Lecture Principles of economics (Asia Global Edition) - Chapter 16

given class of goods and services relative to the price of the same goods and services in a base year. • CPI measures the change in consumer prices • Other indices[r]

Inflation and the Price Level

Chapter 16

Learning Objectives

1 Explain how the consumer price index (CPI) is

constructed and use it to calculate the inflation rate

2 Show how the CPI is used to adjust dollar amounts

to eliminate the effects of inflation

3 Discuss the two most important biases in the CPI

4 Distinguish between inflation and relative price

changes to find the true costs of inflation

5 Summarize the connections among inflation,

nominal interest rates, and real interest rates

Keeping up with Grandpa

• Prices of goods change over time

– Adjust values, incomes, or spending for change in prices

– Constant purchasing power

• Baseball salaries

– Bruce Lee earned US$500,000 in 1973

– Jackie Chan earned US$15 million in 2007

• Inflation increases uncertainty when planning for the future

Measuring the Price Level

• The Consumer Price Index (CPI) is a measure

of the cost of living during a particular period

• The CPI measures

– The cost of a standard basket of goods and

services in a given year

– relative to the cost of the same basket of goods and services in the base year

• Base year for the CPI changes periodically,

normally it changes every five years

Calculating the CPI

Monthly expenditures

Calculating the CPI

• CPI is the ratio of the cost of the basket of goods

in the current year to the cost in the base year

– Base year cost $680

– 2018 cost $850

CPI = (850 / 680) (100) = 1.25

• Cost of living in 2018 is 25% higher than in 2013

– CPI for the base year is always 1

– CPI for a given period is the cost of living in that

period relative to what it was in the base year

– Statistical authorities around the world use CPI as a percentage – the ratio times 100

2013 Spending Monthly Cost in 2013

2018 Spending Monthly Cost in 2018

CPI = 1050 / 800 = 1.31

Price Index

• A price index measures the average price of a

given class of goods and services relative to the price of the same goods and services in a base year

• CPI measures the change in consumer prices

• Other indices

– Core inflation is CPI without energy and food

– Producer price index

– Import / export price index

• The rate of inflation is the annual percentage

change in the price level

CPI of Selected Countries

Adjusting for Inflation

• A nominal quantity is measured in terms of its

current dollar value

• A real quantity is measured in physical terms

– Quantities of goods and services

• To compare values over time, use real quantities

quantity

express the quantity in real terms