Consumer Price Index (CPI)

• A measure of the average of the prices paid by the households for a fixed basked of consumer goods and services
• The major purpose of CPI is to measure changes in the cost of living and in the value of money

• A period for which the CPI is defined to equal 100.
• Currently the base period is 1992

1. Selecting the CPI basket
2. Conducting the monthly price survey
3. Calculating the CPI

• Contains the goods and services represented in the index and the relative importance attached to each of them
• The idea is to make the relative importance of the items in the CPI basket the same as in the budget of an average household

1. CPI-All-Items
2. CPI-All-Items excluding the 8 most volatile components

These volatile items include:

1. prices of fruits
2. vegetables
3. natural gas and oil
4. gasoline
5. inter-city transportation
6. tobacco products
7. smoker's supplies
8. mortgage interest cost

What are the steps in calculating CPI?

1. Find the cost of the CPI basket at the base period prices
2. Find the cost of CPI basket at current period prices
3. Calculate the CPI for the base period and the current period

CPI

=

Cost of CPI basket at current period prices _{x 100}

    Cost of CPI basket at base period prices

• To measure changes in CPI, we calculate inflation rate
• Is the percentage change in the price level from one year to the next

Inflation Rate

=

(CPI in the current year - CPI in Previous year) _x 100

CPI in Previous year

• Also called money wage rate
• The average hourly wage rate measured in current dollars

Real Wage Rate:

1. Because we measure the real wage rate in constant base-year dollars, a change in the real wage rate measures the change in the quantity of goods and services that an hour's work can buy
2. Real Wage rate takes the effect of inflation out of changes in nominal wage rate
3. Is a significant economic variable because it measures the real reward and cost for labour, which is a major determinant of the standard of living

Nominal Wage Rate

• In contrast, a change in the nominal wage rate measures a combination of a change in the quantity of goods and services than an hour's work can buy and a change in the price level.
• This rate includes inflation rate

Real Interest rate

=

Nominal rate

—

Inflation rate

Because as a consumer, we can be crucially affected by these same distinctions over the coming years

• The inflation rate that people forecast and use to make decisions
• Both the nominal interest rate and nominal wage rate are influenced by the expected inflation rate

• When inflation rate exceeds expected inflation rate, the real interst rate and real wage rate falls. People spend more, firms hire more labour and produce more - the economy expands
• When inflation rate is less than expected inflation rate, the real interest rate and the real wage rate rises. People spend less, firms hire less labour and produce less and the economy shrinks

• A measure of changes in the amount of money that people would need to spend to achieve a given standard of living
• Is also sometimes referred to as CPI. But CPI does not measure the cost of living.

1. CPI does not try to measure all the components of the cost of living
2. Even those components of the cost of living that are included in the CPI are not always measured accurately. The result is that CPI is possibly a biased measure of changes in the cost of living

1. New goods bias
2. Quality change bias
3. Commodity substitution bias
4. Outlet substitution bias

New Goods Bias

New goods keep replacing the old ones.

For ex. Videocassette player and DVD of today

Which has a better value

Quality Change Bias

When confronted with higher prices, people use discount stores more frequently and less of the convenience stores.

1. Distorst private contracts
2. Increases government payments

P.89

P.89

P.89

How do we convert a nominal value to a real value?

Real Value

=

Price at year being compared

x

CPI at current year

÷

CPI at year being compared

Real GDP

=

Nominal GDP

÷

GDP Deflator

What are the Nominal and Real Values Distinctions in Macroeconomics?

1. A Nominal value is expressed in current dollars vs Real value expressed in dollars at a given time period
2. Nominal GDP vs. Real GDP
3. CPI vs. GDP Deflator
4. Nominal Wage Rate vs. Real Wage rate
5. Nominal Interest Rate vs. Real Interest Rate

Real Wage Rate

=

Nominal wage rate

÷

GDP Deflator

x

100%

Real Interest Rate

=

Nominal Interest Rate

-

Inflation Rate

True or False

Nominal Interest Rate and nominal wage rate are influenced by the expected inflation rate

When inflation rate exceeds the expected inflation rate, real wage rate and real interest rate falls. So people spend more, firms hire more labour and produce more and the economy expands

When inflation rate is less than the expected inflation rate, real wage rate and interest rate rise. People spend less, firms hire less labour and produce less and the economy shrinks

In 1996, a study conducted estimates that the U.S CPI overstate inflation by _____ percentage points a year.