Introduction to Macroeconomics Chapter 11 Measuring the Cost

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Introduction to Macroeconomics Chapter 11 Measuring the Cost of Living Inflation, CPI, and Prices

Introduction to Macroeconomics Chapter 11 Measuring the Cost of Living Inflation, CPI, and Prices

Cost of Living • Another measure of what is happening in the economy is

Cost of Living • Another measure of what is happening in the economy is the cost of living • Prices of many goods and services change in different directions – some increase, some decrease, some stay the same • When the majority of prices increase – inflation! Use a price index to measure overall prices in an economy

The Consumer Price Index (CPI) • Measures the typical consumer’s cost of living •

The Consumer Price Index (CPI) • Measures the typical consumer’s cost of living • CPI is made up of a fixed basket of goods whose prices change year over year • The change in prices for the basket of goods indicates inflation

How the CPI Is Calculated 1. Fix the “basket. ” Determine what goods make

How the CPI Is Calculated 1. Fix the “basket. ” Determine what goods make it into the basket Quantity of goods remains constant 2. Find the prices. Determine the prices of each good Prices change 3. Compute the basket’s cost. Cost of the basket = number of goods in basket x price of each good

How the CPI Is Calculated 4. Choose a base year and compute the index.

How the CPI Is Calculated 4. Choose a base year and compute the index. CPI = Cost of basket in current year Cost of basket in base year X 100 5. Compute the inflation rate. Inflation = rate CPI this year – CPI last year x 100% CPI last year

Application 1 Consider an economy where the typical consumer consumes 10 lbs. of beef

Application 1 Consider an economy where the typical consumer consumes 10 lbs. of beef and 20 lbs. of chicken. These are the two goods in the CPI basket. price of beef price of chicken 2010 $4 $4 2011 $5 $5 2012 $9 $6 • What is the CPI each year if the base year is 2010? • What is the inflation rate in 2011 and 2012?

Application 1 $80 Cost of the Basket $120 100 $50 $100 $150 125 $90

Application 1 $80 Cost of the Basket $120 100 $50 $100 $150 125 $90 $120 $210 175 Px. Q Beef Px. Q Chicken 2010 $40 2011 2012 Inflation: 2010 - 2011: (125 – 100)/100 = 25% 2011 – 2012: (175 – 125)/100 = 40% CPI

What’s in the CPI’s Basket?

What’s in the CPI’s Basket?

Finding Inflation Data • Go to http: //databank. worldbank. org/data/home. aspx • Click on

Finding Inflation Data • Go to http: //databank. worldbank. org/data/home. aspx • Click on “World Development Indicators” – Choose 4 -5 countries from the list – In series – Choose Inflation – In Time – Choose 2000 – 2015 (or recent 15 years) • Download the data – Download option Excel • Open Excel File – Copy data paste in new sheet (Transpose) – Add Year column in Column A – Create a line graph • What do you observe from your data? What has been happening with prices in these economies?

Prices across time •

Prices across time •

Application • Pick a typical consumer good you purchase frequently. • Find an estimate

Application • Pick a typical consumer good you purchase frequently. • Find an estimate of the price of that in 1940, 1960, 1980, 2000. • What is the value of that good in 2015 dollars? Is it more or less expensive today? • What implication does this have on today’s standard of living compared to the standard of living in the past?

Problems with CPI can overstate inflation because of: • Substitution Bias When eggs become

Problems with CPI can overstate inflation because of: • Substitution Bias When eggs become more expensive, consumers will buy other breakfast products and buy less eggs. This adjustment in quantity is not always taken into account in the cost of the basket. • Introduction of New Goods New goods increase the variety of products available to satisfy a consumer’s needs and wants, making each dollar “more valuable”. Without including new goods, CPI misses out on this effect. • Unmeasured Quality Changes Improvements in products again increase the value of each dollar, because you get more for each dollar spent. Without accounting for it, cost of living is overstated.

Costs of Inflation • • Menu costs Shoe-leather costs Drop in purchasing power General

Costs of Inflation • • Menu costs Shoe-leather costs Drop in purchasing power General confusion and inconvenience

Key Takeaways • The CPI shows the cost of a basket of goods and

Key Takeaways • The CPI shows the cost of a basket of goods and services that most consumers purchase. • Though imperfect, it provides a decent reflection on the cost of living in a country and how it changes • With the price index (CPI or GDP deflator) we can calculate inflation and adjust for the value of goods overtime