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Consumer Price Index Chapter 7 Price Index Price index is the average level of prices in the economy and inflation is measured by the rate of changes in this index. Three types of price index – Consumer price index (CPI) – Producer price index (PPI) – GDP deflator: the most comprehensive price index CPI (Consumer Price Index) A measure of the average of the prices paid by urban consumers for a fixed maker basket of goods and services – CPI basket: 80,000 products in the eight broad categories – Monthly price survey by BLS employees – CPI calculation • Cost of current year CPI basket / cost of base year CPI basket * 100 Inflation Rate Inflation rate is the percentage change in a price index (CPI). Inflation rate reflects changes in the cost of living. Formula: – Inflation rate = change in CPI / previous (or base) CPI * 100 Higher inflation rates during the 1970s and 1980s and lower inflation rates during the 1990s. Related Terms to Inflation Deflation: the price index declines (the inflation rate is negative) Disinflation: the rate of inflation declines (the price index still rises) Hyperinflation: the extremely high rate of inflation (annually 100% or more) Bias in CPI The CPI is sometimes called a cost of living index, but not true for two reasons – It does not measure price changes of all products (only 80,000) – It does not always measure accurately due to the bias. • Sources of bias: new products, quality changes, commodity substitution, outlet substitution The bias in the CPI results in overstatement of the inflation rate by 1.1%. Also resulting in increased government outlays and distorted wage contracts. Bias in GDP Deflator GDP deflator also suffers from the bias, but to a lesser degree due to the facts that – It includes new products and quality improvement and allows substitution to some extent. – It covers a broader range of products The GDP deflator has increased slower than the CPI over the last 20 years. Nominal vs. Real Values Nominal vs. real prices – Real price = nominal price / CPI * 100 Nominal vs. real wage rates – Real wage rate = nominal wage rate / CPI * 100 – The nominal wage rate has increased rapidly, but the real wage rate has increased very mildly. Nominal vs. real interest rates – Real interest rate = nominal interest rate – inflation rate