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Flashcards in Chapter Seven Deck (25):
1

What is the Consumer Price Index CPI

CPI is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. The abs calculated the CPI every quarter (3mos). We can use these numbers to compared what a fixed basket of goods costs this quarter with what it cost in some previous quarter or period.

2

How to read the CPI numbers

The CPI is defined to equal 100 for a period called the reference based period. Reference base period is a period for which the CPI is defined to equal 100.

3

What are the three stages in constructing the CPI

Three stages:
Selecting the CPI basket
Conducting the quarterly price surgery
Calculating the CPI

4

Explain the CPI market basket

Make the relative importance of the items in the CPI basket the same as in budget of an average urban household. The CPI is calculated each quarter but the CPI basket is not updated each quarter. The CPI basket in 2015 is based on information obtained from the 2009/10 household expenditure survey.

5

What is the quarterly price survey

Each quarter, abs employees check the prices of the goods and services in the 11 large groups shown in the CPI basket in all major cities. Because the CPI measures price changes it is important that the prices recorded refer to exactly the same items

11 major keys: communication, education, clothing and footwear, health, insurance and financial services, alcohol and tobacco, furnishing and household equipment and services, transportation, recreation, food and housing. Last two are biggest.

6

What are the three steps to CPI calculation.

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.

7

CPI formula

CPI = cost of CPI basket at current period prices divided by cost of CPI basket at base period prices X 100.

8

How to measure inflation and deflation

Inflation rate is the percentage change in the price level from one year to the next.

Inflation rate = CPI in current year - CPI in previous year divided by CPI in previous years X 100.

If the inflation rate is negative, the price level is falling and we have deflation. Deflation is a situation in which the inflation rate is negative.

9

What is the cost of living index

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 and some components are not measured exactly. So the CPI is possibly a biased measure.

10

What are the sources of bias in the CPI

The potential sources of bias in the CPI are new goods bias, quality change bias, commodity substation bias, outlet substitution bias

11

What is new goods bias

New goods do a better job than the old goods that they replace but cost more. The arrival of new goods puts an upward bias into the CPI and it measure of the inflation rate

12

What is quality change bias

Better cars, TVs, and mobile phones cost more than the versions they replace. A price rise that is a payment for improved quality is not inflation but might be measured as inflation.

13

What is commodity substitution bias

If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. The CPI basket doesn't change to allow for the effects of substitution between goods.

14

What is the outlet substitution bias

If prices rise more rapidly, people use discount stores more frequently. The CPI basket doesn't change to allow for the effects of outlet substitution.

15

What is the magnitude of the biases

The reserve bank estimated that substitution bias is about 0.5 percentage points, but broader bias estimates are not available.

16

What are the two main consequences of CPI bias

Distortion of private contracts: many wage contracts are linked to the CPI. If the CPI is biased, these contracts might deliver an outcome different from that intended by the parties.

Increases in government outlays and decreases in taxes: the CPI is used to adjust the incomes of the server all million recipients of a government pension, jobseekers benefit, single parent allowance and other benefits. The CPI is also used to adjust budgets for benefits in kind. Close to a half of federal and state government outlays are linked to the CPI. If the CPI bias is 1.0 percentage point, the bias adds billions of dollars to government outlays. The CPI is used to adjust the income levels at which higher tax rates apply. Because tax rates on large incomes are higher than those on small incomes so as incomes rise the burden of taxes would raise relentlessly if these adjustments were not made. To the extent that the CPI is biased upward the tax adjustments overcompensate for rising prices and decrease the amount paid in taxes.

17

What are the alternative measures of the price levels and inflation rate

Several alternative measures of the price level are available but three mains are:

GDP deflator

Chain price index for household final consumption expenditure (HFCE)

Trimmed mean CPI

18

What is the GDP deflator

The GDP deflator is an average of current prices of all the goods and services included in GDP expressed as a percentage of base year prices.

GDP deflator = nominal GDP divided by real GDP x 100.

It is a measure of the price level

The percentage change in the GDP deflator is a measure of the inflation rate.

19

What are the two differences between the GDP deflator and the CPI result in different estimates of the price level and inflation rate

The GDP deflator uses the prices of all final goods and services in GDP

The CPI uses prices of consumption goods and services

The GDP deflator weights each item using information about current as well as past quantities. In contrast, the CPI weights each item using information from a past household expenditure survey.

Because the GDP deflator uses information on current year quantities it includes new goods and quality improvements and even allows for substitution effects of both commodities and retail outlets. So in principle the GDP deflator is not subject to the biased of the CPI.

20

Explain the chain price index for household final consumption expenditure

The chained price index is an average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base year prices. The chained price index like the GDP deflator uses current information on quantities and prices and to some degree overcomes the sources of bias in the CPI. Because it focuses on consumption expenditure it a possible measure of the cost of living.

21

Explain the trimmed mean CPI

The trimmed mean CPI is the CPI excluding the 15 per cent of items who prices rose fastest and the 15 per cent who lose prices rose slowest.

The percentage change in the trimmed mean CPI is called the core inflation rate.

22

Explain nominal and real wage rates

Nominal wage rate is the average hourly wage rate measured in current dollars.

Real wage rate is the average hourly wage rate measured in the dollars of a given reference base year.

23

How to measure changes in dollar amounts at different dates

To compare dollar amounts at different dates we need to know the CPI at those date. Converting the price of four cent stamp in 1966 into its 2014 equivalent.

Price of stamp in 2014 dollars = price of stamp in 1966 dollars x CPI in 2014 divided by CPI in 1966

4c x 106.6 divided by 8.6 = 50 cents

24

How to calculate real wage rate

In 2014 the nominal wage rate (average hourly earnings) of production workers was $29.71, the CPI was 106.2 and the CPI in 1980 was 25.4.

Real wage rate in 1980 dollars = nominal wage rate in 2014 dollars x CPI in 1980 divided by CPI in 2014.

Real wage rate in 1980 dollars = $29.71 x 26.4 divided by 106.1 = $7.39

The real wage rate measured the real reward for labour which is a major determinant of the standard of living.

25

Explain nominal interest rate and real interest rate

Nominal interest rate is the dollar amount of interest expressed as a percentage of the amount loaned

Real interest rate is the goods and services forgone in interest expressed as a percentage of the amount loaned

Real interest real = nominal interest rate - inflation rate