CPI

Question 1

What is CPI (consumer price index)

Answer 1

-Computed and reported every month by BLS (Bureau of Labor Statistics)

Measure of overall cost of goods and services bought by a consumer

Monitors changes in COST OF LIVING over time

Way of measuring inflation

Question 2

How is CPI computed?

Answer 2

1. Fix the basket (survey consumers)
2. Find the prices
3. Compute basket’s cost
4. Choose a base year to compute the index

Question 2

CPI equation

Answer 2

CPI = (basket’s cost in current year/basket’s cost in BASE year) * 100

Remember to use prices from BASE year

Question 3

Inflation rate equation

Answer 3

Inflation rate in year 2 = (CPI in year 2 - CPI in year 1)/ (CPI in year 1) *100

Question 4

3 Problems with CPI?

Answer 4

1. Substitution bias: when prices rise over time, consumers substitute toward goods that are cheaper

CPI misses the substitution bc it uses a basket of goods

prices of goods and services do not change in the same proportion from year to year

2. Introduction of new goods- dollars become more valuable but CPU uses a fixed basket of goods, therefore overstates increases in costs of living
3. Unmeasured quality change: things get better over time, but quality is hard to measure

Question 5

GDP deflator vs CPI

Answer 5

GDP deflator: ratio of nominal GDP to real GDP
Reflects prices of ALL goods and services produced DOMESTICALLY
Compares prices of recently produced goods and services to price of same goods and services in the BASE YEAR

CPI: Reflects prices of goods and services bought by producers
Compares price of a FIXED basket of goods to price of the basket in the base year

Question 6

How to convert dollar values from the past to today’s dollars?

Answer 6

Amount in today’s dollars = Amount in year T dollars * (Price level today)/(Price level in year T)

OR

(Amount in today’s dollars)/(price level today) =
(amount in year T dollars)/(price level in year T)

Question 7

What is indexation?

Answer 7

Automatic correction by law or contract of a dollar amount for the effects of inflation

Question 8

What does the increase in CPI automatically determine?

Answer 8

• COLA (cost-of-living-allowance) in many multi-year labor contracts
• Adjustments in social security payments and federal income tax brackets

Question 9

What is nominal interest rate?

Answer 9

Interest rate not corrected for inflation
Rate of growth in dollar value of a deposit/debt

Question 10

What is the real interest rate?

Answer 10

Interest rate corrected for inflation
Rate of growth in purchasing power of a deposit/debt

Question 11

How to compute real interest rate:

Answer 11

Real interest rate = nominal interest rate - inflation rate