Macroeconomics Dr.

Sauer

Measuring the Cost of Living (ch6) Inflation is an increase in the ______________________. formula: Inflation Rate = Price Level 2 Price Level 1 ( ) Price Level 1 The inflation rate is the _______________________ in the price level. Recall: The GDP deflator is one measure of the price level. GDP Deflators 2005: 100 2006: 171.4 2007: 240 Inflation Rate 2005 2006 2007

x 100

Instead of using the GDP Deflator to measure the price level we could use the ____________________.

I. The Consumer Price Index measures changes in the overall cost of the goods and services that a _________________________________ buys. - Compiled monthly by the Bureau of __________________ Statistics. www.bls.gov

A. How to Calculate: 1. decide on a ______________ of goods 2. find _____________ for the goods 3. compute the ______________ of the basket 4. chose a _________________ and compute the index

1. How is the basket decided? Detailed expenditure information is collected from families and individuals on what they ____________ bought. - Consumer Expenditure Surveys for 2005 and 2006 - 7,000 families from around the country provided information each quarter on their spending habits - another 7,000 families in each of these years kept diaries listing everything they bought during a 2-week period Over the 2 year period, then, expenditure information came from approximately 28,000 weekly diaries and 60,000 quarterly interviews used to determine the importance, or weight, of the more than 200 item categories in the CPI index structure. BLS has classified all expenditure items into more than 200 categories, arranged into _____________major groups:

The CPI ___________________________ investment items, such as stocks, bonds, real estate, and life insurance. - These items relate to ____________________ and not to day-to-day consumption expenses. For each of the more than 200 item categories, using scientific statistical procedures, the Bureau has chosen samples of several hundred specific items within selected business establishments frequented by consumers to represent the thousands of varieties available in the marketplace. Ex: In a given supermarket, the Bureau may choose a plastic bag of golden delicious apples, U.S. extra fancy grade, weighing 4.4 pounds to represent the Apples category.

2. How are prices collected? Each month, BLS data collectors (called economic assistants) ______________________ thousands of retail stores, service establishments, rental units, and doctors' offices, all over the US. - They record the prices of about ____________________ items each month.

3. How is the cost of the basket computed? Example: Suppose the basket contains 4 sodas and 2 hotdogs. year Psoda Photdog 2005 $1 $2 2006 $2 $3 2007 $3 $4 Cost of basket: 2005: 2006: 2007: 4. How is the Index computed? Formula for the Index: CPIyearA = cost of basket in year A cost of basket in base year

x 100

Continuing our example, suppose the base year is 2005. CPI: 2005: 2006: 2007: Note: In the base year, the CPI is always ____. ______________________________________________________________________

B. Using the CPI to calculate inflation Calculate the inflation rate for December 2010:

Calculate the inflation rate from January 2000 to December 2010:

C. Some Problems with the CPI: _______________________________: When the price of a good changes, consumers often respond by purchasing a different product in its place. _______________________________: goods are often left out of the basket Because the market basket is not changed constantly, new

_______________________________: Attempts are made to adjust for quality changes but quality changes are hard to measure. Most studies indicate that the CPI overstates the rate of inflation by about _______ percentage point per year.

II. The CPI vs the GDP Deflator Similarity: both try to measure changes in the ____________________ Difference: 1) CPI is based on goods that ______________________ but GDP Deflator is based on ___________________________ in a nation 2) CPI uses a ___________________ basket but GDP Deflator uses the ___________________ that have been produced

III. Other Price Indices The _____________________________ measures changes in the selling prices received by domestic producers for their output. -because firms eventually pass on higher costs to consumers in the form of higher prices, the PPI is believed to be useful in _________________________ in the CPI - also available by industry or type of good (ex: grocery, medical, electric power) _______________________ Price Indexes (MXP) measures changes in the prices of nonmilitary goods and services traded between the U.S. and the rest of the world.

IV. Dollar Figures from Different Times In order to make a ________________________ comparison of dollar figures over time, you need to ____________________________ the effects of inflation. Formula: $ value in year A = $ value in year B x price level in year A price level in year B

Ex: Your father graduated from college and took his first job in 1972. He was paid a salary of $10,000. What is that salary worth in 2008 dollars? In 1972, the CPI was 41.8 and in 2008 the CPI was 215.3.

Ex: Your friend lives in St. Louis, MO and makes $50,000 a year. Shes received a job offer in Honolulu, HI for $55,000 a year. She knows that you take economics and asks your opinion on the salary negotiation. You do a little research and find that the CPI in St. Louis is 192.1 and the CPI in Honolulu is 216.6. What do you adviser her? - How much would she need to keep her purchasing power the same?

When making comparisons, what if you dont adjust dollar figures for inflation? Domestic Box Office Sales
Rank 1 2 3 4 5 6 7 8 9 10 Title Avatar Titanic The Dark Knight Star Wars Shrek 2 E.T.: The Extra-Terrestrial Star Wars: Episode I - The Phantom Menace Pirates of the Caribbean: Dead Man's Chest Spider-Man Transformers: Revenge of the Fallen Studio Fox Par. WB Fox DW Uni. Fox BV Sony P/DW

(boxofficemojo.com)
Lifetime Gross $612,693,000 $600,788,188 $533,345,358 $460,998,007 $441,226,247 $435,110,554 $431,088,301 $423,315,812 $403,706,375 $402,111,870 Year 2009 1997 2008 1977 2004 1982 1999 2006 2002 2009

Rank 1 2 3 4 5 6 7 8 9 10 21

Title Gone with the Wind Star Wars The Sound of Music E.T.: The Extra-Terrestrial The Ten Commandments Titanic Jaws Doctor Zhivago The Exorcist Snow White and the Seven Dwarfs Avatar

Studio MGM Fox Fox Uni. Par. Par. Uni. MGM WB Dis. Fox

Adjusted $1,537,559,600 $1,355,490,100 $1,083,781,000 $1,079,511,500 $996,910,000 $976,712,200 $974,679,800 $944,670,800 $841,427,600 $829,490,000 $612,693,000

Unadjusted $198,676,459 $460,998,007 $158,671,368 $435,110,554 $65,500,000 $600,788,188 $260,000,000 $111,721,910 $232,671,011 $184,925,486 $612,693,000

Year 1939 1977 1965 1982 1956 1997 1975 1965 1973 1937 2009

V. Indexation is an _______________________ correction of a dollar amount for the effects of inflation - by law or by contract Many government transfer programs use indexation for benefits. Many labor contracts include cost of living allowances. The government also indexes the _______________________ brackets. - If you get a 5% cost of living adjustment, your salary is 5% higher than it was the previous year. - When your income is higher, you may move to a higher tax bracket. - But your purchasing power hasnt changed! - The government adjusts the tax brackets so this doesnt happen as much. VI. Real and Nominal Interest Rates The nominal interest rate is the interest rate _________________. - the rate you see on your credit card statement - the rate you pay on your car loan The real interest rate has been _____________________for inflation. Relationship: nominal interest rate

real interest rate

inflation rate

Intuition: You deposit $1000 into a bank account that pays you 10% interest. One year later you have $1100. If inflation that year is: 0% then your purchasing power has _______________% 2% then your purchasing power has _______________% 10% then your purchasing power has ______________% 15% then your purchasing power has ______________% If there is 2% deflation that year, your purchasing power has ___________________% What matters to you is the __________________________ of your money. As a borrower, unexpected inflation _____________ you. - get the purchasing power now - pay back the money over time - inflation means you are paying back less purchasing power 6

As a lender, unexpected inflation __________ you. - receive the nominal interest rate - after adjusting for inflation, your real rate is less

_____________________________________________________________________ Summary: The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate. The consumer price index is an imperfect measure of the cost of living for three reasons. Like the consumer price index, the GDP deflator also measures the overall level of prices in the economy. Although the two price indexes usually move together, there are important differences. Dollar figures from different times do not represent a valid comparison of purchasing power. Various laws and private contracts use price indexes to correct for the effects of inflation. A correction for inflation is especially important when looking at data on interest rates.