Happy Tuesday  Please get out your notes! PSAT tomorrow – you will only see 5 and 6. Quiz on Thursday. Goals: 1 Explain what the Consumer Price Index (CPI) is and how it is calculated. 2 Explain the limitations of the CPI and describe other measures of the price level. 3 Adjust money values for inflation and calculate real wage rates and real interest rates. Notes and teaching tips: 9, 11, 15, 22, 39, and 45. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure. To enhance your lecture, check out the Lecture Launchers, Land Mines, and Class Activities in the Instructor’s Manual.

Measuring Inflation through Price Indices The main reasons that prices go up is due to inflation. Inflation is a general increase in prices. When prices rise, consumer purchasing power decreases. One of the ways that we study inflation is to look at price indices. A price index is a measurement that shows the average price of a standard group of goods changes over time.

Consumer Price Index (CPI) is a measure of the average of the prices paid by consumers for a fixed “market basket of consumer goods and services”. The BLS calculates the CPI every month. We can use these numbers to compare what a fixed basket of goods costs this month with what it cost in some previous month, or from year to year.

Every ten years, the market basket is updated to reflect changes in consumers buying habits. To see how prices have changed, we compare them to the reference base period (or the earliest year) Reference base period is a period where the CPI is equal to 100.

Figure 22.1 shows the CPI basket at the end of 2008. This shopping cart is filled with the items that an average household buys. There are eight categories: Ask your students to make an estimate of their own baskets and compare them with the BLS basket.

The Monthly Price Survey Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas. Because the CPI measures price changes, it is important that the prices recorded refer to exactly the same items. Surveying college textbook prices might capture the students’ attention. (See the IM for a detailed discussion).

22.1 THE CONSUMER PRICE INDEX The CPI calculation has three steps: Find the cost of the CPI basket at base period prices. Find the cost of the CPI basket at current period prices. Calculate the CPI for the base period and the current period.

22.1 THE CONSUMER PRICE INDEX

22.1 THE CONSUMER PRICE INDEX Cost of CPI basket at current period prices Cost of CPI basket at base period prices x 100 CPI = For 2005, the CPI is: = 100 $50 x 100 For 2010, the CPI is: = 140 $70 $50 x 100

Inflation Rate In addition to measuring changes in prices of certain goods and services, economists also examine the inflation rate. The inflation rate is the percentage rate of change in price level over time.

Example Say that the CPI for the base year was $200 and today it is $360. What is the inflation rate for this chage? (Current year CPI – base year CPI/ base year CPI x 100) 360-200/200 x 100 =

Different types of inflation Core Inflation Rate – is the rate of inflation that excludes the cost of food and energy Hyperinflation – inflation that is out of control; prices increase between 100-500% Changes in the price levels can stem from lots of things and different causes of inflation The Quantity Theory – too much money in the economy causes inflation because the value of the dollar goes down. Demand Pull Theory – inflation happens when demand for goods exceeds the supply and the increase in demand PULLS prices up. Cost-Push Theory – inflation happens when producers raiser their prices which are PUSHED up by increased cost of resources.

Effects of Inflation Purchasing Power – higher prices mean that consumers dollars don’t stretch as far. Income – If wages increase to match inflation, than there is little affect on income. But if wages stay the same, and inflation occurs, it make it hard for households to keep up. People living on fixed incomes have this problem. Interest Rates – people earn interest on their savings accounts. If interest rates are increased to match inflation, there is no difference. But if inflation goes up and interest rates do not, savers can actually lose their money.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES Cost of living index is a measure of changes in the amount of money that people would need to spend to achieve a given standard of living. The CPI does not measure the cost of living because It does not measure all the components of the cost of living Some components are not measured exactly So the CPI is possibly a biased measure. Estimated at an additional 1.1 percent per year above real inflation.

The Poverty Threshold Based on the surveys conducted by the BLS and Census Bureau, assumptions are made about cost of living and wages. The poverty threshold is the income level below which income is insufficient to support a family or household. This is often called the poverty line.

The Poverty Rate The percentage of people who live in households with income below the poverty threshold. The surveys conducted make some generalizations about groups who are below the poverty line: Race and ethnicity Type of families (nuclear, single-parent) Age – children make up the largest group Residence (urban/suburban)

Causes of Poverty Lack of education Location Racial and gender discrimination Economic Shifts (structural unemployment) Shifts in Family Structures

The straight line represents complete equality of income The straight line represents complete equality of income. The dotted line shows actual distribution. Income Distribution The Lorenz Curve was developed to show how income is distributed across the nation’s population. This curve is divided into five “quintiles”. Rank households by income. Divide list into quintiles (the bottom quintiles is the poorest; top is the richest) Compute average incomes Plot them on the curve.

Why is there such a difference among incomes? Income gap Due to a number of causes: Difference in skills and training Inheritances/family structure Many anti-poverty policies have been enacted to offset this income gap: Employment Assistance Programs Welfare Reform