Econ 2 Lecture 2 Notes (Chapter 24)
Econ 2 Lecture 2 Notes (Chapter 24) ECON 2
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This 4 page Class Notes was uploaded by Anna on Wednesday October 5, 2016. The Class Notes belongs to ECON 2 at University of California - Los Angeles taught by Rojas in Fall 2016. Since its upload, it has received 8 views.
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Date Created: 10/05/16
Lecture 2: Measuring the Cost of Living (Chapter 24) 1. The Consumer Price Index (CPI) a. Measures the typical consumer’s cost of living b. The basis of Cost Of LivingAdjustments (COLAs) in many contracts and in Social Security c. Will be able to tease out level of inflation d. GDP deflator looks at economy as whole vs. CPI looks at individual level i. Government purchase/spending -- GDP; Consumer purchase -- CPI e. Can compare for different cities, states, etc. f. Estimated across many things 2. How the CPI is Calculated a. Fix the “basket” i. Bureau of Labor Statistics (BLS) survey consumers to determine what is in consumer’s “shopping basket” b. Find the prices i. BLS collects data on prices of all the goods in the basket c. Compute the basket’s cost i. Use the prices to compute the total cost of the basket d. Choose a base year and compute the index i. CPI = 100 x (cost of basket in current year/cost of basket in base year) e. Compute the inflation rate i. Percentage change in the CPI from the preceding period ii. Inflation rate = (CPI this year - CPI last year)/CPI last year x 100 3. What is in the CPI’s Basket? a. 41% Housing b. 17% Transportation c. 15% Food and beverages d. 7% Medical Care e. 7% Education and communication f. CPI assumes fixed percentage of spending on goods, does not take into account less spending of luxury goods during recession 4. Problems with CPI a. All problems overstate CPI → CPI always higher than if we were to correct for inflation b. Substitution bias Over time, some prices rise faster than others i. ii. Consumers substitute toward goods that become relatively cheaper, mitigating effects of price increases iii. CPI misses substitution because it uses a fixed basket of goods → CPI overstates increases in cost of living c. Introduction of New Goods i. Increases variety → consumers find products that more closely meet their needs ii. Dollars become more valuable because more opportunities/ability to attain greater variety of goods iii. CPI misses this effect because of use of fixed basket of good → CPI overstates increases in cost of living d. Unmeasured Quality Change i. Improvements in quality of goods in basket increases value of each dollar ii. Ex: fuel efficiency, better laptops iii. BLS tries to account for quality changes but misses some because quality is hard to measure iv. Not account for improvements → CPI overstates increases in cost of living e. CPI overstates magnitude of inflation by about 0.5% per year i. Important because Social Security payments and contracts have COLA’s tied to CPI 5. Contrasting CPI and GDP Deflator a. Important consumer goods i. Included in CPI ii. Excluded from GDP deflator b. Capital goods i. Excluded from CPI ii. Included in GDP deflator if produced domestically iii. Ex: buildings, airplane c. The basket i. CPI uses fixed basket ii. GDP deflator uses basket of currently produced goods/services iii. Matters if different prices are changing by different amounts due to inflation ○ Inflation affects prices as a whole, not just specific to consumer/ capital goods Examples d. i. Starbucks raises price of Frappuccinos ○ CPI and CDP deflator both rise ii. Caterpillar raises the price of the industrial tractors it manufactures as its Illinois factory ○ GDP deflator rises, CPI does not iii. Armani raises the price of Italian jeans it sells in the U.S. ○ CPI rises, GDP deflator does not 6. Correcting Variables for Inflation a. Comparing Dollar Figures from Different Times i. Inflation makes it harder to compare dollar amounts from different times ii. Amount in today’s dollars = amount in year T dollars x (CPI today/ CPI in year T) iii. Research, business analysts, policymakers often use this technique to convert a time series of current dollar (nominal) figures into constant dollar (real) figures b. Indexation i. Adollar amount is indexed for inflation if it is automatically corrected for inflation ii. Increase in CPI automatically determines ○ COLAin multi-year labor contracts ○ Adjustments in Social Security payments and federal income tax brackets ○ Government spending (infrastructure, public education) iii. Allows you to plan ahead c. Real vs. Nominal Interest Rates i. Interest rate - cost of borrowing, rate on saving accounts ○ Regulated by Federal Reserve ○ Stimulate economy - lower interest rate as incentive for people to borrow money ii. Nominal interest rate ○ Interest rate not corrected for inflation ○ Rate of growth in dollar value of a deposit/debt ○ Inflation decreases purchasing power ○ Get taxed on nominal interest rate iii. Real interest rate ○ Corrected for inflation Rate of growth in the purchasing power of a deposit/debt ○ ○ Real interest rate = nominal interest rate - inflation rate iv. Graph of nominal and real interest rate ○ Two lines trace each other ○ Difference between two lines is inflation
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