Chapter 21

When you have completed your study of this chapter, you will be able to1 Explain what the Consumer Price Index (CPI) is and how it is calculated.2 Explain how CPI is used. CHAPTER CHECKLISTThe CPI and the Cost of Living 2013 Pearson1#

April 2014 inflation rate 0.72% 2013 PearsonHOW DO WE CONSTRUCT THE CPI?

How is the CPI value obtained? 2013 PearsonSTEP 1: SELECT THE BASKET OF GOODS

2013 PearsonConsumer price indexThe chart shows the composition of the basket of goods used to create the CPI. This basket of goods derives from a survey of 14,000 households by the BLS.

The CPI market basket, December 2012Figure 9.7

CPI is not a $ sign because there is no value, but just numbers.

Base year CPI is always 100

We can find out % change as compared to the base year quickly.

# of 72 2015 Pearson Education, Inc.The Bureau of Labor Statistics surveys14,000 households on their spending habits.The results are used to construct a marketbasket of goods and services purchased bya typical urban family of four. The chartshows these goods and services, groupedinto eight broad categories. The percentagesrepresent the expenditure shares of the categorieswithin the market basket. The categoriesof housing, transportation, and foodmake up about three-quarters of the marketbasket.Source: U.S. Bureau of Labor Statistics.5#STEP 2: CONDUCT A PRICE SURVEY

Price Survey

2013 PearsonSTEP 3 + 4: CALCULATE THE COST & CPI

ProductsQuantity 2012Price 2012Price 2013RON9580 liters$1.80$2.10RON97160 liters$2.00$2.90Kangkung2kg$3.00$1.00Question: Using 2012 as the base year, calculate the CPI for year 2012 and 2013.CPIt = Cost of Basket of Goods (BOG) in Year t/ Cost of BOG in Base Year X 100

t = Represents a year ( an Unknown ) 2013 PearsonCPI 2012= cost of BOG 2012/ cost of BOG 2012 x100 =134.89 or 135

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#THE CONSUMER PRICE INDEXConclusions: Consumer Price Index (CPI) is a value in an index format. And the index represents the cost of BOG purchased by the consumers in a particular year compared to the cost of the base year. PPI = Producer Price IndexTo construct the CPI, there are FOUR simple steps: Select the basket of goods (Carry out a survey to find out the BOG) (Represents peoples spending pattern on average)Conduct a price survey on the goods that are on sale monthly from the BOG from different outlets. Calculate the costs of the BOGs sold from different periods of time. (Price of Base Year x the produces)Calculate the CPI of the BOG from different periods of time based on the Base Year. (CPIt = Cost of BOG in Year t / Cost of BOG in Base Year x 100)

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NEXT HOW DO WE DETERMINE THE INFLATION RATE? 2013 PearsonDETERMINING INFLATION RATE

Question: Whats the inflation rate in 2012 for both countries? 2013 Pearson10#LIMITATIONS OF CPI Limitations Inflation rate measured using CPI is often used to estimate the change in a persons costs of living be careful while interpreting the results.

Question:

Assume that price of petrol rises by 8%, as a result, the CPI increases and this leads to inflation of 4%. Why cant we conclude that the costs of living have increased by 4% too for every Malaysian? 2013 Pearson11#LIMITATIONS OF CPI

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LIMITATIONS OF CPI Limitations CPI has the tendency to overestimates the true inflation rate due to following bias: Commodity substitution bias Outlet substitution bias New goods biasQuality change bias

Refer to: Additional handout 2013 Pearson13#LIMITATIONS OF CPI COMMODITY SUBS. ProductsQuantity 2012Price 2012Price 2013RON9580 liters$1.80$2.10RON97160 liters$2.00$2.90Kangkung2kg$3.00$1.00Total cost of the basket of goods$470.00$634.00 CPI100134.89 2013 Pearson14#LIMITATIONS OF CPI COMMODITY SUBS. ProductsQuantity 2012Quantity 2013Price 2013RON9580 liters160 liters$2.10RON97160 liters80 liters$2.90Kangkung2kg5kg$1.00Total cost of the basket of goods$634.00 $573.00CPI134.89 121.91Question: Does basket of goods remain the same? 2013 Pearson15#QUESTION

Should Malaysian government subsidizes petrol to lower inflation rate? 2013 Pearson NEXT USES OF CPI

2013 PearsonOTHER USES OF CPI (1) COMPARING DOLLARS

1861: CPI - 27 2009: CPI 644.7 1967: Base Year 2013 Pearson18Spend time helping students appreciate the distinction between real values and nominal values.#Methods for slide 18.

1. Take Abraham Lincolns pay and change it to the value to 20092. Take Obamas pay and change it back to 1861

Method 1In 1861, Abrahams pay is $25,000 with CPI 27. Bring the pay to current CPI which is 644.7. Calculation

27/27 x 644.7 = 644.7 CPI

$25,000/27 x 644.7 = $596,944.

Abraham receives $596,944 in 2009 which is higher than Obamas.

Method 2In 2009, Obamas pay is $400,000 with CPI 644.7. Bring that pay to the past CPI in 1861 which is 27.Calculation

644.7/644.7 x 27 = 27 CPI

$400,000/644.7 x 27 = $16,751.98

Obama receives $ 16,751.98 in 1861 which is lower than Abraham. 2013 PearsonYou are given 2 different years CPI which is year 2008 with CPI of 120 and year 2013 with CPI of 148.

A doctors salary in 2008 is $35,000. In 2013 a doctors salary is $47,250. Is the salary in 2013 higher than in 2008?

AnswerIn 2008, pay is $35,000 with CPI 120

120/120 x 148 = 148

$35,000 / 120 x 148 = $43,166.67

In 2013, pay is $47,250 with CPI 148

148/148 x 120 = 120

$47,250 / 148 x 120 = $38,310.81

The doctors salary is better in 2008 than in 2013, the answer is No. 2013 PearsonOTHER USES OF CPI (2)Determining the purchasing powerNominal wage is the wage measured in current dollars.Real wage is the wage measured in the dollars of a given reference base year. By adjusting the wages for inflation, the real wage shows the purchasing power of the wages.

2013 Pearson21Spend time helping students appreciate the distinction between real values and nominal values.#

OTHER USES OF CPI (2) 2013 Pearson

OTHER USES OF CPI (2)Determining the purchasing powerQuestion: Did higher wages bring higher purchasing power to the workers in Shanghai?

2013 Pearson23Spend time helping students appreciate the distinction between real values and nominal values.#NOMINAL AND REAL VALUESDiagram shows nominal and real wage rates in the U.S from 1981 to 2011.

2013 Pearson24Real interest rate= nominal interest rate- inflation rate#OTHER USES OF CPI (3)Nominal Interest Rate and Real Interest RateNominal interest rate is the interest rate stated in current dollars. Real interest rate is the interest rate stated in the dollars of a given reference base year.

Question: How do we derive real interest rate from nominal interest rate? 2013 Pearson25#

NOMINAL AND REAL VALUESDiagram shows the real and nominal interest rates in the U.S from 1971 to 2011.

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