Lec-3 - Chapter 24 - Cost of Living.ppt

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Measuring the Cost of Living
Inflation refers to a situation in which the
economy’s overall price level is rising.
The inflation rate is the percentage
change in the price level from the
previous period.

The Consumer Price Index
measure of the overall cost of the goods
and services bought by a typical
consumer.
the CPI each month.
of living over time.

The Consumer Price Index
living.

How the Consumer Price Index Is
Calculated
are most important to the typical
consumer.
identifies a mar&et bas&et of goods and
services the typical consumer buys.
The !" conducts monthly consumer
those goods and services.

Calculated
of the goods and services in the bas&et
for each point in time.

Calculated
different times.

Calculated
Index 'esignate one year as the base year$ ma&ing
it the benchmar& against which other years
are compared.
Compute the index by dividing the price of
the bas&et in one year by the price in the
base year and multiplying by +,,.

Calculated
inflation rate is the percentage change
in the price index from the preceding
period.

The Inflation Rate
100 1 YearinCPI
The inflation rate is calculated as follows

Calculating the Consumer Price Index and
the Inflation Rate !n "xample
#tep $#urve% Consumers to &etermine a 'ixed
(as)et of *oods

Calculating the Consumer Price Index and the
Inflation Rate !n "xample
Price o Hamburgers
2001 $1 $2
2002 $2 $3
2003 $3 $4

Calculating the Consumer Price Index and
the Inflation Rate !n "xample
2001 ($1 per hot dog x 4 hot dogs) + ($2 per hamburger x 2 hamburgers) = $8
2002 ($2 per hot dog x 4 hot dogs) + ($3 per hamburger x 2 hamburgers) =$14
2003 ($3 per hot dog x 4 hot dogs) + ($4 per hamburger x 2 hamburgers) =$20
#tep , Compute the Cost of the (as)et of *oods
in "ach +ear

#tep 4 Choose -ne +ear as the (ase +ear .2//$0 and
Compute the Consumer Price Index in "ach +ear
2001 ($8/$8) x 100 = 100
2002 ($14/$8) x 100 = 17
2003 ($20/$8) x 100 = 20

#tep 1 se the Consumer Price Index to Compute the
Inflation Rate from Previous +ear

Inflation Rate !nother "xample
The same bas&et in 0,,, costs /+$012.
CPI 3 (/+$0124/+$0,,) 5 +,, 3 +,1.
Prices increased 1 percent between +--
and 0,,,.

*&P &eflator
100 #$PRea%

-ther Price Indexes
The !" calculates other prices indexes The index for different regions within the country.
The producer price index$ which measures the cost of a bas&et of goods and services
bought by firms rather than consumers.

Housing
Food/Beverages
Transportation
40!40!
1(!1(!
17!17!
(!(!
!! (!(!
!! !!

Pro6lems in Measuring The Cost
of Living
of the cost of living.

Pro6lems in Measuring The Cost
of Living
"ubstitution bias

#u6stitution (ias
consumer reaction to changes in relative
prices.
The index overstates the increase in cost of
living by not considering consumer
substitution.

Introduction of 7ew *oods
purchasing power brought on by the
introduction of new products.
in turn ma&es each dollar more valuable.
Consumers need fewer dollars to maintain
any given standard of living.

nmeasured 8ualit% Changes
the same.
If the 7uality of a good falls from one year
to the next$ the value of a dollar falls$ even
if the price of the good stays the same.

nmeasured 8ualit% Changes
for constant 7uality$ but such
differences are hard to measure.

Pro6lems in Measuring the Cost of
Living
the CPI to overstate the true cost of living.
The issue is important because many government
programs use the CPI to ad9ust for changes in the
overall level of prices.
percentage point per year.

The *&P &eflator versus the
Consumer Price Index
both the 6'P deflator and the
consumer price index to gauge how
7uic&ly prices are rising.
There are two important differences
between the indexes that can cause
them to diverge.

all goods and services produced
domestically$ whereas...
prices of all goods and services bought
by consumers.

a fixed basket of goods and services to the price
of the bas&et in the base year (only occasionally
does the !" change the bas&et)...
;whereas the 6'P deflator compares the price
of currently produced goods and services to the
price of the same goods and services in the base
year.

$9:1
Percent
CPI

&ollar 'igures
comparing dollar figures from

&ollar 'igures
<uth’s wages in +-1+ to dollars in +--=
1)"1in%e*e%Price

&ollar 'igures from &ifferent
<uth’s wages in +-1+ to dollars in +--=
$87"(84'
×
×

The Most Popular Movies of !ll Time=
Inflation !d>usted
2* .tar -ars 1)77 7)8
3* &he .ou(d o /us!' 1)5 38
4* &!ta(!' 1))7 01
* &he &e( omma(dme(ts 1)5 587
7* a,s 1)75 574
)* &he u(g"e oo9 1)7 485

Indexation
automatically corrected for inflation
to be indexed for inflation.

Real and 7ominal Interest Rates
Interest represents a payment
money in the past.

The nominal interest rate is the interest
rate not corrected for inflation.
It is the interest rate that a ban& pays.
The real interest rate is the nominal
interest rate that is corrected for inflation.
Rea% interest rate ' /&omina% interest
rate Infation rate

*ou borrowed /+$,,, for one year.
8ominal interest rate was +=>.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%

$9:1
&omina%

#ummar%
of a bas&et of goods and services relative
to the cost of the same bas&et in the base
year.
level of prices in the economy.
The percentage change in the CPI
measures the inflation rate.

#ummar%
measure of the cost of living for the
following three reasons substitution
unmeasured changes in 7uality.
CPI overstates annual inflation by about
+ percentage point.

#ummar%
because it includes goods and services
produced rather than goods and services
consumed.
of goods$ while the 6'P deflator
automatically changes the group of
goods and services over time as the
composition of 6'P changes.

#ummar%
comparison of purchasing power.
price indexes to correct for the effects
of inflation.
nominal interest rate minus the rate of
inflation.

6raphical
<eview

3hats in the CPIs (as)et5
Housing
Food/Beverages
Transportation
(!(!
!! (!(!
!! !!

Two Measures of Inflation
CPI

$9:1
&omina%

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Lec-3 - Chapter 24 - Cost of Living.ppt