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Basic+Macroeconomic+Concepts+-+II

# Basic+Macroeconomic+Concepts+-+II - Basic Macroeconomic...

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Basic Macroeconomic Concepts - II

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Inflation Rate The Consumer Price Index (CPI) measures the typical consumer’s cost of living the basis of cost of living adjustments (COLAs) in many contracts and in Social Security 0
How the CPI Is Calculated 1. Fix the “basket.” The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.” 2. Find the prices. The BLS collects data on the prices of all the goods in the basket. 3. Compute the basket’s cost. Use the prices to compute the total cost of the basket. 0

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How the CPI Is Calculated 1. Choose a base year and compute the index. The CPI in any year equals 1. Compute the inflation rate. The percentage change in the CPI from the preceding period. 100 x cost of basket in current year cost of basket in base year CPI this year CPI last year CPI last year Inflation rate x 100% = 0
EXAMPLE basket: {4 pizzas, 10 lattes} \$12 x 4 + \$3 x 10 = \$78 \$11 x 4 + \$2.5 x 10 = \$69 \$10 x 4 + \$2 x 10 = \$60 cost of basket \$3.00 \$2.50 \$2.00 price of latte \$12 2009 \$11 2008 \$10 2007 price of pizza year Compute CPI in each year 2007: 100 x (\$60/\$60) = 100 2008: 100 x (\$69/\$60) = 115 2009: 100 x (\$78/\$60) = 130 Inflation rate: 0 15% 115 100 100 x 100% = 13% 130 115 115 x 100% = using 2007 base year:

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Calculat Calculat e the CPI e the CPI 6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost \$120 in 2004, the base year. A. Compute the CPI in 2005. B. What was the CPI inflation rate from 2005-2006? 0 price of beef price of chicken 2004 \$4 \$4 2005 \$5 \$5 2006 \$9 \$6
Answers Answers 7 0 A. Compute the CPI in 2005: Cost of CPI basket in 2005 = (\$5 x 10) + (\$5 x 20) = \$150 CPI in 2005 = 100 x (\$150/\$120) = 125 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost \$120 in 2004, the base year. price of beef price of chicken 2004 \$4 \$4 2005 \$5 \$5 2006 \$9 \$6

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Answers Answers 8 0 price of beef price of chicken 2004 \$4 \$4 2005 \$5 \$5 2006 \$9 \$6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost \$120 in 2004, the base year. B. What was the inflation rate from 2005-2006? Cost of CPI basket in 2006 = (\$9 x 10) + (\$6 x 20) = \$210 CPI in 2006 = 100 x (\$210/\$120) = 175 CPI inflation rate = (175 – 125)/125 = 40%
What’s in the CPI’s Basket? 43% 17% 15% 6% 6% 6% 4% 3% Housing Transportation Food & Beverages Medical care Recreation Education and communication Apparel Other 0

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CPI basket: {10# beef, 20# chicken} 2004-5: Households bought CPI basket. 2006: Households bought {5 lbs beef, 25 lbs chicken}. Substitution bias Substitution bias 10 beef chicken cost of CPI basket 2004 \$4 \$4 \$120 2005 \$5 \$5 \$150 2006 \$9 \$6 \$210 A. Compute cost of the 2006 household basket. B. Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate. 0
Answers Answers 11 A. Compute cost of the 2006 household basket. (\$9 x 5) + (\$6 x 25) = \$195 CPI basket: {10# beef, 20# chicken} Household basket in 2006: {5# beef, 25# chicken} beef chicken cost of CPI basket 2004 \$4 \$4 \$120 2005 \$5 \$5 \$150 2006 \$9 \$6 \$210

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Answers Answers 12 B. Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate. Rate of increase: (\$195 – \$150)/\$150 = 30% CPI inflation rate from previous problem = 40% CPI basket: {10# beef, 20# chicken} Household basket in 2006: {5# beef, 25# chicken} beef chicken cost of CPI basket 2004 \$4 \$4 \$120 2005 \$5 \$5 \$150 2006 \$9 \$6 \$210
Problems with the CPI:   Substitution Bias Over time, some prices rise faster than others.

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