Price index

Nominal GDP

For 2013 GDP we use prices paid in 2013 .

GDP at current prices

(Qapplesx$Papples) + (Qcomputersx $Pcomputers) + (Qhaircutsx

$Phaircuts) + (Qcarsx $Pcars)+(Qhouses x $Phouses) + … = $14,000T

real GDP

For 2013 real GDP we use prices paid in base year.

GDP at constant

prices

(Qapplesx$Papples) + (Qcomputersx $Pcomputers) + (Qhaircutsx $Phaircuts) + (Qcarsx $Pcars)+(Qhouses x $Phouses) + … =

$7,000T

Nominal GDP

Real GDP

Price ApplePrice Apple

Price Computer

Price Computer

Price HaircutPrice Haircut

==

By how much to

multiply Real GDP

to get Nominal

GDP

By how much to

multiply Real GDP

to get Nominal

GDP

How much prices

“inflate” Nominal

GDP

How much prices

“inflate” Nominal

GDP

Price indexNominal GDPReal GDP

X 100GDP D

eflator

=

Inflation = Change in Price Index

6

Year GDP Deflator Inflation Rate2005 1132006 1162007 119

(Deflator Year X)

-(Deflator previous year)

(Deflator previous year)X 100

Which offer is better?

Colombia

$500,000 PesosBolivia

$650 Bolivianos

7

Rent is $250,000

Rent is $100

What is important is NOT how much they pay you, but how much you CAN BUY with what they pay you

Which offer is better?Colombia

$500,000 PesosBolivia

$650 Bolivianos

Rent is $250,000 Rent is

$100

Some things are more expensive, others are cheaper…

Food is $50,000

Food is $200

We need to put all prices into ONE single measure to be

able to see which salary buys more.

We need to put all prices into ONE single measure to be

able to see which salary buys more.

Price index=Consumer Price

Index

CPI

The Consumer Price Index

The CPI measures average change in prices over time for a basket of goods and services.

10

CPI

28,000 diaries and 60,000 interviews Determine

What and How Many?

28,000 diaries and 60,000 interviews Determine

What and How Many?

200

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A Basket of Basic Necessities

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).

2007-2008

Although not a “price” CPI includes

Some 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.

CPI Excludes

Personal Taxes:• Such as income and Social Security taxes that are

not directly associated with purchase goods and services.

Prices of paper goods:• Such as stocks, bonds, real estate, and life insurance.

These are saving instruments not consumer goods.

What is included in each category?

Relative Importance

Calculating the CPI

15

Basket Quantity Price Base Year

Food 10 $10

Doctor 2 $50

Rent 1 $700

Gasoline 50 $2

Basket Cost   $1000

1982-841982-84

Item Quantity Price Base Year Price TodayFood 10 $10 $20Doctor 2 $50 $100Rent 1 $700 $1400Gasoline 50 $2 $4

Basket Cost   $1000 $2000

     

Basket is 2 times more expensive today than in the 

base year

         Basket Cost current year             Basket Cost base year         Basket Cost current year             Basket Cost base year X100CPI=  2000

1000

CPI= 20

0

CPI= 20

0

Item Quantity Price Base Year Price TodayFood 10 $10 $20Doctor 2 $50 $100Rent 1 $700 $1400Gasoline 50 $2 $4

Basket Cost   $1000 $2000CPI   (1000/1000)*100=100 (2000/1000)*100=200

Nominal Wage $1000 $1000

Real Wage ($1000/200)*100 = $500

Real Wage = (Nominal Wage/Price Index)*100

$1,000 today buys half of what you could buy with $1,000 in the base year.

The real value of $

1000 in tod

ay’s prices i

s 

equal to $5

00 in base y

ear prices.

The real value of $

1000 in tod

ay’s prices i

s 

equal to $5

00 in base y

ear prices.

         Basket Cost current year             Basket Cost base year         Basket Cost current year             Basket Cost base year X100CPI= 

Which offer is better?

$500,000

Bolivia

$650 Bolivianos

$700

Colombia

$500,000 Pesos

Inflation Rate for Year X

(CPI Year X) - (CPI previous year)

(CPI previous year)X 100

Change in CPI relative to

previous year not to base year

20

Item Quantity Price Base

Year Price 2008 Price 2009Food 10 10 20 40Doctor 2 50 100 200Rent 1 700 1400 2800Gasoline 50 2 4 8Basket Cost   1000 2000 4000

     

Basket is 2 times more expensive in 2008  than in the base year

Basket is 4 times more expensive in 2009 than in the base year

CPI   100 200 400Inflation     (400-200)/200)*100=100%

You need 100% more money in 09 than in 08 to buy the same

basket.

Why is the CPI important?• Government use prices to set interest rates.• Used in labor contracts.• Landlords use it to determine 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.

Problems with CPI

1. Substitution Bias: Because the basket is fixed, the CPI does not account for substitutions consumers do in response to higher prices.

24

25

4 Frozen Desserts3 Fruits

New

Ignores substitution away from “frozen” to “cake-like” desserts

Ignores substitution away from “frozen” to “cake-like” desserts

4 ice creams3 apples

Old

New Basket: More General Categories

Problems with CPI…

2. New Goods not included in the basket allow consumers to attain the same (or higher) standard of living at lower cost.

3. Unmeasured Quality change: If quality improves, a dollar buys more.

26

2.0 MB floppy to 256 Gb flash drive

27

The GDP Deflator vs. CPI

GDP Deflator

Uses a basket with different goods and different quantities

Uses current production items and quantities.

CPI

Uses a basket with same goods and same quantities

Uses the Market Basket

28

Comparing dollar values across time

29

19301930 20112011

$100$100

CPI (1930) = 16.7CPI (1930) = 16.7 CPI (2011) = 226CPI (2011) = 226

Prices in 2011 are 13.5 times larger than in 1930Prices in 2011 are 13.5 times larger than in 1930

You need to have 13.5 times as much money in 2011You need to have 13.5 times as much money in 2011

??$1,350$1,350

To buy the same I needTo buy the same I need

(226)/(16.7)=13.5

(226)/(16.7)=13.5

Multiply by 13.5Multiply by 13.5

Comparing dollar values across cities

1. $40,000 in Boston

2. $35,000 in Kansas City.

How much money do I need in Kansas City to buy what $40,000 buy in Boston?

CPI (Boston) =250 CPI (Kansas City) = 200

40,000 $?

200 / 250 = 0.8

Prices in Kansas City are 80% of prices in Boston: In Kansas, you need 80% of the money you need in Boston:

With $40,000 in Boston you buy the same you buy with $32,000 in Kansas.

$32,000

CPI (Boston) =250 CPI (Kansas City) = 200

40,000

Kansas City offer is $35,000

Kansas

City Offer

is better

Kansas

City Offer

is better

40,000*0.8

Boston’s 40,000 offer is equivalent to $32,000 in

Kansas

Boston’s 40,000 offer is equivalent to $32,000 in

Kansas

Or…you can compare Real Values

32

Real Value Boston:(40,000/250)*100 =16,000

Real Value Kansas:(35,000/200)*100 = 17,500

In real terms the KC offer is $1,500 higher

$35,000

CPI (Boston) =250 CPI (Kansas City) = 200

40,000

CPI

Salary in 2014 dollars

CPI : 238

9.5

12.5

9.9

24

37

177Bush

Washington

Grant

Taft

Truman

Nixon

Obama 2014 $400,000 238

PresidentBest paid president is ____?

34

President Salary CPI

New CPI/Old

CPI

Salary in 2014 dollars

Taft 1909  75000 9.9 24.04 1803030Nixon 1969  200000 37 6.43 1286486Truman 1949  100000 24 9.92 991667Grant 1873  50000 12.5 19.04 952000Washington 1789   25000 9.5 25.05 626316Bush 2001  400000 177 1.34 537853Obama 2011  400000 238 1.00 400000

Practice

Today, you need $60,000/year to pay your bills. You plan to retire in 2055.

CPI (2010) = 100; CPI (2055) = 244.

How much money do you need in 2055 in order to be able to buy what you buy today with 60,000?

1. Breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks

2. Rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture

3. Men's shirts and sweaters, women's dresses, jewelry

4. New vehicles, airline fares, gasoline, motor vehicle insurance

5. Income and Social Security taxes

6. Stocks, bonds, real estate, and life insurance

7. Sales tax.

Which items are included in the CPI basket?

  Good A Good B

Year QuantityPrice per

unit QuantityPrice per

unit

1 2,000 0.1 75 1

2 2,400 0.15 60 1.1

3 2,600 0.25 75 1.2

Calculate: GDP deflator for year 3

The Core Consumer Price Index

38

Unlike the overall CPI, the core CPI 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.

Updating the Market Basket• CPI revisions occur approximately every 10

years.• The most important revision is the introduction of

a new “market basket”• Annual Consumer Expenditure Surveys and

Point-of-Purchase Surveys

39

Cost Of Living Adjustment

Calculation is based on the increase in the CPI from the third quarter of the prior year to the third quarter of the current year.

41

CPI Inflation2004 1862005 192 3.232006 197.2 2.712007 205.8 4.362008 204.8 -0.492009 211.7 3.372010 215.889 1.98

James Bond in Dr. No in 1962

$10 million

CPI = 30

Indiana Jones and the Kingdom of the Crystal Skull 2009.

$65 million

CPI = 215

43

CPI (2010) =100 CPI (2055) = 244

60,000 ?244/100 =2.44

60,000 * 2.44 = $146,400 per year

CPI (2010) =100 CPI (2055) = 378

60,000 ?

378/100=3.78

60,000 * 3.78 = $226,800

2% inflation

3% inflation

146,400 x 20 years =2,928,000 2,091,429 * 0.07 = 146,400

44

Year CPI

2005 195.3

2006 201.6

2007 207.342

Calculate the inflation rate for 2007

1. 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?

2. In what way are the CPI and the GDP deflator the same? In what way are they different?

3. Use the data in the table in the next slide to calculate:a) Inflation rate 1975b) Inflation rate 1980

4. Identify Inflation/Deflation.

Practice

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

46

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

47

Year CPI Inflation1970 39.81971 41.1 3.31972 42.5 3.41973 46.3 8.91974 51.9 12.11975 55.6 7.11976 58.4 5.01977 62.3 6.71978 67.9 9.01979 76.9 13.31980 66.9 -13.0

Practice Measuring Inflation

NAME ___________________

1. Use the table above to calculate the inflation rate for 2011.2. Your salary in 2002 was $60,000. What should be your salary in 2011 in

order to leave you with the same buying power $60,000 had in 2002?3. Your salary in 2011 is $60,000. Calculate the real value of your salary.

Practice Measuring Inflation

1. Use the table above to calculate the inflation rate for 2011.

Inflation Rate 2011 =((CPI 2011 – CPI 2010)/CPI 2010)*100

=((224.939 – 218.056)/218.056)*100

=3.156%

50

2002 2011

$60,000

CPI (2002) = 179.9 CPI (2011) = 224.9

(224.9)/(179.9)=1.25

Prices in 2011 are 1.25 times larger than in 2002

You need to have 1.25 times as much money in 2011

Multiply by 1.25

?$75,008.3

2. Your salary in 2002 was $60,000. What should be your salary in 2011 in order to leave you with the same buying power $60,000 had in 2002?

51

base 2011

$26,678.52

CPI (base) = 100 CPI (2011) = 224.9

(224.9)/(100)=2.249

Prices in 2011 are 2.249 times larger than in base yearYou need to have 2.249 times as much money in 2011

Divide by 2.249

?$60,000

3. Your salary in 2011 is $60,000. Calculate the real value of your salary.

3. Your salary in 2011 is $60,000. Calculate the real value of your salary.

You can also calculate the real value of $60,000 using the following formula:Real Value = (Nominal Value /Price Index )*100Real Value = ($60,000 /224.9 )*100 = $26,678.52