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Chapter 9: Measuring the Cost of Living Notes by Gritchen (26/06/21) -…
Chapter 9: Measuring the Cost of Living
Notes by Gritchen (26/06/21)
The Consumer Price Index
Definition:
a measure of the overall cost of the goods and services bought by a typical consumer.
reported by The Department of Statistics every month.
is used to monitor changes in the cost of living over time.
When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.
CPI Calculation
Fix the Basket:
Determine what prices are most important to the typical consumer
The Department of Statistics (DOS) identifies a market basket of goods and services the typical consumer buys.
The DOS conducts monthly consumer surveys to set the weights for the prices of those goods and services.
Find the Prices:
Find the prices of each of the goods and services in the basket for each point in time.
Compute the Basket’s Cost:
Use the data on prices to calculate the cost of the basket of goods and services at different times.
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.
Compute the inflation rate:
The inflation rate is the percentage change in the price index from the preceding period.
The Inflation Rate
Problems in Measuring
the Cost of Living
Substitution bias:
The basket does not change to reflect consumer reaction to changes in relative prices.
Consumers substitute toward goods that have become relatively less expensive.
The index overstates the increase in cost of living by not considering consumer substitution.
Introduction of New Goods
The basket does not reflect the change in purchasing power brought on by the introduction of new products
New products result in greater variety, which in turn makes each dollar more valuable.
Consumers need fewer dollars to maintain any given standard of living.
Unmeasured Quality Changes
If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same.
If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.
The Bureau of Labor Statistics (BLS) tries to adjust the price for constant quality, but such differences are hard to measure.
The GDP Deflator vs
the Consumer Price Index
The DOS calculates other prices indexes:
The index for different regions within the country.
The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.
The GDP deflator reflects the prices of all goods and services produced domestically where as the consumer price index reflects the prices of all goods and services bought by consumers.
the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year where as The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the DOS change the basket)
Correcting Economic Variables for
the Effects of Inflation
Comparing dollar figures from different times.
Indexation
When some dollar amount is automatically corrected for inflation by law or contract,
Real and Nominal Interest Rates
Interest represents a payment in the future for a transfer of money in the past.
Nominal interest rate is the interest rate usually reported and not corrected for inflation.
It is the interest rate that a bank pays.
Real interest rate is the nominal interest rate that is corrected for the effects of inflation.