ECN 111 Chapter 7 Lecture Notes 7.1 The Consumer Price Index A. Reading the CPI Numbers The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. 1. The CPI is defined to equal 100 for the reference base period. B. Constructing the CPI Constructing the CPI involves three stages: selecting the CPI basket; conducting the monthly price survey; calculating the CPI. C. The CPI Basket 1. The CPI basket contains the goods and services represented in the index and the relative importance attached to each of them. 2. The CPI basket is determined by the Consumer Expenditure Survey. Today’s CPI is based on data gathered in a survey of 1999-2000. D. The Monthly Price Survey 1. Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas. E. Calculating the CPI 1. To calculate the CPI, the cost of the CPI basket at base period prices and the cost of the CPI basket at current period prices is needed. Cost of CPIbasketat current period prices 2. The CPI = 100. Cost of CPIbasketat baseperiod prices F. Measuring Inflation 1. The inflation rate is the percentage change in the price level from one year to the next. (CPIin current year CPIin previous year) 100. 2. The inflation rate = CPI in previous year 3. When the price level rises rapidly, the inflation rate is high. When the price level rises slowly, the inflation rate is low. 7.2 The CPI and the Cost of Living A. The Biased CPI 1. New Goods Bias The fact that new goods gradually supplant old ones makes it difficult for the BLS to figure out how much of the higher price of the new goods is a sign of higher quality. More than likely, new goods put an upward bias into the CPI measurements. 2. Quality Change Bias To the extent that a price rise is a payment for improved quality, it is not inflation. The CPI probably counts too much of any price rise as inflation and not enough as quality improvement, so the CPI overstates inflation. 3. Commodity Substitution Bias The CPI ignores the substitution of goods that results from relative price changes. This omission leads the CPI to overstate inflation. 4. Outlet Substitution Bias The CPI does not take into account the fact that people respond to price increases by shopping at discount stores and online. B. The Magnitude of the Bias The Congressional Advisory Commission on the Consumer Price Index, chaired by Michael Boskin, concluded that the CPI overstates inflation by 1.1 percentage points a year. C. Two Consequences of the CPI Bias 1. Distortion of Private Contracts Labor contracts that link the wage to the CPI artificially raise wage rates if the CPI is overstated. 2. Increases in Government Outlays Close to a third of federal government outlays are linked to the CPI. If the 1.1 percentage point bias is accurate, the government will spend almost a trillion dollars more than it otherwise would have spent over the next decade. D. The GDP Deflator: A Better Measure? The GDP deflator is not a better measure of the cost of living than the CPI for two reasons: 1. In calculating real GDP (and hence the GDP deflator) the Commerce Department does not directly measure the physical quantities produced but uses estimates by dividing expenditures by price indexes. One of those price indexes is the CPI. So the biased CPI injects a bias into the GDP deflator. 2. The GDP deflator is broader than the CPI. GDP is the sum of expenditures on all final goods and services, not just consumption expenditures. So the GDP deflator is not an alternative to the CPI as a measure of the cost of living. 7.3 Nominal and Real Values A. Dollars and Cents at Different Dates To compare dollar amounts at different dates, we need to know the CPI at those dates. 1. To convert the price of a good in past dollars to its price in current dollars, multiply the CPI in present year earlier price by . CPI in earlier year B. Nominal and Real Values in Macroeconomics The difference between nominal and real variables is important in macroeconomics. In macroeconomics, we use the GDP deflator rather than the CPI as our measure of the price level because we are dealing with economy totals, of which consumer spending is just one part. C. Nominal and Real Wage Rates The nominal wage rate is the average hourly wage rate measured in current dollars and the real wage rate is the average hourly wage rate measured in dollars of a given reference base year. Nominal wagerate 1. The real wage rate = 100. CPI 2. The real wage rate is the quantity of goods and services that an hour’s work can buy. 3. Between 1972 and 2002 the real wage rate decreased as the nominal wage rate increased because the nominal wage rate didn’t keep up with inflation. D. Nominal and Real Interest Rates The nominal interest rate is the percentage return on a loan calculated by using dollars. The real interest rate is the percentage return on a loan calculated by using purchasing power—the nominal interest rate adjusted for the effects of inflation. 1. Real interest rate = Nominal interest rate Inflation rate. 2. When the inflation rate was high, during the 1970s and 1980s, the gap between the real interest rate and the nominal interest rate was large. The real interest rate was negative in the mid-1970s.