages. The price of a firecracker in 2000 was $2, and
the price of bandages was $1 a pack. In the current year, 2011, the price of a
firecracker is $3 and the price of bandages is $1.25 a pack. Calculate:
1a. The CPI basket.
1b. The percentage of a household's budget spent on firecrackers in the base
year.
1c. The CPI in 2011.
1d. The inflation rate in 2011.
2. Assume a two-good world in which the market basket is 10 units of good A
and 2 units of good B. Good A costs $4 and good B costs $1 in year 1. Fur-
thermore, assume that in year 2 the prices rise to $5 and $2, respectively.
Calculate the inflation rate in year 2. Will the choice of base year affect your
answer?
◼ Checkpoint 7.2 The CPI and Other Price Level Measures
3. In Virtual Reality, time travel became 3001 3002
possible only in 3002. Economists in the
Item Quantity Price Quantity Price
Statistics Bureau decided to conduct a
Games 10 $30 5 $35
Consumer Expenditure Survey in both
Time 0 − 10 $4,000
3001 and 3002 to check the substitution Travel
bias of the CPI. The table shows the re-
sults of the survey. It shows the items
that consumers buy and their prices. The Statistics Bureau fixes the refer-
ence base year as 3001 and asks you to:
3a. Calculate the CPI in 3002 using the 3001 CPI basket.
3b. Calculate the CPI in 3002 using the 3002 CPI basket. I
3c. Explain whether there is any substitution bias in the CPI that uses the 3001
basket.
4. List the sources of bias in the CPI that are discussed in the text and give a
brief explanation of each.
5. Identify the consequences of the CPI bias mentioned in the text and discuss
each.
◼ Answers
◼ Checkpoint 7.1 The Consumer Price Index
1a. The CPI basket is the quantities bought during the Expenditure Survey
year, 2010. Households spend $100 on firecrackers at $2 a firecracker so the
quantity of firecrackers bought was 50. Households spend $10 on bandages
at $1 a pack so the quantity of bandages bought was 10 packs. The CPI bas-
ket is 50 firecrackers and 10 packs of bandages.
1b. In the reference base year, expenditure on firecrackers was $100 and ex-
penditure on bandages was $10, so the household budget was $110. Ex-
penditure on firecrackers was 90.9 percent of the household budget: ($100
$110) 100 = 90.9 percent.
1c. To calculate the CPI in 2011, find the cost of the CPI basket in 2011 and
2010. In 2010, the CPI basket costs $110 ($100 for firecrackers and $10 for
bandages). In 2011, the CPI basket costs $150 for firecrackers (50 $3 a fire-
cracker) plus $12.50 (10 packs of bandages $1.25 a pack), which is $162.50.
The CPI in 2011 equals ($162.50 $110) 100 = 147.7.
1d. The inflation rate in 2011 is [(147.7 − 100.0) 100.0] 100 = 47.7 percent.
2. The cost of the basket in year 2 is $50 + $4 = $54. The cost of the basket in
year 1, the base year is $40 + $2 = $42. The CPI for year 2 is $54 $42 100 =
128.5. The inflation rate in year 2 is [(128.5 − 100.0) ÷ 100.0] 100.0 = 28.5
percent. It doesn’t make any difference which year is chosen as the base
year. We get the same rate of inflation for year 2.
◼ Checkpoint 7.2 The CPI and Other Price Level Measures
3a. Using the 3001 CPI basket, the cost of the basket in 3001 is $300 and the cost
of the basket in 3002 is $350. (Note that time travel does not enter into the
cost in 3002 because it is not in the CPI basket.) The CPI in 3002 is ($350
÷$300) 100 = 116.7.
3b. Using the 3002 CPI basket, the cost of the basket in 3001 is $150. (Note that
time travel does not affect the cost of this basket because its price is unde-
fined in 3001.) The cost of 3002 CPI basket in 3002 is $40,175. (10 time trav-
els $4,000 + 5 games $35). The CPI in 3002 is ($40,175 ÷ $150) 100 =
26,783.3.
3c. There is not any commodity substitution bias but there is a huge new goods
bias. In particular, the new good, time travel, is significantly more expen-
sive than the good it is partially replacing, games. Some of the price in-
crease caused by the introduction of time travel is not pure inflation but in-
stead represents the higher quality of time travel as entertainment com-
pared to games.