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Ch24

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Ch24

     MEASURING THE COST OF

     24 LIVING

WHAT’S NEW IN THE FOURTH EDITION:

    The discussion of why the introduction of new products is problematic when calculating the CPI has been augmented and clarified. The discussion of real and nominal interest rates has also been rewritten for clarity. The text discussion of U.S. interest rates over time is now a Case Study. There is a new In the

     box on ―Accounting for Quality Change.‖ News

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

how the consumer price index (CPI) is constructed.

why the CPI is an imperfect measure of the cost of living.

     how to compare the CPI and the GDP deflator as measures of the overall price level.

how to use a price index to compare dollar figures from different times.

the distinction between real and nominal interest rates.

CONTEXT AND PURPOSE:

    Chapter 24 is the second chapter of a two-chapter sequence that deals with how economists measure output and prices in the macroeconomy. Chapter 23 addressed how economists measure output. Chapter 24 develops how economists measure the overall price level in the macroeconomy.

     The purpose of Chapter 24 is twofold: first, to show students how to generate a price index and, second, to teach them how to employ a price index to compare dollar figures from different points in time and to adjust interest rates for inflation. In addition, students will learn some of the shortcomings of using the consumer price index as a measure of the cost of living.

    1

2 ; Chapter 24/Measuring the Cost of Living

    KEY POINTS:

    1. The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost

    of the same basket in the base year. The index is used to measure the overall level of prices in the

    economy. The percentage change in the consumer price index measures the inflation rate.

    2. The consumer price index is an imperfect measure of the cost of living for three reasons. First, it

    does not take into account consumers’ ability to substitute toward goods that become relatively

    cheaper over time. Second, it does not take into account increases in the purchasing power of the

    dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the

    quality of goods and services. Because of these measurement problems, the CPI overstates annual

    inflation by about one percentage point.

    3. Like the consumer price index, the GDP deflator also measures the overall level of prices in the

    economy. Although the two price indexes usually move together, there are important differences.

    The GDP deflator differs from the CPI because it includes goods and services produced rather than

    goods and services consumed. As a result, imported goods affect the consumer price index but not

    the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP

    deflator automatically changes the group of goods and services over time as the composition of GDP

    changes.

    4. Dollar figures from different points in time do not represent a valid comparison of purchasing power.

    To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated

    using a price index.

    5. Various laws and private contracts use price indexes to correct for the effects of inflation. The tax

    laws, however, are only partially indexed for inflation.

    6. A correction for inflation is especially important when looking at data on interest rates. The nominal

    interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a

    savings account increases over time. By contrast, the real interest rate takes into account changes in

    the value of the dollar over time. The real interest rate equals the nominal interest rate minus the

    rate of inflation.

CHAPTER OUTLINE:

I. The Consumer Price Index

    A. Definition of consumer price index (CPI): a measure of the overall cost of the

    goods and services bought by a typical consumer.

    B. How the Consumer Price Index Is Calculated

     Table 1

    1. Fix the basket.

    a. The Bureau of Labor Statistics uses surveys to determine a

    representative bundle of goods and services purchased by a typical

    consumer.

    Chapter 24/Measuring the Cost of Living ; 3

    b. Example: 4 hot dogs and 2 hamburgers.

    2. Find the prices.

    a. Prices for each of the goods and services in the basket must be

    determined for each time period.

    b. Example:

    Year Price of Price of

    Hot Dogs Hamburgers

    2005 $1 $2

    2006 $2 $3

    2007 $3 $4

    3. Compute the basket’s cost.

    a. By keeping the basket the same, only prices are being allowed to change.

    This allows us to isolate the effects of price changes over time.

    b. Example:

    Cost in 2005 = ($1 × 4) + ($2 × 2) = $8.

    Cost in 2006 = ($2 × 4) + ($3 × 2) = $14.

    Cost in 2007 = ($3 × 4) + ($4 × 2) = $20.

     It is very important that students understand how to make these calculations.

    Students often have a difficult time recreating the steps taken in class without the

    instructor’s help.

     ALTERNATIVE CLASSROOM EXAMPLE: Using the example from Chapter 23: 1. Fix the basket: 3 footballs and 4 basketballs. 2. Find the prices: Year Price of Footballs Price of Basketballs Year 1 $10 $12

    Year 2 12 15

     Year 3 14 18

     3. Compute the Cost of the Basket: Cost in Year 1 = (3 × $10) + (4 × $12) = $78 Cost in Year 2 = (3 × $12) + (4 × $15) = $96 Cost in Year 3 = (3 × $14) + (4 × $18) = $114 4. Using Year 1 as the base year, compute the index: CPI in Year 1 = ($78/$78) × 100 = 1 × 100 = 100 CPI in Year 2 = ($96/$78) × 100 = 1.2308 × 100 = 123.08 CPI in Year 3 = ($114/$78) × 100 = 1.4615 × 100 = 146.15

    5. Compute the inflation rate:

    Inflation rate for Year 2 = [(123.08 100)/100] × 100% = 23.08%

    Inflation rate for Year 3 = [(146.15 123.08)/123.08] × 100% = 18.74%

    4 ; Chapter 24/Measuring the Cost of Living

    Activity 1 Create a Student Price Index

Type: Take-home assignment

    Topics: Consumer price index

    Class limitations: Works in any size class

Purpose

    This assignment gives students a practical look at how price indices are measured. It also

    establishes base prices for calculating inflation rates later in the term.

Instructions

    The students should pick real transaction prices for goods they actually purchase. If the indices will be used to calculate inflation rate, they should save a copy of this assignment in a

    safe place. They should not use prices from catalogs because such prices will not be subject to much change over the semester.

Points for Discussion

    This assignment makes a good introduction to a discussion of market basket selection for

    price indices. The goods that students usually pick for their market basket account for a relatively small portion of consumer spending compared to housing, medical care, transportation, etc. Ask the students which goods are likely to change price frequently.

This can be used to introduce problems with the measurement of the consumer price index.

Assignment

    The consumer price index includes the prices of hundreds of goods purchased by consumers. It is possible to construct many other price indexes.

Your mission: Create a personalized student price index.

1. Choose five (or more) different products.

     be specific e.g., unleaded gasoline, Budweiser beer

    2. Pick a quantity for each product. This will be your market basket.

     e.g., 15 gallons gasoline, 12 pack of Budweiser

    3. Find the actual price for each product.

    4. Calculate the total cost of buying these products.

    At the end of the semester, have students find the prices for these same five products and recalculate the cost of their market basket. Then, have them calculate their SPI (Student Price Index) and the rate of inflation.

    4. Choose a base year and compute the index.

    a. The base year is the benchmark against which other years are compared.

    b. The formula for calculating the price index is:

     ?,cost of basket in current year CPI100;?,( cost of basket in base year!;c. Example (using 2005 as the base year):

    Chapter 24/Measuring the Cost of Living ; 5

    CPI for 2005 = ($8)/($8) × 100 = 100.

    CPI for 2006 = ($14)/($8) × 100 = 175.

    CPI for 2007 = ($20)/($8) × 100 = 250.

     Point out that the CPI must be equal to 100 in the base year.

    5. Compute the inflation rate.

    a. Definition of inflation rate: the percentage change in the price

    index from the preceding period.

     Make sure that you explain that inflation does not mean that the prices of all goods

    on average are rising. In fact, in the economy are rising. Inflation means that prices

    the prices of many electronic goods (such as computers and DVD players) have fallen in recent years.

    b. The formula used to calculate the inflation rate is:

    ?,CPI CPI; Year 2Year 1inflation rate100%;? ,( CPIYear 1!;

    c. Example:

    Inflation Rate for 2006 = (175 100)/100 × 100% = 75%.

    Inflation Rate for 2007 = (250 175)/175 × 100% = 43%.

    Be sure to point out to students that it is possible for the CPI to fall if deflation is present. Point out to students that, even though they have not experienced deflation in their lifetimes, it has occurred during several periods of U.S. history (especially during the Great Depression).

C. The Producer Price Index

    1. Definition of producer price index (PPI): a measure of the cost of a

    basket of goods and services bought by firms.

    2. Because firms eventually pass on higher costs to consumers in the form of higher

    prices on products, the producer price index is believed to be useful in predicting

    changes in the CPI.

D. FYI: What Is in the CPI’s Basket?

     Figure 1

    1. Figure 1 shows the makeup of the market basket used to compute the CPI.

    6 ; Chapter 24/Measuring the Cost of Living

    2. The largest category is housing, which makes up 42% of a typical consumer’s

    budget.

One way to highlight this is to draw the pie chart on the board without the category

    names and let the students decide what goes where. Most likely, they will be surprised by the sizes of entertainment and health care.

E. In the News: Accounting for Quality Change

     1. When considering how price changes affect consumers’ well-being, it is

    important to measure changes in the quality of goods and services over time.

     2. This is an article from the Wall Street Journal that discusses how the Bureau of

    Labor Statistics takes product improvements into account when computing the

    CPI.

F. Problems in Measuring the Cost of Living

    1. Substitution Bias

    a. When the price of one good changes, consumers often respond by

    substituting another good in its place.

    b. The CPI does not allow for this substitution; it is calculated using a fixed

    basket of goods and services.

    c. This implies that the CPI overstates the increase in the cost of living over

    time.

    2. Introduction of New Goods

    a. When a new good is introduced, consumers have a wider variety of

    goods and services to choose from.

    b. This makes every dollar more valuable, which lowers the cost of

    maintaining the same level of economic well-being.

    c. Because the market basket is not revised often enough, these new

    goods are left out of the bundle of goods and services included in the

    basket.

    3. Unmeasured Quality Change

    a. If the quality of a good falls from one year to the next, the value of a

    dollar falls; if quality rises, the value of the dollar rises.

    b. Attempts are made to correct prices for changes in quality, but it is often

    difficult to do so because quality is hard to measure.

    4. The size of these problems is also difficult to measure.

    Chapter 24/Measuring the Cost of Living ; 7

    5. Most studies indicate that the CPI overstates the rate of inflation by

    approximately one percentage point per year.

    6. The issue is important because many government transfer programs (such as

    Social Security) are tied to increases in the CPI.

    G. The GDP Deflator versus the Consumer Price Index

    1. The GDP deflator reflects the prices of all goods produced domestically, while the

    CPI reflects the prices of all goods bought by consumers.

    2. The CPI compares the prices of a fixed basket of goods over time, while the GDP

    deflator compares the prices of the goods currently produced to the prices of the

    goods produced in the base year. This means that the group of goods and

    services used to compute the GDP deflator changes automatically over time as Figure 2 output changes.

    3. Figure 2 shows the inflation rate as measured by both the CPI and the GDP

    deflator.

    II. Correcting Economic Variables for the Effects of Inflation

    A. Dollar Figures from Different Times

    1. To change dollar values from one year to the next, we can use this formula:

     Price level in Year 2?, Value in Year 2 dollarsValue in Year 1 dollars;?,(Price level in Year 1!;

2. Example: Babe Ruth’s 1931 salary in 2005 dollars:

    price level in 2005 Salary in 2005 dollars = Salary in 1931 dollars × price level in 1931

    Salary in 2005 dollars = $80,000 × (195/15.2).

    Salary in 2005 dollars = $1,026,316.

     ALTERNATIVE CLASSROOM EXAMPLE: Your father graduated from school and took his first job in 1972, which paid a salary of $7,000. What is this salary worth in 2005 dollars? CPI in 1972 = 41.8 CPI in 2005 = 195 Value in 2005 dollars = 1972 salary × (CPI in 2005/CPI in 1972) Value in 2005 dollars = $7,000 × (195/41.8) = $7,000 × 4.67 = $32,690

3. Case Study: Mr. Index Goes to Hollywood

    a. Reports of box office success are often made in terms of the dollar

    values of ticket sales.

    8 ; Chapter 24/Measuring the Cost of Living

    b. These ticket sales are then compared with ticket sales of movies in the

    past.

    c. However, no correction for changes in the value of a dollar are made.

    d. Table 2 shows a table of the top 20 films with the estimated box office Table 2

    gross in 2004 dollars. The winner: Gone with the Wind.

     Activity 2You Paid How Much?

     Type: Take-home assignment

     Topics: Consumer price index

     Class limitations: Works in any size class

     Purpose

     This assignment gives students a chance to see how much dollar values have changed over

     time. It also provides them some practice at using the formula to calculate the change in

     dollar values over time.

     Instructions

     Have students ask their parents (or grandparents) how much they paid for their first car and

     in what year they bought it. (If there are older students in the class, ask them to remember

     how much they paid for their first car.) Students can then determine how much they would

     have to pay in current dollars using the consumer price index.

B. Indexation

    1. Definition of indexation: the automatic correction of a dollar amount for

    the effects of inflation by law or contract.

    2. As mentioned above, many government transfer programs use indexation for the

    benefits. The government also indexes the tax brackets used for federal income

    tax.

    3. There are uses of indexation in the private sector as well. Many labor contracts

    include cost-of-living allowances (COLAs).

C. Real and Nominal Interest Rates

     Use an example to make the importance of real interest rates clear. Suppose a

    student has $100 in his savings account earning 3% interest. Ask students what will

    happen to the purchasing power of that money if prices rise 3% during the year.

    Then, change the inflation rate to 5% and then 1% and go through the example again.

    1. Example: Sally Saver deposits $1,000 into a bank account that pays an annual

    interest rate of 10%. A year later, she withdraws $1,100.

    2. What matters to Sally is the purchasing power of her money.

    Chapter 24/Measuring the Cost of Living ; 9

     a. If there is zero inflation, her purchasing power has risen by 10%.

     b. If there is 6% inflation, her purchasing power has risen by about 4%.

     c. If there is 10% inflation, her purchasing power has remained the same.

     d. If there is 12% inflation, her purchasing power has declined by about

    2%.

     e. If there is 2% deflation, her purchasing power has risen by about 12%.

    3. Definition of nominal interest rate: the interest rate as usually reported

    without a correction for the effects of inflation.

    4. Definition of real interest rate: the interest rate corrected for the effects

    of inflation.

     real interest ratenominal interest rateinflation rate;;

    5. Case Study: Interest Rates in the U.S. Economy

     a. Figure 3 shows real and nominal interest rates from 1965 to the present. Figure 3

     b. The nominal interest rate is always greater than the real interest rate in

    this diagram because there was always inflation during this period.

     c. Note that in the late 1970s the real interest rate was negative because

    the inflation rate exceeded the nominal interest rate.

SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes

    The answers to the Quick Quizzes can also be found near the end of the textbook.

    1. The consumer price index tries to measure the overall cost of the goods and services bought by a

    typical consumer. It is constructed by surveying consumers to determine a basket of goods and

    services that the typical consumer buys. Prices of these goods and services are used to compute

    the cost of the basket at different times, and a base year is chosen. To compute the index, we

    divide the cost of the market basket in the current year by the cost of the market basket in the

    base year and multiply by 100.

    2. Since Henry Ford paid his workers $5 a day in 1914 and the consumer price index was 10 in

    1914 and 195 in 2005, then the Ford paycheck was worth $5 195 / 10 = $97.50 a day in 2005

    dollars.

10 ; Chapter 24/Measuring the Cost of Living

    Questions for Review

    1. A 10% increase in the price of chicken has a greater effect on the consumer price index than a

    10% increase in the price of caviar because chicken is a bigger part of the average consumer's

    market basket.

    2. The three problems in the consumer price index as a measure of the cost of living are: (1)

    substitution bias, which arises because people substitute toward goods that have become

    relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the

    CPI; and (3) unmeasured quality change.

    3. If the price of a Navy submarine rises, there is no effect on the consumer price index, because

    Navy submarines are not consumer goods. But the GDP price index is affected, because Navy

    submarines are included in GDP as a part of government purchases.

    4. Because the overall price level doubled, but the price of the candy bar rose sixfold, the real price

    (the price adjusted for inflation) of the candy bar tripled.

    5. The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest

    rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest

    rate minus the rate of inflation.

Problems and Applications

1. a. Find the price of each good in each year:

    Year Cauliflower Broccoli Carrots

    2006 $2 $1.50 $0.10

    2007 $3 $1.50 $0.20

    b. If 2006 is the base year, the market basket used to compute the CPI is 100 heads of

    cauliflower, 50 bunches of broccoli, and 500 carrots. We must now calculate the cost of

    the market basket in each year:

    2006: (100 x $2) + (50 x $1.50) + (500 x $.10) = $325

    2007: (100 x $3) + (50 x $1.50) + (500 x $.20) = $475

     Then, using 2006 as the base year, we can compute the CPI in each year:

    2006: $325/$325 x 100 = 100

    2007: $475/$325 x 100 = 146

    c. We can use the CPI to compute the inflation rate for 2007:

     (146 ? 100)/100 x 100% = 46%

2. Many answers are possible.

3. a. The percentage change in the price of tennis balls is (2 2)/2 × 100% = 0%.

     The percentage change in the price of golf balls is (6 4)/4 × 100% = 50%.

     The percentage change in the price of Gatorade is (2 1)/1 × 100% = 100%.

     b. The cost of the market basket in 2006 is ($2 × 100) + ($4 × 100) + ($1 × 200) = $200

    + $400 + $200 = $800.

     The cost of the market basket in 2007 is ($2 × 100) + ($6 × 100) + ($2 × 200) = $200

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