the cpi and the cost of living

11
The CPI and the Cost of Living CHAPTER 6

Upload: hadley-fowler

Post on 01-Jan-2016

22 views

Category:

Documents


1 download

DESCRIPTION

6. The CPI and the Cost of Living. CHAPTER. THE CONSUMER PRICE INDEX. What is meant by inflation? Why is it important? Defn : The rate of inflation is the percentage change in the general price level from one period to the next. - PowerPoint PPT Presentation

TRANSCRIPT

Page 1: The CPI and the Cost of Living

The CPI and the Cost of Living

CHAPTER6

Page 2: The CPI and the Cost of Living

THE CONSUMER PRICE INDEX

What is meant by inflation? Why is it important?

Defn: The rate of inflation is the percentage change in the general price level from one period to the next.

Defn: Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services.

Calculating CPI

1)Identify the market basket

2)Find the prices of each good

3)Compute the cost of the basket

4)Use the basket cost in the base year to calculate the index.

Page 3: The CPI and the Cost of Living

THE CONSUMER PRICE INDEX

Fun Fact

Page 4: The CPI and the Cost of Living

Calculating the Inflation Rate

CPI in current year CPI in previous year

CPI in previous year

x 100Inflation rate =

Page 5: The CPI and the Cost of Living

If 2006 is the base year.

1) Calculate the CPI in 2007.

2) Calculate the 2007 inflation rate and interpret the number.

3) What percent of household budget is spent on books in 2007.

Example

Quantity Price ($) Year

Books 2 30 2006

Cereal 20 2 2006

Books 4 40 2007

Cereal 10 4 2007

Page 6: The CPI and the Cost of Living

Solution

1) Cost of market basket in 2006 =

(2*$30)+(20*$2)= $100

Cost of market basket in 2007 =

(2*$40)+(20*$4)= $160

CPI in 2007=

(160/100)*100= 160

2) 2007 inflation rate = [(CPI in 07-CPI in 06)/CPI in 06 ]*100

n.b Inflation is calculated using the previous year NOT the base year.

inflation=

(160-100)/100 = 60%

Page 7: The CPI and the Cost of Living

Solution contd.

3) Household budget in 2007 = 4*$40+10*$4 = $200

percentage spent on books = ($160/$200)*100= 80%

Page 8: The CPI and the Cost of Living

CPI is not a perfect measure of the C.O.L due to certain biases.

The idea is that we want to compare cost of living over time.

Sources of Bias in the CPI

The potential sources of bias in the CPI are• New goods bias• Quality change bias• Commodity substitution bias• Outlet substitution bias

6.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Page 9: The CPI and the Cost of Living

Alternative Measures of the Price Level

1) The GDP deflator

GDP deflator = (Nominal GDP Real GDP) 100.

The inflation rate can also be calculated using the GDP deflator.

2) The personal consumption expenditures deflator(PCE deflator)

The PCE deflator is an average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices.

Idea: Is a subset of the GDP deflator.

THE CPI AND OTHER PRICE LEVEL MEASURES

Page 10: The CPI and the Cost of Living

NOMINAL AND REAL VALUES

Nominal vs Real Values

Examples 1)Nominal GDP and real GDP (recall) 2)Nominal wage rate and real wage rate

3)Nominal interest rate and real interest rate

Real interest rate = Nominal interest rate – Inflation rate

Converting from nominal to real value

Real value= nominal value/ Price Level (CPI or GDP deflator)

Converting from year T into today’s dollars

Value today= Value in yr T * ( Price level today/ Price level Yr T)

Page 11: The CPI and the Cost of Living

Use of CPI

Three good uses: calculate inflation, calculating the expected price, calculating real value.

Ex. If CPI in 2007= 150, the CPI in 1995= 120. A Nintendo costs $200 in 1995. What is the price of a Nintendo in 2007.

Price 07= (price in 95 ) X (CPI 07/ CPI 95)

Price in 07 =$200*1.52 = $250

2)Nominal wage in 2007 was $10/ hr. If 2007 CPI=150, what is the real wage. i.e the wage in base year price?

Real wage= (nominal value/CPI )*100= ($10/150)*100= $6.667