macro lecture 4

8/12/2019 Macro Lecture 4

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MacroLecture4The Consumer Price Index and the Cost of

LivingLecture Highlights

Explain what the Consumer Price Index

(CPI) is and how it is calculated Explain the limitations of the CPI and

describe other measures of the price level

Adjust money values for inflation andcalculate real wage rates and real interestrates


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The Consumer Price Index

(CPI)A measure of the average of the prices

paid by urban consumers for a fixed

market basket of consumer goods andservices

The CPI is defined to equal 100 for a

period called the reference base period


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Constructing the CPI

Constructing the CPI is a huge operationthat costs millions of dollars and involves

three stages Selecting the CPI basket

Conducting the monthly price survey

Calculating the CPI


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Contd.

The CPI basketselect the CPI basket. Contains thegoods and services represented in the index and therelative importance attached to each of them.

The monthly price surveyeach month the Dept. ofStatistics check the prices of goods and services in theCPI basket.because the CPI aims to measure price changestheprices recorded each month refer to exactly the samegood/ item.

e.g. the price of a jelly beans has increased but a box nowcontains more beans. Has the price of a jelly increased?

The survey must record the details of changes in quality,size, weight or packaging so that prices changes can beisolated from other changes.


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Calculating the CPI

The CPI calculation has 3 steps:

(i) Find the cost of the CPI basket at base

period prices.

(ii) Find the cost of the CPI basket at currentperiod prices.

(iii) Calculate the CPI for the base periodand the current period.


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Contd.

Suppose the CPI basket contains only two goodsand servicesoranges & haircuts.

(a) The cost of the CPI basket at base periodprices: 2000

item qty P cost of CPI basket

__________________________________oranges 10 $1 each $10

Haircuts 5 $8 each $40

Cost of CPI at base period prices $50


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Contd.

(b) The cost of the CPI basket at currentperiod prices: 2003

Item qty P cost of CPI basket

__________________________________

Oranges 10 $2 $20

Haircuts 5 $10 $50Cost of CPI basket at current period prices $70


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Contd.

Find the CPI for 2000 and 2003

CPI = cost of CPI basket at current period prices

___________________________________ X 100cost of CPI basket at base period prices

CPI in 2000 = 50

___ X 100 = 100

50CPI in 2003 = 70

__ X 100 = 140

50


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Measuring inflation

CPI is used to measure changes in the cost ofliving and in the value of money.

To measure these changes, we calculate the

inflation ratethe percentage change in theprice level from one year to the next.

Inflation rate = CPI in current yearCPI in previous year________________________________ X 100

CPI in previous year

e.g. the current yaer 2003 CPI 2003 = 140the previous year 2003 CPI 2002 = 120

inflation rate in 2003 = 140120________ X 100 = 16.7%

120


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The CPI and the Cost of Living

CPIa cost of living index.The purpose of a cost of living index is to measure changes in the

amount of money that people would need to spend to achieve agiven standard of living.

The CPI does not measure the cost of living for 2 reasons:(i) The CPI does not try to measure all the components of the cost of

living e.g. a severe winter cause people to buy more natural gasand electricity to heat their homes. An increase in the prices ofthese items would increase the CPI, but the increased quantities

bought would not change the CPI because the CPI basket is fixed.

(i) Components of the cost of living that are measured by the CPI arenot always measured accuratelythe CPI is a biased measure ofchanges in the cost of living.


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The Biased CPI

New good bias

Quality change bias

Commodity substitution bias

Outlet substitution bias


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Contd.

New good biasnew products replacing the oldones e.g. the PC has replaced the typewriter,the DVD is replacing the videocassette player.

If you want to compare the price in 2003 with thatin 1993, you must compare the price of a DVDtoday with that of a videocassette player in 1993.

Because DVDs do a better job than videocassette

players, you are better off with the newtechnology if the prices were the same. ButDVDs are more expensive than videocassetteplayers. How much of the higher price is a signof the higher quality?


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Contd.

Quality change biascars, CD players,cameras, and many other items get better

every year e.g. central locking, airbags,and ABS all add to the quality of a car.They also add to the cost.

Is the improvement in quality greater thanthe increase in cost?

A price rise is a payment for improvedqualityit is not inflation.


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Contd.

Commodity substitution biaschanges in relative pricesi.e. consumers to change the items they buy.

People buy less on items that become relatively more

costlyincrease their consumption of items that becomerelatively less costly e.g. when the price of beef andthe price of chicken remains constant, you buy morechicken and less beef.

Suppose that you switch from beef to chickenspend thesame amount on meat as before and get the sameenjoyment as before.

The cost of meat has not changed. But the CPI shows thatthe price of meat has increased.


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Contd.

Outlet substitution biaswith higher pricespeople use discount store more frequently andconvenience stores less frequently. E.g. gasprices rise by 10 cents/gallon. Instead of buyingfrom your nearby gas station for $1.50/gallon,you now drive farther to a gas station thatcharges $1.40/gallon.

Your cost of gas has not increased by as much asthe 10 cents/gallon. However, the CPI says thatthe price of gas has increased by 10 cents/gallon.


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Two consequences of the CPI

bias It distorts private contracts

It increases government outlays

Distortion of private contractsmany wage contracts

contain a cost of living adjustment.Suppose a trade union and XYZ corporation agree on

wage rate of $28/hour that increases over 3 years at arate of 2%/ year plus the increase in the cost of living.

Suppose that over the 3 years, the CPI increases by 3%each year, but the true price increase is 1.9%/year (1.1%point bias in the CPI).

The gap between the actual and intended wage ratethewage bias.


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Contd.

Fixedincrease

(%)

CPIincrease

Wagerate($/hr)

Truepriceincreas

e

Intended wagerate

($/hr)

Wagebias($/hr)

Initially

After 1year

After 2years

After 3years

2

2

2

3

3

3

28.00

29.40

30.87

32.41

1.9

1.9

1.9

28.00

29.09

30.23

31.40

0.31

0.64

1.01


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Contd.

At the end of the 1styear, the wage raterises by 5% to 29.40 = 28 X 1.05

The intention of the contract was it toincrease by 3.9% to 29.09 = 28 X 1.039

Wage bias after 1 year = 29.4029.09 =

0.31


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Contd.

Increases in government outlaysbecause rising prices decreases the

buying power of the dollar, the CPI is usedto adjust the incomes of many sectors orgroups.


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Alternative measures of the price

level PPI (Producer Price Index) the same as CPI, but the

goods in its composition are goods that are paid byproducers of goods.

GDP deflator the most comprehensive price index. Itincludes all of the goods and services producedweighted by their relative values, as a fraction of GDP.

The PCE deflator is an average of the current prices ofthe goods and services included in the consumptionexpenditure component of GDP expressed as apercentage of base-year prices.


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Nominal and Real Values

In 2002, it cost 37 cents to mail a firstclass letter. 100 years earlier, in 1902 that

same letter would have cost 2 cents tomail. Does it really cost you 18.5 times theamount that it cost your great-grandmother

to mail a letter?


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Dollars and cents at different

datesTo compare dollar amounts at differentdates, we need to know the CPI at thosedates.

Formula:Price of good in year B dollars

= price of good in year A dollars X CPI in year B

__________CPI in year A


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Contd.

E.g. In 2002, the CPI was 180.3, and in 1902, itwas 9.

Price of stamp in 2002 dollars

= price of stamp in 1902 X CPI in 2002_________CPI in 1902

= 2 cents X 180.3_____ = 40 cents

9It cost your great-grandmother more to mail that 1st

class letter than it cost you in 2002.


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Nominal and Real wage Rates

Nominal wage ratethe average hourly wage ratemeasured in current dollars.

Real wage ratethe average hourly wage ratemeasured in the dollars of a given referencebase year.

e.g. In June 2002, the nominal wage rate of

production workers was $14.68 and the CPI was179.9.

Real wage rate in June 2002= 14.68_____ X 100 = $8.16

179.9


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Nominal and Real Interest

Rates Nominal interest ratethe percentage

return on a loan, calculated by using

dollars. Real interest ratethe percentage return

on a loan, calculated by using purchasing

powerthe nominal interest rate adjustedfor the effects of inflation.

Real interest rate = nominal interest rateinflation rate


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Contd.

e.g. Suppose that you have $100 in a bankaccount and that after 1 year, you take

your money out of the bank. The bankpays you the $100 + $5 interest (at 5% ayear). During the year, prices haveincreased by 3 %. Youve now got $105,

but you need $103 to buy what $100 at thetime when you put your money in thebank. You have earned $2real interestrate = 2%.

macro lecture 4

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