measuring the cost of living chapter 11 copyright © 2001 by harcourt, inc. all rights reserved....

Measuring the Cost of Living

Chapter 11

Copyright © 2001 by Harcourt, Inc.

All rights reserved. Requests for permission to make copies of any part of the

work should be mailed to:

Permissions Department, Harcourt College Publishers,6277 Sea Harbor Drive, Orlando, Florida 32887-6777.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Measuring the Cost of Living

Inflation refers to a situation in which the economy’s overall price level is rising.

The inflation rate is the percentage change in the price level from the previous period.


Using Price IndexesUsing Price Indexes

Because inflation may overstate the value of our GDP we need to make adjustments accordingly.

Price indexes are the way we adjust nominal GDP (the value of GDP in current dollars) to real GDP (the value of GDP in constant dollars)


GDP Deflator: A measure of the price level

100GDP Real

GDP Nominal=deflator GDP

The GDP deflator is calculated as follows:

The GDP deflator allows us to distinguish between nominal GDP,

which measures prices and quantities, and

real GDP, which measures just quantities.


The Consumer Price Index

The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.

The Bureau of Labor Statistics reports the CPI each month. www.bls.gov

It is used to monitor changes in the cost of living over time.


The GDP Deflator versus the Consumer Price Index

The GDP deflator reflects the prices of all goods and services produced domestically, whereas...

…the consumer price index reflects the prices of all goods and services bought by consumers.


1965

Percentper Year

15

10

5

01970 1975 1980 1985 1990 1995 2000

CPI

Two Measures of Inflation

GDP deflator


Other Price Indexes

The BLS calculates other prices indexes: The index for different regions within the country. The producer price index, which measures the cost of a basket of goods and

services bought by firms rather than consumers.


How the Consumer Price Index Is Constructed

Fix the Basket: Determine what prices are most important to the typical consumer.

Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.


How the Consumer Price Index Is Calculated

Choose a Base Year and Compute the Index: Designate one year as the base year, making

it the benchmark against which other years are compared.

Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

Current prices x 100 = CPIBase prices


The Inflation Rate

1001 Year in CPI

1 Year in CPI - 2 Year in CPI Year2in Rate Inflation

Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.


Causes of inflationCauses of inflation

Demand Pull Theory – demand for goods & services exceeds existing supply. One reason for this may be too much money in circulation.

Cost Push Theory- producers raise prices in order to meet increased costs. This is also known as supply shocks (supply curve shifts left).


Demand-pull Cost-push or Supply Shock

PRICE

LEVEL

PRICE

LEVEL

REAL GDP REAL GDP

AS

AD1 AD2

AS2AS1

AD


Effects of Inflation

Interest Rates:•Interest represents a payment in the future for a transfer of money in the past. •When you save or loan someone money you expect a return on that money (interest). •Inflation affects the future value of our money.


Real and Nominal Interest Rates

The nominal interest rate is the interest rate not corrected for inflation. It is the stated interest rate that a bank pays.

The real interest rate is the nominal interest rate that is corrected for inflation. When evaluating your return you need to focus on the real interest rate

Real interest rate = (Nominal interest rate – Inflation rate)



You borrowed $1,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%.

Real interest rate = Nominal interest rate – Inflation

= 15% - 10% = 5%


Anticipated and Unanticipated Anticipated and Unanticipated InflationInflation

If a bank anticipates inflation they will set the nominal rate high enough to insure a return on any loans they make and inflation will not harm them.

If inflation is unanticipated then the interest rate will not be set high enough and the bank (savers) will lose money.


1965

Interest Rates(percent per

year)

15

10

5

0

-51970 1975 1980 1985 1990 1995 1998

Nominal interest rate

Real interest rate



Who’s Hurt? Who’s Helped?Who’s Hurt? Who’s Helped?By Unantipated InflationBy Unantipated Inflation

You’re hurt if you are a Creditor – the money

you loan out is worth less when its paid back

Saver – inflation rates are normally higher than interest rates

Fixed income receiver- a constant income will buy less.

You’re helped if you are a Borrower- the money you

are repaying is worth less Flexible income earner-

if your income is tied to profits you will earn more

If your income is adjusted for inflation you will earn more (COLA)

Payer of fixed amounts

measuring the cost of living chapter 11 copyright © 2001 by harcourt, inc. all rights reserved....

Documents