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Macroeconomics- Chapter 11: Measuring Cost of Living

by: Rooshna Ali

Macroeconomics- Chapter 11: Measuring Cost of Living Econ 10233

Marketplace > Texas Christian University > Economcs > Econ 10233 > Macroeconomics Chapter 11 Measuring Cost of Living
Rooshna Ali

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About this Document

These notes cover chapter 11- measuring cost of living
Intro Macroeconomics
Steven Ellis
Class Notes
Econ, macroecon, Economics, Macroeconomics
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This 3 page Class Notes was uploaded by Rooshna Ali on Wednesday March 30, 2016. The Class Notes belongs to Econ 10233 at Texas Christian University taught by Steven Ellis in Winter 2016. Since its upload, it has received 26 views. For similar materials see Intro Macroeconomics in Economcs at Texas Christian University.


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Date Created: 03/30/16
Chapter 11- Measuring Cost of Living Consumer Price Index (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 the CPI is calculated 1) Fix the “basket” The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket” 2) Find the prices The BLS collects data on the prices of all the goods in the basket 3) Compute the basket’s cost Use the prices to compute the total cost of the basket 4) Choose a base year and compute the index ¿ 100∗costof basket∈CURRENT year costof basket∈BASE year 5) Compute the inflation rate The percentage change in the CPI from the preceding year ¿ CPIthisyearI last ∗100 CPI last year Problems with CPI  Substitution bias o Over time, some prices rise faster than others o Consumers substitute toward goods that become relatively cheaper, migrating the effects of price increases o The CPI misses the substitution because it uses a fixed basket of goods o Thus, the CPI overstates increases in the cost of living  Introduction of new goods o The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs o In effect dollars become more valuable o The CPI misses this effect because it uses a fixed basket of goods o Thus, the CPI overstates increases in the cost of living  Unmeasured quality change o Improvements in the quality of goods in the basket increase the value of each dollar o The BLS tries to account for quality changes but probably misses some, as quality is hard to measure o Thus, the CPI overstates increases in the cost of living  Each of these problems causes the CPI to overstate cost of living increase  The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5% year  This is important because social security payments and many contracts have COLAs tied to CPI Contrasting the CPI and GDP deflator Imported consumer goods  Included in CPI  Excluded from GDP deflator Capital goods  Excluded from CPI  Included in GDP deflator (if produced domestically) The Basket  CPI uses a fixed basket  GDP deflator uses a basked of currently produced goods and services  This matters if different prices are changing by different amounts Correcting variables for Inflation  Comparing Dollar Figures from Different Times dollars∗priceleveltoday Amount∈today sdollars=Ammount∈yearT pricelevel∈yearT **to find dollar value back in time  flip CPI ratio**  Indexation o A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract o For example, the increase in the CPI automatically determines:  The COLA in many multi-year labor contracts  Adjustments in social security payments and federal income tax brackets  Real vs. Nominal Interest Rates o The nominal interest rate:  The interest rate is NOT corrected for inflation  The rate of growth in the dollar value of a deposit or debt o The real interest rate:  IS corrected for inflation  The rate of growth in the purchasing power of a deposit or debt Realinterestrate=nominalinterestrate−inflationrate


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