Macro Chapter 11 Notes
Macro Chapter 11 Notes EC 111
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This 3 page Class Notes was uploaded by Carter Cox on Sunday February 21, 2016. The Class Notes belongs to EC 111 at University of Alabama - Tuscaloosa taught by Zirlott in Spring 2015. Since its upload, it has received 33 views. For similar materials see Principles of Macroeconomics in Economcs at University of Alabama - Tuscaloosa.
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Date Created: 02/21/16
Macro Chapter 11 Notes The Consumer Price Index - Known as CPI - Measures the typical consumer’s cost of living - The basis of cost of living adjustments (COLAs) in many contracts and in Social Security How CPI is calculated (have to go in order) 1) Fix the “basket”- any store a. The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s shopping basket 2) Find the prices a. The BLS collects data on the prices of all the goods in the basket 3) Compute the basket’s cost a. Use the prices to compute the total cost of the basket 4) Choose a base year (base year is given) and compute the index a. CPI in any year equals i. 100 x (Cost of basket in current year/ cost of basket in base year) 5) Compute the inflation rate a. The percentage change in the CPI from the preceding period i. Inflation Rate= ((CPI this year- CPI last year)/ (CPI last year)) x 100% b. (New-old)/ old Problems with the CPI 1) Substitution Bias a. Over time, some prices rise faster than others b. Consumers, substitute toward goods that become relatively cheaper c. The CPI misses this substitution because it uses a fixed basket of goods d. CPI overstates increases in the cost of living i. Everyday people substitute 2) Introduction of New Goods a. The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs i. Stretch your dollar around more stuf b. In efect, dollar becomes more valuable c. The CPI misses this efect because it uses a fixed basket of goods d. Thus, the CPI overstates increases in the cost of living e. CPI is generally updated every 5 years 3) Unmeasured Quality Change a. Improvements in the quality of goods in the basket increase the value of each dollar b. The BLS tries to account for quality changes but probably misses some, as quality is hard to measure c. Overstates increases in the cost of living - Each of these problems causes the CPI to overstate cost of living increases - BLS has made technical adjustments (but can’t fix them all) but the CPI probably still overstates inflation by about .5% per year o Could be another billion to welfare etc. - This is important because Social Security payments and many contract have COLAs tied to the CPI Contrasting the CPI (consumers only) and GDP Deflator - Imported Consumer goods o Included in CPI o Excluded from GDP Deflator - Capital Goods (investment goods) o Excluded from CPI o Included in GDP Deflator (produced domestically) - The Basket (doesn’t change, all currently produced stuf) o CPI uses fixed basket (updated every 5 years) o GDP Deflator uses basket of currently produced goods and services (updated automatically) - They both measure inflation but in diferent ways Examples: A) Starbucks raises the price of Frappuccino’s a. Both afect because CPI and GDP both rise B) Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory a. GDP increases C) Nike raises the price of the Chinese produced athletic shoes in the US a. CPI rises Correcting Variables for Inflation: Comparing the Dollar Figures from Diferent Times - Inflation makes it harder to compare dollar amounts from diferent times’ - Example: the minimum wage o $1.15 in December 1964 o $7.25 today - Did minimum wage have more purchasing power in December 1964 or today - Have to convert to todays dollars - Amount in todays dollars = Amount in year T dollars X (Price level today/ Price level in year T) - Example: o CPI in year T= 31.3, CPI= 220.3 today o Min wage was $1.15 in year T o $1.15 x (220.3/31.3)= $8.0 - Used to see how a variable has changed over time after correcting for inflation Correcting variables for Inflation: Indexation - A dollar amount is indexed (changes toward inflation) for inflation if it is automatically corrected for inflation by law or in a contract - Increase in the CPI automatically determines o The COLA in many multi- year labor contracts o The adjustments in Social security payments and federal tax brackets Real VS Nominal Interest Rates - The Nominal o Interest rate not corrected for inflation o The rate of growth in the dollar value of a deposit or debt - Real interest rate o Corrected for inflation o The rate of growth in the purchasing power of a deposit or debt - Real interest rate o Nominal interest rate- inflation rate - Real rate of growth= real interest rate Summary - The consumer price index is a measure of the cost of living. The CPI tracks the cost of the typical consumer’s basket of goods and services - The CPI is used to make the cost of living adjustments and to correct economic variables for the efects of inflation - The real interest rate is corrected for inflation and is computed by subtracting the inflation rate from the nominal interest rate.