Download Why do prices change?

The Consumer Price Index (CPI)

The Bureau of Labor Statistics collects
price data on…
– 100,000 items
– 85 different locations around the country
– 19,000 retail establishments

CPI is constructed from these data
weighted by each commodity’s relative
importance in the average consumer’s
budget
The CPI (continued)

It reflects both
– the change in individual product/service
prices due to shifts in supply and/or
demand (given the product/service’s
weight in the market basket)
– the general rise (decline) in market prices
What Does the CPI Look Like?
http://research.stlouisfed.org/fred2/series/CPIAUCNS?cid=9
250
210.2
200
156.3
150
108.6
100
50
CPI
56.1
32.3
0
1966
1976
1986
1996
2007
 new  old  
 100


old


Relationship Between CPI & Inflation

Inflation = the Percentage Change from one
year to the next =
 new  old  
 100


old



Example:
• CPI1992=140.3
• CPI1993=144.5
• Annual rate of inflation between 1992 and 1993 =
 144.5  140.3 
 100


140.3


• = 2.99%
More Examples...

Example:
•
•
•
•
CPI1979=72.6
CPI1980=82.4
Annual rate of inflation between 1979 and 1980 =
 82.4  72.6  
 100


72.6

• = 13.5%

Example:
• Overall rate of inflation between 1979 and 1993 =
 144.5  72.6 
100


72.6

• = 99%
So what? Why does the CPI Matter



Helps to answer the age-old question:
Are you better off now than you were
five years ago?
Helps to understand how price changes
may lead to shifts in household
resource allocation patterns over time
Critical to understanding how
costs/benefits may vary through time.
Proverb #6: Only Today’s
Dollars are Comparable
We need to account for the fact
that the costs and benefits
associated with various
alternatives don’t always occur at
the same point in time.
Some Definitions...

Real interest rate - interest rate that
compensates individuals for
– opportunity cost of lending
– risk of lending

Nominal interest rate - interest rate that
compensates individuals for
– opportunity cost of lending
– the risk of lending
– inflation
In other words…

The stated nominal interest rate includes
monetary compensation for inflation.
– What the bank offers you is the nominal interest
rate, it is the price of the money you either loan or
lend from them.

Real interest rate adjusts for inflation.
– It allows us to compare prices across time,
adjusted for the effect of inflation
– A cost of $5 in real dollars in 1950 buys the same
amount of stuff as $5 in real dollars in 2000
Nominal interest rate = real
interest rate + inflation

Nominal interest rate =

Real interest rate =
real  inf  real  inf
nom  inf
1  inf

Examples...


If the credit union needs to get a real rate of return on
loans of 7% to cover costs and inflation is projected to
be 9%, what is the nominal interest rate that should
be charged on their consumer loans?
Please note: All percentages must be converted
to decimals
real  inf  real  inf



=.07 + .09 + (.07)(.09)
= .1663
= 16.63%

Examples...


The rate of inflation is forecast to be 10% and the
bank is currently offering 7% interest on its passbook
savings accounts. What is the real interest rate
earned on these accounts?
Please note: All percentages must be converted
to decimals
.07  .10
1  .10


= -.027
= -2.7%
Sample Test Question






Your bank offers you a five year CD with an
annual interest rate of 7%; annual inflation
rates are forecast at 3% for the next five
years. Based on this information, which of
the following statements is true:
A. The nominal interest rate is 4%
B. The real interest rate is 7%
C. The nominal interest rate is 7%
D. The real interest rate is 3%
E. Both the real and nominal interest rates
are 7%