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7/28/2019 wpi cpi ppp

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Measuring the Cost of

Living


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Measuring the Cost of Living

Inflation refers to a situation in which theeconomys overall price level is rising.

The inflation rate is the percentage change in

the price level from the previous period.


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THE CONSUMER PRICE INDEX

The consumer price index (CPI) is a measureof the overall cost of the goods and servicesbought by a typical consumer.

The Bureau of Labor Statisticsreports the CPIeach month.

It is used to monitor changes in the cost ofliving over time.


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THE CONSUMER PRICE INDEX

When the CPI rises, the typical family has tospend more dollars to maintain the samestandard of living.


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How the Consumer Price Index IsCalculated

Fix the Basket: Determine what prices aremost important to the typical consumer.

The Bureau of Labor Statistics (BLS) identifies amarket basket of goods and services the typicalconsumer buys.

The BLS conducts monthly consumer surveys toset the weights for the prices of those goods andservices.


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Find the Prices: Find the prices of each ofthe goods and services in the basket for eachpoint in time.


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Compute the Baskets Cost: Use the dataon prices to calculate the cost of the basketof goods and services at different times.


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Choose a Base Year and Compute theIndex:

Designate one year as the base year, making itthe benchmark against which other years arecompared.

Compute the index by dividing the price of thebasket in one year by the price in the base yearand multiplying by 100.


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Compute the inflation rate:The inflationrate is the percentage change in the priceindex from the preceding period.


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Table Calculating the Consumer Price Index and theInflation Rate: An Example


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Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example


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Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example


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Table 1 Calculating the Consumer Price Indexand the Inflation Rate: An Example

CPI = COST OF THE BASKET IN THECURRENT YEAR/ COST OF THEBASKET IN THE BASE YEAR X 100


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Table 1 Calculating the Consumer Price Index and theInflation Rate: An Example


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Calculating the Consumer Price Index and theInflation Rate: Another Example

Base Year is 2002.

Basket of goods in 2002 costs $1,200.

The same basket in 2004 costs $1,236.

CPI = ($1,236/$1,200) 100 = 103.

Prices increased 3 percent between 2002 and2004.


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The Inflation Rate

The inflation rate is calculated as follows:

I n f l a t i o n R a t e i n Y e a r 2 =C P I i n Y e a r 2 - C P I i n Y e a r 1

C P I i n Y e a r 1 1 0 0


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Whats in the CPIs Basket?

16%Food and

beverages

17%

Transportation

Medical care

6%

Recreation

6%

Apparel

4%

Other goods

and services

4%

41%Housing

6%Education and

communication

Copyright2004 South-Western


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Problems in Measuring the Cost ofLiving

The CPI is an accurate measure of theselected goods that make up the typicalbundle, but it is not a perfect measure of thecost of living.


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Substitution bias

Introduction of new goods

Unmeasured quality changes


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Substitution Bias

The basket does not change to reflect consumerreaction to changes in relative prices.

Consumers substitute toward goods that have becomerelatively less expensive.

The index overstates the increase in cost of living by notconsidering consumer substitution.


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Introduction of New Goods

The basket does not reflect the change inpurchasing power brought on by the introductionof new products.

New products result in greater variety, which in turnmakes each dollar more valuable.

Consumers need fewer dollars to maintain any givenstandard of living.


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Unmeasured Quality Changes

If the quality of a good rises from one year to thenext, the value of a dollar rises, even if the priceof the good stays the same.

If the quality of a good falls from one year to thenext, the value of a dollar falls, even if the priceof the good stays the same.


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The substitution bias, introduction of newgoods, and unmeasured quality changescause the CPI to overstate the true cost ofliving.

The issue is important because manygovernment programs use the CPI to adjust forchanges in the overall level of prices.

The CPI overstates inflation by about 1

percentage point per year.


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The GDP Deflator versus theConsumer Price Index

The GDP deflator is calculated as follows:

G D P d e f l a t o r =

N o m i n a l G D P

R e a l G D P 1 0 0


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The BLS calculates other prices indexes:

The index for different regions within the country.

Theproducer price index, which measures the

cost of a basket of goods and services bought byfirms rather than consumers.


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Economists and policymakers monitor boththe GDP deflator and the consumer priceindex to gauge how quickly prices are rising.

There are two important differences betweenthe indexes that can cause them to diverge.


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The GDP deflatorreflects the prices of allgoods and servicesproduced domestically,whereas...

the consumer price indexreflects theprices of all goods and services bought byconsumers.


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The consumer price indexcompares theprice of a fixed basketof goods and servicesto the price of the basket in the base year(only occasionally does the BLS change the

basket)...

whereas the GDP deflatorcompares theprice ofcurrently produced goods andservices to the price of the same goods and

services in the base year.


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How is it Measured? Consumer Price Index

Wholesale Price Index


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Wholesale Price Index

WPI was published in 1902,and was one of theeconomic indicators available to policy makersuntil it was replaced by most developed countries

by the CPI market. index in the 1970. WPI is the index that is used to measure the

change in the average price level of goods tradedin wholesale market.

Some countries (like India and The Philippines)use WPI changes as a central measure ofinflation. However, India and the United Statesnow report a producer price index instead.


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Problems with WPI

In present day service sector plays a key rolein Indian economy. Consumers are spendingloads of money on services like educationand health. And these services are not

incorpated in calculation ofWPI.

WPI measures general level of price changeseither at level of wholesaler or at theproducer and does not take into account the

retail margins. Therefore we see here thatWPI does give the true picture of inflation.


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Problems with WPI WPI is supposed to measure impact of priceson business. But we use it to measure theimpact on consumers. Many commodities notconsumed by consumers get calculated in the

index.


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Weight edge to CPI & WPI


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Second Edition

International ParityRelationships &

Forecasting ExchangeRates

Chapter Objective:

This chapter examines severalkey international parityrelationships, such as interestrate parity and purchasingpower parity.


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Introduction

Exchange rates matter in many differentways to many different constituencies in theworld economy

Much of this section on international financewill be directly or indirectly concerned withexchange rates


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The Nominal Exchange Rate

Relative price of two currencies

Often expressed as number of units of local orhome currency required to buy a unit of foreigncurrency

We will usually view India (Rupees) as ourhome country and United States (dollar) asour foreign country

Nominal or currency exchange rate (e) is

If e increases the value of the rupees (homecurrency) falls

If e decreases the value of the rupees (homecurrency) rises

e and the value of the peso are inversely related

e is often graphed as its inverse which is equal to the valueof the ru ees

dollar

rupees

currencyforeign

currencylocale ==


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The Real Exchange Rate

Measures the rate at which two countriesgoods trade against each other

Makes use of the price levels in the two

countries under consideration PMoverall price level in India (the home

country)

PUSoverall price level in the United States (the

foreign country) I

US

P

Pere =


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The Real Exchange Rate Suppose that the price level in the United States rises

Takes more Indian goods to purchase US goods

Represents a fall in the real value of the Rupees

Suppose that the price level in India rises

Takes fewer Indian goods to purchase US goods

Represents a rise in the real value of the Rupees

Suppose that the nominal exchange rate increases

Takes more Indian rupees to buy a US dollar and, therefore,more Indian goods to buy US goods

Represents a fall in the real value of the Rupees

Real exchange rates affected by both nominalexchange rates and price levels


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Business and Economic Forecasting

Demand Forecasting is a critical

managerial activity which comes in two

forms:

Quantitative Forecasting +2.1047%Gives the precise amount

or percentage

Qualitative ForecastingGives the expected direction

Up, down, or about the same


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Significance of Forecasting

Both public and private enterprises operate under conditionsof uncertainty.

Management wishes to limit this uncertainty by predicting

changes in cost, price, sales, and interest rates.

Accurate forecasting can help develop strategies to promoteprofitable trends and to avoid unprofitable ones.

A forecast is a prediction concerning the future. Good

forecasting will reduce, but not eliminate, the uncertainty that

all managers feel.


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Hierarchy of ForecastsThe selection of forecasting techniques depends in part on the level of

economic aggregation involved.

The hierarchy of forecasting is:

National Econom y (GDP, interest rates, inflation, etc.)sectors of the economy(durable goods)

industry forecasts(all automobile manufacturers)

firm forecasts (Ford Motor Company)

Product forecasts (The Ford Focus)


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Direction of sales can be indicated by other variables.

TIME

Index of Capital Goods

peak

PEAK Motor Control Sales

4 Months

Example: Index of Capital Goods is a leading indicatorThere are also lagging indicators and coincident indicators

Qualitative Forecasting10. Barometric Techniques


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LEADING INDICATORS*

M2 money supply (-12.4) S&P 500 stock prices (-

11.1)

Building permits (-14.4)

Initial unemploymentclaims (-12.9)

Contracts and orders forplant and equipment (-7.4)

COINCIDENT INDICATORS

Nonagriculturalpayrolls (+.8)

Index of industrialproduction (-1.1)

Personal income lesstransfer payment (-.4)

LAGGING INDICATORS

Prime rate (+2.0)

Change in labor cost per unitof output (+6.4)

Time given in months from change


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Handling Multiple Indicators

Diffusion Index: Wall Street WithLouis Ruykeyserhas eleven analysts. If4 are negative about stocks and 7 arepositive, the Diffusion Index is 7/11, or63.3%.

above 50% is a positive diffusionindex

Composite Index: One indicator rises 4%and another rises 6%. Therefore, the Composite

Index is a 5% increase.

used for quantitative forecasting


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Econometric Models Specify the variables in the model

Estimate the parameters

single equation or perhaps several stage methods

Qd = a + bP + cI + dPs+ ePc But forecasts require estimates for future prices,

future income, etc.

Often combine econometric models withtime series estimates of the independentvariable.


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example Qd = 400 - .5P + 2Y + .2Ps

anticipate pricing the good at P = $20Income (Y) is growing over time, the

estimate is: Ln Yt = 2.4 + .03T, andnext period is T = 17.

Y = e2.910 = 18.357

The prices of substitutes are likely to be P = $18.

Find Qd by substituting in predictions for P, Y, and Ps Hence Qd = 430.31

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