CPI Define It: Overall cost of Goods and services Bought by typical consumer Compare components of CPI to GDP

Calculate CPI 1.Fix the basket – Set by BLS (In the News p.516) 2. Find the prices 3. Compute Basket Cost (Price of Basket) – Q is now held constant to base year (think about what we are trying to measure and what we want to isolate – Compare to RGDP

4. Compute the Index current yr basket price x 100 = CPI base yr basket price Index #: no $, no % 5. Inflation Rate : % change in CPI

Producer Price Index Measures the cost of a basket of goods and services bought by firms rather than consumers

Problems in Measuring Cost of Living 1.Substitution Bias – When prices change, consumers will respond by buying goods whose prices have fallen, not original goods 2.Introduction of New Goods – Gives more variety to choose from, allowing consumers to reduce costs 3.Unmeasured quality change – BLS tries to adjust for changes in a good’s quality, either up or down

Problems in Measuring Cost of Living All the issues tend to create overstated inflation rates based on CPI This becomes an issue because COLA tied to Social Security

GDP Deflator vs. CPI Both used to measure change in prices Deflator measures prices of all goods/services produced domestically while CPI focuses on goods/services bought by consumers CPI based on fixed basket, Deflator based on currently produced goods They usually move in same direction

Dollar Figures from Different Times For turning dollar figures from past years into today’s dollars Amount in today’s dollars = Price Level Today Amt in year T dollars X ________________ Price Level in year T

Indexation When a dollar amount is automatically corrected for changes in price level by law or contract, the amount has been indexed for inflation

Real and Nominal Interest Rates Real Interest Rate = Nominal interest Rate – Inflation Rate Nominal interest rate tells you how fast the number of dollars in your bank account rises over time; real interest rate tells you how fast the purchasing power of your bank account rises over time