CHAPTER 24 “PRINCIPLES OF [CS sregory Man Premium PowerPoint Slides by Ron Cronovich 2011 © 201 South-Western, a part of Cengage Learning, all rights reserved updateWhat is the Consumer Price Index (CPI)? How is it calculated? What's 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?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 MEASURING THE COST OF LIVING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. MEASURING THE COST OF LIVINGHow the CPI Is Calculated 4. Choose a base year and compute the index. The CPI in any year equals cost of basket in current year 100 ——.2 Le «cost of basket in base year 5. Compute the inflation rate. The percentage change in the CPI from the preceding period. Inflation CPI this year — CPI last year = x 100% rate CPI last year . ° MEASURING THE COST OF LIVINGEXAMPLE basket: {4 pizzas, 10 lattes} price of | price of pizza latte 2007 $10 $2.00 | $10x4 + $2x10 = $60 2008 $11 $2.50 | $11x4 +$2.5x10 = $69 2009 $12 $3.00 | $12x4 + $3x10 = $78 year cost of basket Compute CPI in each year usingr@@giétpaste year: 2007: 100 x ($60/$60) = 100 2008: 100 x ($69/$60) = 115 2009: 100 x ($78/$60) = 130 _ 115-100 > 15% ="759 x 100% 130-115 ° 18% =" Ga x 100% MEASURING THE COST OF LIVINGACTIVE LEARNING Z£ Calculate the CPI price | prog af CPI basket: of beef| chicken {10 lbs beef, 2004 $4 $4 20 Ibs chicken} The CPI basket cost $120 in 2004, the base year. 2005 | $5 $5 2006 | $9 $6 A. Compute the CPI in 2005. B. What was the CPI inflation rate from 2005-2006?ACTIVE LEARNING Z£ Answers price | price of CPI basket: of beef| chicken {10 lbs beef, 2004 | $4 $4 20 Ibs chicken} 2005 | $5 $5 The CPI basket cost $120 in 2004, the base year. 2006 $9 $6 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ACTIVE LEARNING Z£ Answers price | price of CPI basket: of beef| chicken {10 lbs beef, 2004 | $4 $4 20 Ibs chicken} 5 5 - The CPI basket cost $120 ots $ $ in 2004, the base year. 2006 | $9 $6 B. What was the inflation rate from 2005-2006? Cost of CPI basket in 2006 = ($9 x 10) + ($6 x 20) = $210 CPlin 2006 = 100 x ($210/$120) = 175 CPlinflation rate = (175 -125)/125 = 40%What’s in the CPI’s Basket? 4% 3% 43% 17% MEASURING THE COST OF LIVING @ Housing @ Transportation @ Food & Beverages G Medical care @ Recreation a Education and communication @ Apparel @ OtherACTIVE LEARNING 2 Substitution bias CPI basket: cost of CPI {10# beef, beef | chicken basket 20# chicken} 2004| $4 $4 $120 2004-5: 2005; $5 | $5 $150 Households bought CPI basket. |2006| $9 | $6 | $210 2006: Households bought {5 lbs beef, 25 lbs chicken}. A. Compute cost of the 2006 household basket. B. Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate.ACTIVE LEARNING 2 Answers CPI basket: {10# beef, 20# chicken} Household basket in 2006: {5# beef, 25# chicken} . cost of CPI beef | chicken basket 2004| $4 $4 $120 2005 | $5 $5 $150 2006| $9 $6 $210 A. Compute cost of the 2006 household basket. ($9 x 5) + ($6 x 25) = $195ACTIVE LEARNING 2 Answers CPI basket: {10# beef, 20# chicken} Household basket in 2006: {5# beef, 25# chicken} . cost of CPI beef | chicken basket 2004| $4 $4 $120 2005 | $5 $5 $150 2006| $9 $6 $210 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% 12Problems with the CPI: Substitution Bias = Over time, some prices rise faster than others. = Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. = The CPI misses this substitution because it uses a fixed basket of goods. = Thus, the CPI overstates increases in the cost of living. MEASURING THE COST OF LIVINGProblems with the CPI: Introduction of New Goods = The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. = In effect, dollars become more valuable. = The CPI misses this effect because it uses a fixed basket of goods. = Thus, the CPI overstates increases in the cost of living. MEASURING THE COST OF LIVINGProblems with the CPI: Unmeasured Quality Change = Improvements in the quality of goods in the basket increase the value of each dollar. = The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. = Thus, the CPI overstates increases in the cost of living. MEASURING THE COST OF LIVINGProblems with the CPI = Each of these problems causes the CPI to overstate cost of living increases. = The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year. = This is important because Social Security payments and many contracts have COLAs tied to the CPI. MEASURING THE COST OF LIVINGPercent per year Two Measures of Inflation, 1950-2010 15 10 5 - 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 —CPI —GDP deflatorContrasting the CPI and GDP Deflator Imported consumer goods: = included in CPI = excluded from GDP deflator Capital goods: = excluded from CPI = included in GDP deflator (if produced domestically) The basket: = CPI uses fixed basket = GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. MEASURING THE COST OF LIVINGACTIVE LEARNING 3 CPI vs. GDP deflator In each scenario, determine the effects on the CPI and the GDP deflator. A. Starbucks raises the price of Frappuccinos. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. Cc. Armani raises the price of the Italian jeans it sells in the U.S.ACTIVE LEARNING 3 Answers A. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. Cc. Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not. 20Correcting Variables for Inflation: Comparing Dollar Figures from Different Times = Inflation makes it harder to compare dollar amounts from different times. = Example: the minimum wage = $1.15 in Dec 1964 = $7.25 in Dec 2010 = Did min wage have more purchasing power in Dec 1964 or Dec 2010? = To compare, use CPI to convert 1964 figure into “today’s dollars”... MEASURING THE COST OF LIVING alCorrecting Variables for Inflation: Comparing Dollar Figures from Different Times _Amount ‘Amount Price level today intoday’s = inyearT x —WWH—— dollars dollars Price level in year T = In our example, = “year T’ is 12/1964, “today” is 12/2010 = Min wage was $1.15 in year T = CPI = 31.3 in year T, CPI = 220.3 today The minimum wage 220.3 2 in 1964 was $8.09 $8.09 = $1.15 “373 in today’s (2010) dollars. MEASURING THE COST OF LIVING 22Correcting Variables for Inflation: Comparing Dollar Figures from Different Times = Researchers, business analysts and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures. = They can then see how a variable has changed over time after correcting for inflation. = Example: the minimum wage, from Jan 1950 to Dec 2010... MEASURING THE COST OF LIVING 23Dollars per hour The U.S. Minimum Wage in Current Dollars and Today’s Dollars, 1960-2010 $12.00 2010 dollars $10.00 $8.00 $6.00 $4.00 $2.00 current dollars $0.00 - 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010ACTIVE LEARNING 4 Comparing tuition increases Tuition and Fees at U.S. Colleges and Universities 1990 2010 Private non-profit 4-year $9,340 $27,293 Public 4-year $1,908 $7,605 Public 2-year $906 $2,713 CPI 130.7 218.1 Instructions: Express the 1990 tuition figures in 2010 dollars, then compute the percentage increase for all three types of schools. Which type experienced the largest increase in real tuition costs?ACTIVE LEARNING 4 Answers 1990 2010 % change CPI 130.7 218.1 66.9% Private non-profit 4-year (current $) $9,340 | $27,293 Private non-profit 4-year 6 (2010 $) $15,586 | $27,293 75.1% Public 4-year (current $) $1,908 $7,605 Public 4-year (2010 $) $3,184 $7,605 138.9% Public 2-year (current $) $906 $2,713 Public 2-year (2010 $) $1,512 | $2,713 | 79.4%Correcting Variables for Inflation: Indexation A dollar amount is indexed for inflation 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 labor contracts = adjustments in Social Security payments and federal income tax brackets MEASURING THE COST OF LIVING 27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) MEASURING THE COST OF LIVING 28Correcting Variables for Inflation: Real vs. 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% = 55% = The purchasing power of the $1000 deposit has grown 5.5%. MEASURING THE COST OF LIVING 29Interest rate (percent per year) Real and Nominal Interest Rates in the U.S., 15% - 10% 5% 0% -5% -10% + 1950-2010 1950 1955 1960 1965 1970 1975 1980 1985 1990 1 —Nominal —Real 995 2000 2005 2010=" The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumer's “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. 31