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Unformatted text preview: INSTRUCTOR COMMENTARY Chapter Reference: Chapter 7 Measuring the Price Level and the Rate of Inflation 1. Chapter 7 focuses on the following important topics: A. The distinction between changes in relative prices and changes in the absolute price level. Changes in relative prices occur when the prices of different products do not change proportionately. Changes in the absolute price level occur when the average price level changes. (text, p. 173) B. How changes in the “average” price level may be calculated. Changes in the average price level may be calculated, for example, by adding up the percentage changes in prices and dividing by the number of prices. We label this measure a “simple” average of price changes. This simple average, however, does not accurately reflect changes in the cost of living for individuals or families because it does not account for the fact that households spend very different proportions of their budgets on different goods (and services). In order to correctly measure cost-of-living changes, we must calculate a “weighted” average of the percentage changes in prices, where the weights are the relative importance of each item in the household’s budget. (text, pp. 174-176) C. Why a weighted average of percentage price changes accurately measures changes in the cost-of-living. A weighted average of percentage price changes accounts for the relative importance of the item in the typically household’s budget. For example, if you spend 50% of your budget on Product A, and the P(A) rises by 40%, then the purchasing power of your entire budget has declined by 20% (that is, 50% * 40% = 20%). On the other hand, if the Price of B rises by 100% but you spend none of your budget on B, then the increase in the P(B) has no impact on the purchasing power of your budget (that is, 100% * 0% = 0%). D. How the Consumer Price Index (CPI) is calculated. 1 The CPI is calculated as a weighted average of the percentage changes in prices of a “market basket” of goods selected to represent the expenditure patterns of a “typical” urban household. These percentage changes are “weighted” by the relative importance of each item in the typical household’s budget to calculate the change in the cost-of-living. This procedure is equivalent to calculating the ratio of total expenditures on a fixed market-basket of goods using current year (or month) prices to total expenditures on the same market-basket of goods using base year prices. See section 3B below for a numerical example. (text, pp. 174-176) E. Limitations of the CPI as a measure of the cost-of-living. The CPI may not precisely measure changes in the cost of living because: (1) the CPI assumes that households purchase a fixed basket of goods even though relative prices are changing; (2) the CPI does not fully account for changes (either increases or decreases) in product quality; and (3) the expenditure weights used in the CPI may not accurately reflect how an individual household...
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