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### ch06

Course: ECON 101, Spring 2011
School: Carleton University
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Word Count: 1731

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the 6 Measuring Cost of Living PRINCIPLES OF MACROECONOMICS FOURTH CANADIAN EDITION N. G R E G O R Y M A N K I W R O N A L D D. K N E E B O N E K E N N E T H J. M c K ENZIE NICHOLAS ROWE PowerPoint Slides by Ron Cronovich Canadian adaptation by Marc PrudHomme 2008 Nelson Education Ltd. In this chapter, look for the answers to these questions: What is the Consumer Price Index (CPI)? How is it calculated? Whats...

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the 6 Measuring Cost of Living PRINCIPLES OF MACROECONOMICS FOURTH CANADIAN EDITION N. G R E G O R Y M A N K I W R O N A L D D. K N E E B O N E K E N N E T H J. M c K ENZIE NICHOLAS ROWE PowerPoint Slides by Ron Cronovich Canadian adaptation by Marc PrudHomme 2008 Nelson Education Ltd. In this chapter, look for the answers to these questions: What is the Consumer Price Index (CPI)? How is it calculated? Whats it used for? What are the problems with the CPI? How serious are they? How does the CPI differ from the GDP deflator? How can we use the CPI to compare dollar amounts from different years? Why would we want to do this, anyway? How can we correct interest rates for inflation? 2008 Nelson Education Ltd. 1 The Consumer Price Index (CPI) Inflation refers to a situation in which the economys Inflation overall price level is rising. The inflation rate is the percentage change in the price level from the previous period. The consumer price index (CPI) is a measure of the consumer overall cost of the goods and services bought by a typical consumer. Statistics Canada reports the CPI each month. It is used to monitor changes in the cost of living over time. 2008 Nelson Education Ltd. 2 1 How the CPI Is Calculated Determine the Basket: Determine what prices are most important to the typical consumer. If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important and is given more weight in measuring the cost of living. Statistics Canada sets these weights by surveying consumers to find out the basket of goods the typical consumer buys 3 2008 Nelson Education Ltd. How the CPI Is Calculated Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. Compute the Baskets Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. 4 2008 Nelson Education Ltd. How the CPI Is Calculated Choose a Base Year and Compute the Index: Choose Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. cost of basket in current year 100 x cost of basket in base year 2008 Nelson Education Ltd. = CPI 5 2 How the CPI Is Calculated Compute the inflation rate. The percentage change in the CPI from the preceding period. inflation = rate CPI this year CPI last year CPI last year x 100% 6 2008 Nelson Education Ltd. EXAMPLE basket: {4 pizzas, 10 lattes} year price of pizza price of latte 2004 $10$2.00 $10 x 4 +$2 x 10 2005 $11$2.50 $11 x 4 +$2.5 x 10 = $69 2006$12 $3.00$12 x 4 + $3 x 10 cost of basket Compute CPI in each year: =$78 Inflation rate: 2004: 100 x ($60/$60) = 100 = $60 15% 2005: 100 x ($69/$60) = 115 13% 2006: 100 x ($78/$60) = 130 7 2008 Nelson Education Ltd. ACTIVE LEARNING Calculate the CPI Calculate The basket contains 20 movie tickets and 10 textbooks. The table shows their prices for 2004-2006. 1: movie tickets textbooks 2004$10 $50 2005$10 $60 2006$12 $60 The base year is 2004. A. How much did the basket cost in 2004? B. What is the CPI in 2005? C. What is the inflation rate from 2005-2006? 8 3 ACTIVE LEARNING Answers Answers The basket contains 20 movie tickets and 10 textbooks. A. How much did the basket cost in 2004? 1: movie tickets textbooks 2004$10 $50 2005$10 $60 2006$12 $60 ($10 x 20) + ($50 x 10) =$700 9 ACTIVE LEARNING Answers Answers The basket contains 20 movie tickets and 10 textbooks. B. What is the CPI in 2005? 1: movie tickets textbooks 2004 $10$50 2005 $10$60 2006 $12$60 cost of basket in 2005 = ($10 x 20) + ($60 x 10) = $800 CPI in 2005 = 100 x ($800/$700) = 114.3 10 ACTIVE LEARNING Answers Answers The basket contains 20 movie tickets and 10 textbooks. C. What is the inflation rate from 2005-2006? 1: movie tickets textbooks 2004$10 $50 2005$10 $60 2006$12 $60 cost of basket in 2006 = ($12 x 20) + ($60 x 10) =$840 CPI in 2006 = 100 x ($840/$700) = 120 Inflation rate = (120 114.3)/114.3 = 5% 11 4 FYI: Whats in the CPIs Basket? Recreation, education and reading 12% Alcoholic beverages and tobacco products 3% Food 17% Health and personal care 5% Transportation 20% Shelter 27% Clothing and footwear 5% Household operations and furnishings 11% 2008 Nelson Education Ltd. 12 How the CPI Is Calculated Statistics Canada computes many other indexes CPI for each province For 16 cities Food Clothing Core inflation: Measure of the underlying trend in inflation. 2008 Nelson Education Ltd. 13 Problems in Measuring the Cost of Living The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. Three problems with the index are widely acknowledged but difficult to solve Substitution bias Introduction of new goods Unmeasured quality changes 2008 Nelson Education Ltd. 14 5 Problems With the CPI: Substitution Bias Over time, some prices rise faster than others. Consumers substitute toward goods that become relatively cheaper. The CPI misses this substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living. 2008 Nelson Education Ltd. 15 Problems With the CPI: Introduction of New Goods When new goods become available, variety increases, allowing consumers to find products that more closely meet their needs. This has the effect of making each dollar more valuable. The CPI misses this effect because it uses a fixed basket goods. Thus, of the CPI overstates increases in the cost of living. 2008 Nelson Education Ltd. 16 Problems With the CPI: Unmeasured Quality Change Improvements in the quality of goods in the basket increase the value of each dollar. Statistics Canada tries to account for quality changes,but probably misses some quality improvements, as quality is hard to measure. Thus, the CPI overstates increases in the cost of living. 2008 Nelson Education Ltd. 17 6 Problems With the CPI Each of these problems causes the CPI to overstate cost of living increases. Statistics Canada has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year. This is important, because many government programs and many contracts have COLAs tied to the CPI. 2008 Nelson Education Ltd. 18 The GDP Deflator versus the Consumer Price Index The GDP deflator reflects the current level of prices relative to the level of prices in the base year. is monitored by economists to gauge how quickly prices are rising is calculated as follows: GDP deflator = Nominal GDP 100 Real GDP 2008 Nelson Education Ltd. 19 Contrasting the CPI and GDP Deflator Imported consumer goods: Imported consumer goods: included in CPI included in CPI excluded from GDP deflator excluded from GDP deflator Capital goods: Capital goods: excluded from CPI excluded from CPI included in GDP deflator (if included in GDP deflator (if produced domestically) produced domestically) The basket: The basket: CPI uses fixed basket CPI uses fixed basket GDP deflator uses basket of GDP deflator uses basket of currently produced goods & services currently produced goods & services This matters if different prices are This matters if different prices are changing by different amounts. changing by different amounts. 2008 Nelson Education Ltd. 20 7 Contrasting the CPI and GDP Deflator 2008 Nelson Education Ltd. ACTIVE LEARNING CPI vs. GDP deflator CPI 21 2: In each scenario, determine the effects on the CPI and the GDP deflator. A. Starbucks raises the price of Frappuccinos. B. Canadian Machinery Corp. raises the price of its precision tools it manufactures at its Kitchener plant. C. Armani raises the price of the Italian jeans it sells in Canada 22 ACTIVE LEARNING Answers Answers 2: A. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B. Canadian Machinery Corp. raises the price of its precision tools it manufactures at its Kitchener plant. The GDP deflator rises, the CPI does not. C. Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not. 23 8 CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times. 24 2008 Nelson Education Ltd. Comparing Dollar Figures from Different Times Inflation makes it harder to compare dollar amounts from different times. We can use the CPI to adjust figures so that they can be compared. 25 2008 Nelson Education Ltd. EXAMPLE: The High Price of Gasoline Do the following to convert (inflate) the price of gas in 1957 to dollars in 2003: 1957 gas price in 1997 dollars = 1957 gas price x CPI in 2003 CPI in 1957 = 9.5 cents x (122/17.6) = 65.8 cents 2008 Nelson Education Ltd. 26 9 ACTIVE LEARNING Exercise Exercise 3: 1980: CPI = 90, avg starting salary for econ majors = $24,000 Today: CPI = 180, avg starting salary for econ majors =$50,000 Are econ majors better off today or in 1980? 27 ACTIVE LEARNING Answers Answers 3: 1980: CPI = 90, avg starting salary for econ majors = $24,000 Today: CPI = 180, avg starting salary for econ majors =$50,000 Solution Convert 1980 salary into todays dollars $24,000 x (180/90) =$48,000. After adjusting for inflation, salary is higher today than in 1980. 28 Correcting Variables for Inflation: Indexation A dollar amount is indexed for inflation indexed if it is automatically corrected for inflation by law or in a contract. For example, the increase in the CPI automatically determines the COLA in many multi-year labour contracts Tax brackets the adjustments in Canada Pension Plan and Social Security benefits are adjusted annually. 2008 Nelson Education Ltd. 29 10 Case Study: Mr. Index Goes to Hollywood 2008 Nelson Education Ltd. 30 Correcting Variables for Inflation: Real vs. Nominal Interest Rates The nominal interest rate: the interest rate not corrected for inflation the rate of growth in the dollar value of a deposit or debt The real interest rate: corrected for inflation the rate of growth in the purchasing power of a deposit or debt Real interest rate = (nominal interest rate) (inflation rate) 2008 Nelson Education Ltd. 31 Real and Nominal Interest Rates: EXAMPLE Deposit $1,000 for one year. Nominal interest rate is 9%. During that year, inflation is 3.5%. Real interest rate = Nominal interest rate Inflation = 9.0% 3.5% = 5.5% The purchasing power of the$1000 deposit has grown 5.5%. 2008 Nelson Education Ltd. 32 11 Real and Nominal Interest Rates 2008 Nelson Education Ltd. 33 CHAPTER SUMMARY The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumers basket of goods & services. The CPI is used to make Cost of Living Adjustments, and to correct economic variables for the effects of inflation. The real interest rate is corrected for inflation, and is computed by subtracting the inflation rate from the nominal interest rate. 2008 Nelson Education Ltd. 34 End: Chapter 6 2008 Nelson Education Ltd. 35 12
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