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1、Measuring the Cost of Living,Economics,P R I N C I P L E S O F,N.Gregory Mankiw,Premium PowerPoint Slides by Ron Cronovich,24,In this chapter,look for the answers to these questions:,What is the Consumer Price Index(CPI)?How is it calculated?Whats it used for?What are the problems with the CPI?How s
2、erious are they?How does the CPI differ from the GDP deflator?How can we use the CPI to compare dollar amounts from different years?Why would we want to do this,anyway?How can we correct interest rates for inflation?,1,MEASURING THE COST OF LIVING,2,The Consumer Price Index(CPI),measures the typical
3、 consumers cost of livingthe basis of cost of living adjustments(COLAs)in many contracts and in Social Security,0,MEASURING THE COST OF LIVING,3,How the CPI Is Calculated,Fix the“basket.”The Bureau of Labor Statistics(BLS)surveys consumers to determine whats in the typical consumers“shopping basket.
4、”Find the prices.The BLS collects data on the prices of all the goods in the basket.Compute the baskets cost.Use the prices to compute the total cost of the basket.,0,MEASURING THE COST OF LIVING,4,How the CPI Is Calculated,Choose a base year and compute the index.The CPI in any year equals,Compute
5、the inflation rate.The percentage change in the CPI from the preceding period.,0,MEASURING THE COST OF LIVING,5,EXAMPLE,basket:4 pizzas,10 lattes,$12 x 4+$3 x 10=$78,$11 x 4+$2.5 x 10=$69,$10 x 4+$2 x 10=$60,cost of basket,Compute CPI in each year2007:100 x($60/$60)=1002008:100 x($69/$60)=1152009:10
6、0 x($78/$60)=130,Inflation rate:,0,using 2007 base year:,A C T I V E L E A R N I N G 1 Calculate the CPI,6,CPI basket:10 lbs beef,20 lbs chickenThe CPI basket cost$120 in 2004,the base year.,A.Compute the CPI in 2005.B.What was the CPI inflation rate from 2005-2006?,0,A C T I V E L E A R N I N G 1 A
7、nswers,7,0,0,A.Compute the CPI in 2005:,Cost of CPI basket in 2005=($5 x 10)+($5 x 20)=$150 CPI in 2005=100 x($150/$120)=125,CPI basket:10 lbs beef,20 lbs chickenThe CPI basket cost$120 in 2004,the base year.,A C T I V E L E A R N I N G 1 Answers,8,0,0,CPI basket:10 lbs beef,20 lbs chickenThe CPI ba
8、sket cost$120 in 2004,the base year.,B.What was the inflation rate from 2005-2006?,Cost of CPI basket in 2006=($9 x 10)+($6 x 20)=$210 CPI in 2006=100 x($210/$120)=175CPI inflation rate=(175 125)/125=40%,MEASURING THE COST OF LIVING,9,Whats in the CPIs Basket?,0,CPI basket:10#beef,20#chicken2004-5:H
9、ouseholds bought CPI basket.2006:Households bought 5 lbs beef,25 lbs chicken.,A C T I V E L E A R N I N G 2 Substitution bias,10,A.Compute cost of the 2006 household basket.B.Compute%increase in cost of household basket over 2005-6,compare to CPI inflation rate.,0,A C T I V E L E A R N I N G 2 Answe
10、rs,11,A.Compute cost of the 2006 household basket.($9 x 5)+($6 x 25)=$195,CPI basket:10#beef,20#chickenHousehold basket in 2006:5#beef,25#chicken,A C T I V E L E A R N I N G 2 Answers,12,B.Compute%increase in cost of household basket over 2005-6,compare to CPI inflation rate.Rate of increase:($195$1
11、50)/$150=30%CPI inflation rate from previous problem=40%,CPI basket:10#beef,20#chickenHousehold basket in 2006:5#beef,25#chicken,MEASURING THE COST OF LIVING,13,Problems with the CPI:Substitution Bias,Over time,some prices rise faster than others.Consumers substitute toward goods that become relativ
12、ely cheaper.The CPI misses this substitution because it uses a fixed basket of goods.Thus,the CPI overstates increases in the cost of living.,0,MEASURING THE COST OF LIVING,14,Problems with the CPI:Introduction of New Goods,The introduction of new goods increases variety,allows consumers to find pro
13、ducts that more closely meet their needs.In effect,dollars become more valuable.The CPI misses this effect because it uses a fixed basket of goods.Thus,the CPI overstates increases in the cost of living.,0,MEASURING THE COST OF LIVING,15,Problems with the CPI:Unmeasured Quality Change,Improvements i
14、n the quality of goods in the basket increase the value of each dollar.The BLS tries to account for quality changes but probably misses some,as quality is hard to measure.Thus,the CPI overstates increases in the cost of living.,0,MEASURING THE COST OF LIVING,16,Problems with the CPI,Each of these pr
15、oblems causes the CPI to overstate cost of living increases.The BLS has made technical adjustments,but the CPI probably still overstates inflation by about 0.5 percent per year.This is important because Social Security payments and many contracts have COLAs tied to the CPI.,0,MEASURING THE COST OF L
16、IVING,17,Two Measures of Inflation,1950-2007,0,MEASURING THE COST OF LIVING,18,Imported consumer goods:included in CPI excluded from GDP deflator,The basket:CPI uses fixed basketGDP deflator uses basket of currently produced goods&servicesThis matters if different prices are changing by different am
17、ounts.,Capital goods:excluded from CPI included in GDP deflator(if produced domestically),Contrasting the CPI and GDP Deflator,0,In each scenario,determine the effects on the CPI and the GDP deflator.A.Starbucks raises the price of Frappuccinos.B.Caterpillar raises the price of the industrial tracto
18、rs it manufactures at its Illinois factory.C.Armani raises the price of the Italian jeans it sells in the U.S.,A C T I V E L E A R N I N G 3 CPI vs.GDP deflator,19,A.Starbucks raises the price of Frappuccinos.The CPI and GDP deflator both rise.B.Caterpillar raises the price of the industrial tractor
19、s it manufactures at its Illinois factory.The GDP deflator rises,the CPI does not.C.Armani raises the price of the Italian jeans it sells in the U.S.The CPI rises,the GDP deflator does not.,A C T I V E L E A R N I N G 3 Answers,20,MEASURING THE COST OF LIVING,21,Correcting Variables for Inflation:Co
20、mparing Dollar Figures from Different Times,Inflation makes it harder to compare dollar amounts from different times.Example:the minimum wage$1.15 in Dec 1964$5.85 in Dec 2007Did min wage have more purchasing power in Dec 1964 or Dec 2007?To compare,use CPI to convert 1964 figure into“todays dollars
21、”,0,MEASURING THE COST OF LIVING,22,In our example,year T=12/1964,“today”=12/2007Min wage=$1.15 in year TCPI=31.3 in year T,CPI=211.7 today,Correcting Variables for Inflation:Comparing Dollar Figures from Different Times,0,0,Amount in todays dollars,Amount in year T dollars,=,x,$7.78,$1.15,=,x,The m
22、inimum wage in 1964 was$7.78 in todays(2007)dollars.,MEASURING THE COST OF LIVING,23,Correcting Variables for Inflation:Comparing Dollar Figures from Different Times,Researchers,business analysts and policymakers often use this technique to convert a time series of current-dollar(nominal)figures int
23、o constant-dollar(real)figures.They can then see how a variable has changed over time after correcting for inflation.Example:the minimum wage,from Jan 1950 to Dec 2007,0,The U.S.Minimum Wage in Current Dollarsand Todays Dollars,1950-2007,$per hour,$0,$1,$2,$3,$4,$5,$6,$7,$8,$9,1950,1955,1960,1965,19
24、70,1975,1980,1985,1990,1995,2000,2005,Annual tuition and fees,average of all public four-year colleges&universities in the U.S.1986-87:$1,414(1986 CPI=109.6)2006-07:$5,834(2006 CPI=203.8)After adjusting for inflation,did students pay more for college in 1986 or in 2006?Convert the 1986 figure to 200
25、6 dollars and compare.,A C T I V E L E A R N I N G 4 Converting to“todays dollars”,25,A C T I V E L E A R N I N G 4 Answers,26,SolutionConvert 1986 figure into“todays dollars”$1,414 x(203.8/109.6)=$2,629Even after correcting for inflation,tuition and fees were much lower in 1986 than in 2006!,Annual
26、 tuition and fees,average of all public four-year colleges&universities in the U.S.1986-87:$1,414(1986 CPI=109.6)2006-07:$5,834(2006 CPI=203.8),MEASURING THE COST OF LIVING,27,Correcting Variables for Inflation:Indexation,For example,the increase in the CPI automatically determinesthe COLA in many m
27、ulti-year labor contractsthe adjustments in Social Security payments and federal income tax brackets,A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract.,0,MEASURING THE COST OF LIVING,28,Correcting Variables for Inflation:Real vs.Nominal I
28、nterest Rates,The nominal interest rate:the interest rate not corrected for inflationthe rate of growth in the dollar value of a deposit or debtThe real interest rate:corrected for inflationthe rate of growth in the purchasing power of a deposit or debtReal interest rate=(nominal interest rate)(infl
29、ation rate),0,MEASURING THE COST OF LIVING,29,Correcting Variables for Inflation:Real vs.Nominal Interest Rates,Example:Deposit$1,000 for one year.Nominal interest rate is 9%.During that year,inflation is 3.5%.Real interest rate=Nominal interest rate Inflation=9.0%3.5%=5.5%The purchasing power of th
30、e$1000 deposit has grown 5.5%.,0,MEASURING THE COST OF LIVING,30,Real and Nominal Interest Rates in the U.S.,1950-2007,0,CHAPTER SUMMARY,The Consumer Price Index is a measure of the cost of living.The CPI tracks the cost of the typical consumers“basket”of goods&services.The CPI is used to make Cost of Living Adjustments and to correct economic variables for the effects of inflation.The real interest rate is corrected for inflation and is computed by subtracting the inflation rate from the nominal interest rate.,31,
