Measuring the Cost of Living Copyright © 2001 by Harcourt, Inc. All rights reserved.   Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

Measuring the Cost of Living Inflation refers to a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period.

Using Price Indexes Because inflation may overstate the value of our GDP we need to make adjustments accordingly. A price index is a measurement of how the average price of a standard group of goods changes over time. Price indexes are the way we adjust nominal GDP (the value of GDP in current dollars) to real GDP (the value of GDP in constant dollars)

Consumer Price Index The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. The consumer price index uses a “fixed basket of goods” and evaluates changes in the basket’s costs each month.

Calculating a Price Index Price Index in given year = Cost of market basket in a given year Cost of market basket in base year X 100

The Bureau of Labor Statistics reports the CPI each month

Current changes in the CPI

Does the CPI overstate Inflation? Two reasons why it might: The CPI uses a fixed basket of goods. If the price of a good in the basket rises, the CPI rises. In reality, if the price of a good rises consumers typically substitute in a cheaper good. The CPI does not take into account the value of innovation and the improvements in technology we enjoy. A $2000 computer from 1990 is not the same as a $2000 computer today.

Other Price Indexes The BLS calculates other prices indexes: The indices for different regions within the country. The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. This index is a leading indicator of future price increases for consumers. The GDP deflator 11

The GDP deflator is calculated as follows: The GDP deflator allows us to distinguish between nominal GDP, which measures prices and quantities, and real GDP, which measures just quantities. The GDP deflator is calculated as follows:

How the Consumer Price Index Is Calculated Fix the Basket: Determine what prices are most important to the typical consumer. Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. 4

How the Consumer Price Index Is Calculated 4. Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. Current prices x 100 = CPI Base prices 7

The Inflation Rate We use the Consumer Price Index to calculate the inflation rate. Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

Causes of inflation Demand Pull Theory – demand for goods & services exceeds existing supply. One reason for this may be too much money in circulation. Cost Push Theory- producers raise prices in order to meet increased costs. This is also known as supply shocks (supply curve shifts left).

Cost-push or Supply Shock Demand-pull Cost-push or Supply Shock AS2 PRICE LEVEL PRICE LEVEL AS1 AS AD1 AD AD2 REAL GDP REAL GDP

Inflation affects the future value of our money. Effects of Inflation Interest Rates: Interest represents a payment in the future for a transfer of money in the past. When you save or loan someone money you expect a return on that money (interest). Inflation affects the future value of our money. 29

Real and Nominal Interest Rates The nominal interest rate is the interest rate not corrected for inflation. It is the stated interest rate that a bank pays. The real interest rate is the nominal interest rate that is corrected for inflation. When evaluating your return you need to focus on the real interest rate Real interest rate = (Nominal interest rate – Inflation rate) 30

Real and Nominal Interest Rates You borrowed $1,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5% 31

Anticipated and Unanticipated Inflation If a bank anticipates inflation they will set the nominal rate high enough to insure a return on any loans they make and inflation will not harm them. If inflation is unanticipated then the interest rate will not be set high enough and the bank (savers) will lose money.

Real and Nominal Interest Rates (percent per year) 15 Nominal interest rate 10 5 Real interest rate -5 1965 1970 1975 1980 1985 1990 1995 1998 3

Who’s Hurt? Who’s Helped? By Unanticipated Inflation You’re hurt if you are a Creditor – the money you loan out is worth less when its paid back Saver – inflation rates are normally higher than interest rates Fixed income receiver- a constant income will buy less. You’re helped if you are a Borrower- the money you are repaying is worth less Flexible income earner- if your income is tied to profits you will earn more If your income is adjusted for inflation you will earn more (COLA) Payer of fixed amounts