Principles of Macroeconomics
Principles of Macroeconomics ECO 2013
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This 13 page Class Notes was uploaded by Fleta Rempel on Monday October 12, 2015. The Class Notes belongs to ECO 2013 at Florida International University taught by Prasad Bidarkota in Fall. Since its upload, it has received 27 views. For similar materials see /class/221807/eco-2013-florida-international-university in Economcs at Florida International University.
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Date Created: 10/12/15
CHAPTER 6 MEASURING THE COST OF LIVING Review Problems 2 6 11 This chapter examines how economists measure the overall cost of living paying particularly close attention to the calculation use and shortcomings of the consumer price index Introduction Because prices go up and down overtime it is dif cult to compare the standard of living With information about income only Standard of living instead depends on the purchasing power of that income The Consumer Price Index is a statistic Which turns dollar gures into meaningful measures of purchasing power 11 1 The Consumer Price Index De nition of Consumer Price Index CPI A measure of the overall cost of the goods and services bought by a typical consumer It is computed and reported each month by the Bureau of Labor Statistics a part of the Department of Labor How the Consumer Price Index is Calculated Computing the CPI is a ve step process using data on the prices of thousands of good and services 1Fix the basket Determine which goods and services are most important for a typical consumer and determine the relative importance of each The prices of the more important ones will be given more weight than the less important ones 2 Find the prices Once you39ve established the goods nd out what the prices are now and what they were at speci c times in the past 3 Compute the basket39s cost Using the weights established in Step 1 determine the total cost of the basket at each set of prices found in Step 2 Note The market basket isn39t changing only the prices 4 Choose a base year and compute the index Which year is chosen as the base year doesn39t matter The base year is just a benchmark against Which all other years can be compared The consumer price index for each year is the cost of the basket in that year divided by the cost of the basket in the base year multiplied by 100 For instance an index of 150 means that this year39s prices are 150 of the base year prices or 50 higher than the base year 5 Compute the in ation rate The in ation rate is the percentage change in the consumer price index om the preceding period If the index rises from 120 to 150 the in ation rate is 25 percent Producer Price Index The Bureau of Labor Statistics also reports the Producer Price Index Which measures the cost of a basket bought by a typical rm rather than a consumer The PPI is useful in predicting changes in the CPI since rms often pass on rising costs to consumers FYI What39s in the CPI39s Basket See Figure 11 In the News Shopping for the CPI There are 300 employees at the Bureau of Labor Statistics Who gather the information necessary to calculate the CPI This article highlights a few of these and their sleuthing methods Another interesting fact is that the list of items in the market basket is only updated every ten years Cellular phones currently aren39t on the list Three Problems in Measuring the Cost of Living 1 Substitution bias If the price of a good rises sometimes consumers substitute a different good instead of buying less of the good with the new price Therefore the CPI may overstate increases in the cost of living 2 Introduction of new goods New goods mean more choices and more choices mean that the purchasing power of your dollar may go up it producers compete with each other aggressively for your business Therefore it is possible for you to maintain your standard of living with less money The CPI would miss that change 3 Unmeasured quality change It is dif cult to compare one period to the next because even though the BLS tries to adjust for it the quality of a good may change making it more or less valuable relative to its price to the consumer In the News The CPI Commission A 1996 commission of economists found that When the CPI changes changes in the cost of living are overstated by l 1 The GDP De ator versus the Consumer Price Index Differences 1The GDP de ator re ects the prices of all goods and services produced domestically Whereas the consumer price index re ects the prices of all goods and serves bought by consumers When consumers buy foreign goods or producers sell to the government rather than consumers the indexes are different 2 The GDP measures production of goods currently being produced Where as the CPI uses a xed market basket of goods 112 Correcting Economic Variables for the Effects of In ation Dollar Figures from Different Times To compare dollar amounts in different times use this formula Value in Year B Price Level in Year B Price Level in Year A X Value in Year A In the News Mr Index Goes to Hollywood Gone with the Wind is the highest grossing movie of all times in real terms De nition of indexation when some dollar amount is automatically corrected for in ation by law or contract Social Security is indexed and so are tax brackets De nition of COLA a costofliving allowance which means that income is automatically adjusted to offset the effects of in ation Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past De nition of nominal interest rate the interest rate that the bank pays tells you how fast the number of dollars in your bank account rises over time De nition of real interest rate the interest rate corrected for in ation tells you how fast the purchasing power of your bank account rises over time Real interest rate nominal interest rate in ation 1 13 Conclusion In ation reduces the purchasing power of money over time Therefore it is necessary to have a tool to compare dollars over time A price index is such a tool
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