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Chapter 11: Measuring the Cost of Living

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Chapter 11: Measuring the Cost of Living

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    1. Chapter 11: Measuring the Cost of Living

    3. Outline LR Standard of Living depends on real income growth. How do we “deflate” our nominal income figures? Real vs. Nominal Income CPI Real Interest Rates: “The true value of saving.”

    4. Inflation 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. BLS www.bls.gov

    5. How the Consumer Price Index Is Calculated 1. Fix the basket. Determine what prices are most important to the typical consumer. The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

    6. FYI: What Is in the CPI’s Basket?

    7. How the Consumer Price Index Is Calculated 2. Find the prices. Find the prices of each of the goods and services in the basket for each point in time. 3. Compute the basket’s cost. Use the data on prices to calculate the cost of the basket of goods and services at different times.

    8. How the Consumer Price Index Is Calculated 4. Choose a base year and compute the index. 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.

    9. How the Consumer Price Index Is Calculated 5. Compute the inflation rate. The inflation rate is the percentage change in the price index from the preceding period.

    10. How the Consumer Price Index Is Calculated The inflation rate is calculated as follows:

    11. Calculating the Consumer Price Index and the Inflation Rate

    12. Calculate the Stones River Price Index Average family in a year eats (2008 prices) 100 BBQ Pork Samiches at $1.50 each 30 dozen Slick Pig Wings at $10.00 each 25 Publix subs at $6.00. What is the S.R. Price Index (Base year=2008) today?

    13. S.R. Price Index 2009 BBQ Pork $1.75 Wings $9.75 Publix Subs $7 What is the SR .P.I. next year? How much inflation has occurred?

    14. 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. Substitution bias Introduction of new goods Unmeasured quality changes

    15. Problems in Measuring the Cost of Living The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. The CPI overstates inflation by about 1 percentage point per year.

    16. Finding Real Incomes We will assume inflation is the natural state. Realistically, it always happening.

    17. How to inflate past income values to find real income today

    18. Practice with Inflation Adjustments http://boxofficemojo.com/alltime/adjusted.htm http://boxofficemojo.com/about/adjuster.htm

    19. What is an Interest Rate? Payment for the use of funds. Would you rather have $1 today or $1 in a year (even with zero inflation)? How much more would you need to forgo the $1 today?

    20. Nominal vs. Real Interest Interest is payment for the use of money. If you are going to give up consumption today, you want to be able to buy at least as much in the future. $1 lent today=>$1 plus interest tomorrow. Interest must be at least large enough to cover the rising prices. At least the same number of real dollars are needed when the money is repaid.

    21. Real and Nominal Interest Rates The nominal interest rate is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays. The real interest rate is the interest rate that is corrected for the effects of inflation.

    22. Real and Nominal Interest Rates You borrowed $1,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 15% – 10% = 5%

    23. Winners and Losers Which party benefits from inflation? …….from deflation?

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