Price index

Nominal GDP For 2013 GDP we use prices paid in GDP at current prices (Q apples x$P apples ) + (Q computers x $P computers ) + (Q haircuts x $P haircuts ) + (Q cars x $P cars )+(Q houses x $P houses ) + … = $14,000T

real GDP For 2013 real GDP we use prices paid in base year. GDP at constant prices (Q apples x$P apples ) + (Q computers x $P computers ) + (Q haircuts x $P haircuts ) + (Q cars x $P cars )+(Q houses x $P houses ) + … = $7,000T

Nominal GDP Real GDP Price Apple Price Computer Price Haircut = = By how much to multiply Real GDP to get Nominal GDP How much prices “inflate” Nominal GDP

Price index Nominal GDP Real GDP X 100 GDP Deflator =

Inflation = Change in Price Index 6 (Deflator Year X) - (Deflator previous year) X 100

Which offer is better? Colombia $500,000 Pesos Bolivia $650 Bolivianos 7 Rent is $250,000 Rent is $100 What is important is NOT how much they pay you, but how much you CAN BUY with what they pay you

Which offer is better? Colombia $500,000 Pesos Bolivia $650 Bolivianos Rent is $250,000 Rent is $100 Some things are more expensive, others are cheaper… Food is $50,000 Food is $200 We need to put all prices into ONE single measure to be able to see which salary buys more.

Price index = Consumer Price Index CPI

The Consumer Price Index The CPI measures average change in prices over time for a basket of goods and services. 10 CPI

28,000 diaries and 60,000 interviews Determine What and How Many? 28,000 diaries and 60,000 interviews Determine What and How Many? 200 categories of goods and services divided into 8 groups and weighted by importance. A Basket of Basic Necessities 1. FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks); 2. HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture); 3. APPAREL (men's shirts and sweaters, women's dresses, jewelry); 4. TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance); 5. MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services); 6. RECREATION (televisions, cable television, pets and pet products, sports equipment, admissions); 7. EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); 8. OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses)

Although not a “price” CPI includes Some government-charged user fees: Water and sewerage charges, auto registration fees, and vehicle tolls. The CPI also includes taxes: Such as sales and excise taxes that are directly associated with the prices of specific goods and services.

CPI Excludes Personal Taxes: Such as income and Social Security taxes that are not directly associated with purchase goods and services. Prices of paper goods: Such as stocks, bonds, real estate, and life insurance. These are saving instruments not consumer goods.

What is included in each category? Relative Importance

Calculating the CPI 15 BasketQuantityPrice Base Year Food10$10 Doctor2$50 Rent1$700 Gasoline50$2 Basket Cost $

ItemQuantityPrice Base YearPrice Today Food10$10$20 Doctor2$50$100 Rent1$700$1400 Gasoline50$2$4 Basket Cost $1000$2000 Basket is 2 times more expensive today than in the base year Basket Cost current year Basket Cost base year Basket Cost current year Basket Cost base year X100 CPI= CPI= 200

ItemQuantityPrice Base YearPrice Today Food10$10$20 Doctor2$50$100 Rent1$700$1400 Gasoline50$2$4 Basket Cost $1000$2000 CPI (1000/1000)*100= 100 (2000/1000)*100= 200 Nominal Wage$1000 Real Wage ($1000/200)*100 = $500 Real Wage = (Nominal Wage/Price Index)*100 $1,000 today buys half of what you could buy with $1,000 in the base year. The real value of $1000 in today’s prices is equal to $500 in base year prices. Basket Cost current year Basket Cost base year Basket Cost current year Basket Cost base year X100 CPI=

Which offer is better? $500,000 Bolivia $650 Bolivianos $700 Colombia $500,000 Pesos

Inflation Rate for Year X (CPI Year X) -(CPI previous year) X 100 Change in CPI relative to previous year not to base year

20 ItemQuantity Price Base YearPrice 2008Price 2009 Food Doctor Rent Gasoline50248 Basket Cost Basket is 2 times more expensive in 2008 than in the base year Basket is 4 times more expensive in 2009 than in the base year CPI Inflation ( )/200)*100=100% You need 100% more money in 09 than in 08 to buy the same basket.

Why is the CPI important? Government use prices to set interest rates. Used in labor contracts. Landlords use it to determine rents. Judges use it to determine alimony and child support payments. Used to adjust payments to: Social Security recipients (50 million) Federal and Military retirees Food Stamps and School Lunches (25 million ) Used to adjust individual income tax brackets.

Problems with CPI 1.Substitution Bias: Because the basket is fixed, the CPI does not account for substitutions consumers do in response to higher prices. 24

25 4 Frozen Desserts 3 Fruits New Ignores substitution away from “frozen” to “cake-like” desserts 4 ice creams 3 apples Old New Basket: More General Categories

Problems with CPI… 2.New Goods not included in the basket allow consumers to attain the same (or higher) standard of living at lower cost. 3.Unmeasured Quality change: If quality improves, a dollar buys more MB floppy to 256 Gb flash drive

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The GDP Deflator vs. CPI GDP Deflator Uses a basket with different goods and different quantities Uses current production items and quantities. CPI Uses a basket with same goods and same quantities Uses the Market Basket 28

Comparing dollar values across time $100 CPI (1930) = 16.7 CPI (2011) = 226 Prices in 2011 are 13.5 times larger than in 1930 You need to have 13.5 times as much money in 2011 ? ? $1,350 To buy the same I need (226)/(16.7) =13.5 (226)/(16.7) =13.5 Multiply by 13.5

Comparing dollar values across cities 1. $40,000 in Boston 2. $35,000 in Kansas City. How much money do I need in Kansas City to buy what $40,000 buy in Boston? CPI (Boston) =250 CPI (Kansas City) = ,000 $?

200 / 250 = 0.8 Prices in Kansas City are 80% of prices in Boston: In Kansas, you need 80% of the money you need in Boston: With $40,000 in Boston you buy the same you buy with $32,000 in Kansas. $32,000 CPI (Boston) =250 CPI (Kansas City) = ,000 Kansas City offer is $ 35,000 Kansas City Offer is better 40,000*0.8 Boston’s 40,000 offer is equivalent to $32,000 in Kansas

Or…you can compare Real Values 32 Real Value Boston:(40,000/250)*100 =16,000 Real Value Kansas:(35,000/200)*100 = 17,500 In real terms the KC offer is $1,500 higher $35,000 CPI (Boston) =250 CPI (Kansas City) = ,000

CPI Salary in 2014 dollars CPI : Bush Washington Grant Taft Truman Nixon Obama2014 $400, President Best paid president is ____?

34 PresidentSalaryCPI New CPI/Old CPI Salary in 2014 dollars Taft Nixon Truman Grant Washington Bush Obama

Practice Today, you need $60,000/year to pay your bills. You plan to retire in CPI (2010) = 100; CPI (2055) = 244. How much money do you need in 2055 in order to be able to buy what you buy today with 60,000?

1.Breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks 2.Rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture 3.Men's shirts and sweaters, women's dresses, jewelry 4.New vehicles, airline fares, gasoline, motor vehicle insurance 5.Income and Social Security taxes 6.Stocks, bonds, real estate, and life insurance 7.Sales tax. Which items are included in the CPI basket?

Good AGood B YearQuantity Price per unitQuantity Price per unit 12, , , Calculate: GDP deflator for year 3

The Core Consumer Price Index 38 Unlike the overall CPI, the core CPI excludes food and energy prices, which can bounce around enough each month to distort the overall price trend picture. For the most recent core CPI data, click here.here

Updating the Market Basket CPI revisions occur approximately every 10 years. The most important revision is the introduction of a new “market basket” Annual Consumer Expenditure Surveys and Point-of-Purchase Surveys 39

Cost Of Living Adjustment Calculation is based on the increase in the CPI from the third quarter of the prior year to the third quarter of the current year.

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James Bond in Dr. No in 1962 $10 million CPI = 30 Indiana Jones and the Kingdom of the Crystal Skull $65 million CPI = 215

43 CPI (2010) =100 CPI (2055) = ,000 ? ? 244/100 = ,000 * 2.44 = $146,400 per year CPI (2010) =100 CPI (2055) = ,000 ? ? 378/100= ,000 * 3.78 = $226,800 2% inflation 3% inflation 146,400 x 20 years =2,928,0002,091,429 * 0.07 = 146,400

44 YearCPI Calculate the inflation rate for 2007

1.In 1964 earnings per hour were $7.96 (CPI= 31). Today, earnings per hour are $45(CPI=196.4). Are per hour earnings today equivalent to those in 1964? WHY or why not? 2.In what way are the CPI and the GDP deflator the same? In what way are they different? 3.Use the data in the table in the next slide to calculate: a)Inflation rate 1975 b)Inflation rate Identify Inflation/Deflation. Practice

(c) 2000,2001, 2002 Claudia Garcia - Szekely 46

(c) 2000,2001, 2002 Claudia Garcia - Szekely 47

Practice Measuring Inflation NAME ___________________ 1.Use the table above to calculate the inflation rate for Your salary in 2002 was $60,000. What should be your salary in 2011 in order to leave you with the same buying power $60,000 had in 2002? 3.Your salary in 2011 is $60,000. Calculate the real value of your salary.

Practice Measuring Inflation 1.Use the table above to calculate the inflation rate for Inflation Rate 2011 =((CPI 2011 – CPI 2010)/CPI 2010)*100 =(( – )/ )*100 =3.156%

$60,000 CPI (2002) = CPI (2011) = (224.9)/(179.9) =1.25 (224.9)/(179.9) =1.25 Prices in 2011 are 1.25 times larger than in 2002 You need to have 1.25 times as much money in 2011 Multiply by 1.25 ? $75, Your salary in 2002 was $60,000. What should be your salary in 2011 in order to leave you with the same buying power $60,000 had in 2002?

51 base 2011 $26, CPI (base) = 100 CPI (2011) = (224.9)/(100) =2.249 (224.9)/(100) =2.249 Prices in 2011 are times larger than in base year You need to have times as much money in 2011 Divide by ? $60,000 3.Your salary in 2011 is $60,000. Calculate the real value of your salary.

You can also calculate the real value of $60,000 using the following formula: Real Value = (Nominal Value /Price Index )*100 Real Value = ($60,000 /224.9 )*100 = $26,678.52