(c) 2000,2001, 2002 Claudia Garcia - Szekely 1 GDP Recession?

(c) 2000,2001, 2002 Claudia Garcia - Szekely©2001Claudia Garcia-Szekely 2 Price Index A price index is a number that represents overall prices for a given period of time –say a year-.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 3 Measuring Inflation:The Consumer Price Index Claudia Garcia-Szekely

(c) 2000,2001, 2002 Claudia Garcia - Szekely 4 The CPI relevant to consumers and workers Determines how much consumers pay for goods and services. Principal source of information for trends in consumer prices and inflation. It is one of the most important indicators of inflation. High inflation equals high interest rates. Low inflation allows interest rates to fall. Helps set labor contracts and government policy. Influences quality of life for retirees. Landlords use it to determine future increases in 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.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 5 The Consumer Price Index CPI The CPI is a measure average change in retail prices over time for a basket of goods and services. 200 categories of goods and services divided into eight groups and weighted by importance.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 6 Current Market Basket Weights determined by survey about actual purchases in 2003 and Weights are revised every two years to adjust for changing tastes and priorities. In each year, more than 5,000 families from around the country provided information on their spending habits in a series of quarterly interviews. To collect information on frequently purchased items such as food and personal care products, another 5,000 families in each of the 3 years kept diaries listing everything they bought during a 2-week period.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 7 Updating the Market Basket CPI revisions occur approximately every 10 years. The most important revision is the introduction of a new “market basket” The last revision to the CPI started in 1998 and completed in 2000.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 8 The CPI 1.Fix the basket: select the most commonly purchased items by conducting surveys. 3 trips 1 computer 5 Doctor visits 2 tuitions

(c) 2000,2001, 2002 Claudia Garcia - Szekely 9 The CPI 2.Find the prices of the items included in the basket: scouts go every month looking for these prices. Ticket = $600 Doctor Visit=$100 Tuition =$20,000 Computer=$1200

(c) 2000,2001, 2002 Claudia Garcia - Szekely 10 3 tickets $600/ea 1 Computer $1,200/ea 5 Doctor visits $100/ea 2 Tuitions $20,000/ea Cost of the Basket Y2000 $43,500 $1,800 $1,200 $500 $40,000

(c) 2000,2001, 2002 Claudia Garcia - Szekely 11 The CPI 4.Choose a base year - the benchmark for comparison- and compute the cost of the basket in the base year…Say 1995 Ticket Price in 1995 = $500 Doctor Visit in 1995 =$90 Tuition in 1995 =$20,000 Computer Price in 1995 =$1500

(c) 2000,2001, 2002 Claudia Garcia - Szekely 12 3 tickets $500/ea 1 Computer $1,500/ea 5 Doctor visits $90/ea 2 Tuitions $20,000/ea Cost of the Basket in the Base Year (1995) $43,450 $1,500 $450 $40,000 Note: Same items, same quantities, same qualities we used for 2000

(c) 2000,2001, 2002 Claudia Garcia - Szekely 13 The CPI 5. Compute the CPI. CPI (Year 2000) = Cost of Basket in 2000 Cost of Basket Base Year x100

(c) 2000,2001, 2002 Claudia Garcia - Szekely 14 Calculating the CPI 1.Fix the quantities and items in the basket. 2.Find the prices of these items. 3.Compute the cost of the items in the basket at each year’s prices. 4.Choose a base year -the benchmark for comparison- CPI (Year 2000) = Cost of Basket in 2000 Cost of Basket Base Year x100

(c) 2000,2001, 2002 Claudia Garcia - Szekely 15 Calculate Cost of basket in each year… X X X X X X = = =

(c) 2000,2001, 2002 Claudia Garcia - Szekely 16 CPI = Basket cost Year X /Basket cost base year. (20/8)*100 = CPI Cost of the Basket Year (8/8)*100 = (14/8)*100 =

(c) 2000,2001, 2002 Claudia Garcia - Szekely 17 Inflation Measures the rate of CHANGE in prices. Is calculated from a price index, for different time periods: months, quarters, years.

The Inflation Rate for Year X (Price Index Year X) - (Price Index previous year) X 100

(c) 2000,2001, 2002 Claudia Garcia - Szekely 19 Calculating the Inflation Rate X100 = 75% X 100 = 43% You need 75% more money in 2001 than in 2000 to buy the same goods

(c) 2000,2001, 2002 Claudia Garcia - Szekely©2001Claudia Garcia-Szekely 20 What goods and services does the CPI cover? All goods and services purchased for consumption are classified into 200 categories, arranged into eight major groups.

The CPI includes 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).

(c) 2000,2001, 2002 Claudia Garcia - Szekely 22 Although not a “price” CPI includes… Also included are various 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. The CPI excludes taxes: such as income and Social Security taxes that are not directly associated with the purchase of consumer goods and services. The CPI does not include investment items: such as stocks, bonds, real estate, and life insurance. Because these items relate to savings and not to day- to-day consumption expenses.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 23 The Core Consumer Price Index Measures what consumers are paying for goods and services at malls, grocery stores and other retail locations. Unlike the overall CPI, it 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

What is included in each category? Relative Importance Dec 2006

(c) 2000,2001, 2002 Claudia Garcia - Szekely 25 Problems Measuring the Cost of Living 1.Substitution Bias: Because the basket is fixed, the CPI does not account for substitutions consumers do in response to higher prices. Substitution away from “frozen desserts” to “cake-like desserts”.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 26 Geometric Mean Estimator Employs a set of fixed expenditure proportions as weights. Consumers can alter the quantities of goods and services they buy within the category, when the relative prices of those goods and services change. 3 apples 4 ice cream bars 3 fruits 4 frozen desserts

(c) 2000,2001, 2002 Claudia Garcia - Szekely 27 Problems with CPI… 2.New Goods Bias: Not included in the basket. Consumers spend less to attain the same (or higher) standard of living. CPI does not reflect this change in the purchasing power of a dollar. 3.Unmeasured Quality change: If quality improves, the value of the dollar rises.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 28 Inflation Inflation refers to an INCREASE in the price level from one period to the next. Inflation can be high (20%) or low (2%) When inflation drops from 20% to 2% prices still INCREASE, but not as much as the previous time period.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 29 Deflation Deflation refers to a DECREASE in the price level from one period to the next. Deflation shows up as a NEGATIVE number for the inflation rate: a –5% “inflation” means that prices DECREASED by 5%. This is not only a slowing down of inflation but a DROP in prices.

For which years there is Deflation? Inflation?

(c) 2000,2001, 2002 Claudia Garcia - Szekely 31

(c) 2000,2001, 2002 Claudia Garcia - Szekely 32 The GDP Deflator The GDP deflator is a price index. It is calculated from nominal and real GDP. Sometimes called “implicit” price deflator because it is the price implicit in the difference between real and nominal.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 33 The GDP Deflator Formula GDP Deflator = Nominal GDP Real GDP X 100 Also called the GDP Price Index

(c) 2000,2001, 2002 Claudia Garcia - Szekely 34 YearCPI Calculate the inflation rate for these three years.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 35 Inflation Rate for 1999 (Deflator Year X) - (Deflator previous year) X 100 Calculate the inflation rate for these three years.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 36 The GDP Deflator vs. the CPI 1. GDP Deflator reflects the prices of all goods and services produced domestically bought by consumers, the government and other countries.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 37 The GDP Deflator vs. the CPI 1.The CPI reflects prices of goods purchased by consumers only. The CPI does not take into account prices of goods and services bought by the government or foreigners.

(c) 2000,2001, 2002 Claudia Garcia - Szekely 38 The GDP Deflator vs. The CPI 2.The CPI uses a fixed basket whereas the GDP deflator uses prices of currently produced goods

(c) 2000,2001, 2002 Claudia Garcia - Szekely 39 Comparing dollar values from different years $100 in 1930 is not the same as $100 in Why not? Because prices were different: $100 used to buy you more then… To compare $100 in 1931 with $100 today we must find out what $100 used to buy in 1930 and compare that to what $100 buys today..

(c) 2000,2001, 2002 Claudia Garcia - Szekely 40 Moving dollar values forward in time… $100 CPI (1930) = 16.7 CPI (2000) = (172.2)/(16.7) =10.31 Prices in 2000 are times larger than in 1930 You need to have times as much money in 2000 Multiply by ? $1,031

(c) 2000,2001, 2002 Claudia Garcia - Szekely 41 Example If you want to know what is the equivalent in today’s dollars of an $80,000 salary in 1931, 1.Find the ratio of prices: CPI in 2000 / CPI in 1931 = 172.2/16.7 = ___ 2.Multiply 80,000 by that # =________ An $80,000 salary in 1931 is equivalent to a $_________salary in ,910.2

(c) 2000,2001, 2002 Claudia Garcia - Szekely 42 Using the Inflation Calculator The Presidential salary from was $75,000 annually (President Hoover ) CPI = 17.1 George W. Bush salary is $200,000 annually. CPI = Do we pay our president a salary equivalent to that of President Hoover?

(c) 2000,2001, 2002 Claudia Garcia - Szekely©2001Claudia Garcia-Szekely 43 Inflation Calculator This site finds the equivalencies for dollars in different years. bin/cpicalc.pl

(c) 2000,2001, 2002 Claudia Garcia - Szekely 44 Questions to prepare for the test 1. Is the CPI inflation rate measured correctly? In your answer you must mention the new goods bias, the quality bias and the substitution bias. Provide an example for each to illustrate your answer.

2.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? 3.In what way are the CPI and the GDP deflator the same? In what way are they different? 4.Use the data in the table in the next slide to calculate: a)Inflation rate 1975 b)Inflation rate Identify Inflation/Deflation.

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

(c) 2000,2001, 2002 Claudia Garcia - Szekely Which items are included in the CPI basket? Breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks Rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture Men's shirts and sweaters, women's dresses, jewelry New vehicles, airline fares, gasoline, motor vehicle insurance Income and Social Security taxes Stocks, bonds, real estate, and life insurance Sales taxes

(c) 2000,2001, 2002 Claudia Garcia - Szekely 48 ECI comes out quarterly and measures changes in employee wages, salaries and benefits. AHE, the Employment Situation report, comes out monthly, shows how worker wages are changing month to month. Both are important because rapidly rising labor costs can force businesses to raise prices to compensate, spurring inflation. For the most recent ECI data, click here. For the most recent AHE data, click here here Employment Cost Index (ECI) Average Hourly Earnings (AHE)

(c) 2000,2001, 2002 Claudia Garcia - Szekely 50 More Information on the CPI Go to: bin/surveymost?cuhttp://data.bls.gov/cgi- bin/surveymost?cu Check on first box: U.S. All items, =100 - CUUR0000SA0