G - Price Indexes and the Aggregate Price Level PDF

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Aggregate price level ○ A measure of the overall level of prices in the economy ○ To measure the aggregate price level, economists calculate the cost of purchasing a market basket Market basket ○ A hypothetical set of consumer purchases of goods and services Price index ○ The cost of purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the selected base year ○ Price index in a given year ■ Cost of market basket in a given year DIVIDED by cost of market basket in base year TIMES 100 Aggregate price level is measured using price indexes (CPI, PPI, GDP deflator) ○ CPI, PPI, and GDP deflator are 3 different ways to measure inflation ○ All 3 are graphed and trend very similarly Inflation rate ○ The yearly percentage change in a price index, typically based on CPI, the most common measure of the aggregate price level ○ ~2% is a standard rate ○ Lower inflation rate, encourages people to go buy stuff ○ Inflation rate ■ (Price index in year 2 - price index in year 1) / Price index in year 1 x 100 Measures of “price level” ○ 1. CPI ○ 2. PPI ○ 3. GDP deflator ○ We use these to measure inflation and the price level ○ Increase in price level = inflation ○ Decrease in price level = deflation ■ Creates a really strong incentive to save ○ Reduction in the rate of inflation = disinflation Consumer Price Index (CPI) ○ A measure of inflation calculated by US government statisticians based on the price level from a fixed basket of goods and services that represents the purchases of the average consumer ○ The average cost of what consumers are buying as measured by a “market basket: ■ Market basket: collection of goods and service that represent every product that the average consumer buys ○ Measures cost of living ■ Social security payments increase from year to year ○ We look at CPI to determine is it increasing or decreasing and by what percentage? ○ A measure intended to show how the cost of all purchases by a typical urban

family has changed over time In 2010, CPI showed us that 43% of consumer spending was on housing and 15% was on food and beverages ○ Calculating the cost of a market basket: ■ Pre-frost ● Price of orange: $0.20 ● Price of grapefruit: $0.60 ● Price of lemon: $0.25 ● Cost of market basket (200 oranges, 50 grapefruit, 100 lemons) ○ (200 × $0.20) + (50 × $0.60) + (100 × $0.25) = $95.00 ■ Post-frost ● Price of orange: $0.40 ● Price of grapefruit: $1.00 ● Price of lemon: $0.45 ● Cost of market basket (200 oranges, 50 grapefruit, 100 lemons) ○ (200 × $0.40) + (50 × $1.00) + (100 × $0.45) = $175.00 ■ Cost of basket before = $95 ■ Cost of basket after = $175 ■ CPI post-frost ● Cost of basket after DIVIDED by cost of basket before TIMES 100 ● (175 / 95) x 100 = 184 ■ CPI pre-frost using pre-frost as base year ● (95 / 95) x 100 = 100 ■ Inflation = 84% ● (184-100) / 100 x 100 = 84 ○ Percent change formula ○ Starts at 100 ■ Above a 100 if prices go up ■ Below a 100 if prices go down ○ CPIbase year = cost of the basket in the base year DIVIDED by the cost of the basket in the base year TIMES 100 ■ Cancel out and = 100 ○ CPIyear X = cost of the basket in year x DIVIDED by the cost of the base year TIMES 100 Producer Price Index (PPI) ○ Measures changes in the prices of goods purchased by producers ○ The average cost of what producers buy as measured by a different “market basket” ○ Ex: steal, iron GDP deflator ○ Measures ALL goods and services ○ Measures the price level by calculating the ratio of nominal to real GDP ○ GDP deflator ■ Nominal GDP DIVIDED by Real GDP TIMES 100 ○

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The three measures usually move closely together ○ As seen in a graph Correlation between life satisfaction and GDP per capita Which president had higher salary? ○ 1999- Bill Clinton $200,000 ○ 2007- Donald Trump $400,000 ○ CPI1999 = 100 ○ CPI2017 = 147 ■ Inflation rate from 1999-2017 = 47% (147-100 / 100 x 100) ○ Nominal is measured in current dollars ■ Need to convert to real dollars to adjust for inflation ■ Can’t just say $400,000 > $200,000 ○ Real is measured in “constant dollars” ○ Real income ■ Nominal income DIVIDED by CPI x 100 ○ 1999 - Bill Clinton’s real income ■ 200,000/100 x 100 ■ $200,000 ○ 2017- Donald Trump’s real income measured in 1999 dollars ■ 400,000/100 x 100 ■ $272,108

Key Terms

Key Term

inflation

Definition

a sustained increase in the overall price level in the economy, which reduces the purchasing power of a dollar

the pace at which the overall price level is increasing; this is the inflation rate

percentage increase in the price level from one period to the next.

deflation

a sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative.

a slowing of the rate of inflation; for example if the rate of disinflation

inflation is 5\%5%5, percent in 2016 and 3\%3%3, percent in 2017, there is still inflation in 2017.Prices are just not rising as fast as they were before.

aggregate price level

a single number that summarizes all prices in an economy; price indices are frequently used to represent the aggregate price level.

a measure that calculates the changing cost of purchasing a price index

particular (and unchanging) combination of goods (called a “market basket”) each year; the consumer price index and the producer price index are examples.

consumer

an index that calculates the cost of a market basket of goods

price index

purchased by a typical family that lives in an urban area; the

(CPI)

purpose of the CPI is to track changes in the cost of living over time.

market

the combination of goods that are used to calculate a price

basket

index; the goods stay the same from year to year.

a reference year to which variables are compared; for example, base year

the current CPI in the United States uses 1983 as its base year, so all values of the CPI compare the current to 1983.

variables that are adjusted for the rate of inflation that represent the true value of something (such as real interest, real income, real variables

or real GDP); for example if your boss gives you a 10\%10%10, percent raise, but the purchasing power of your money has decreased by 8\%8%8, percent because of inflation, your raise is really only worth 2\%2%2, percent.

variables such as wages, income, or interest that have not been nominal variables

adjusted for the rate of inflation; you can think of nominal variables as the “sticker price.” The bank tells you they will pay you 3\%3%3, percent interest, but the real interest rate that tells you what you are actually earning.

purchasing power

what can actually be bought with money; if you walk into a store with \$10$10dollar sign, 10 and want to buy apples that cost \ $1$1dollar sign, 1 each, the purchasing power of your \ $10$10dollar sign, 10 is 101010 apples; If the next day the price

of apples increases to \$2$2dollar sign, 2, you can only buy 555 apples, so the purchasing power of your \$10$10dollar sign, 10 has decreased.

the interest rate earned that reflects the actual purchasing power real interest rate

of that interest; for example if a bank pays 3\%3%3, percent interest, but there is 2\%2%2, percent inflation, you really have only gained 1\%1%1, percentinterest because the purchasing power of your interest has decreased.

Key takeaways The Consumer Price Index (CPI) The Consumer Price Index (CPI) measures the change in income a consumer needs to maintain the same standard of living over time. The CPI is meant to reflect changes in the cost of living for a typical urban household.

For example, suppose every household buys 222 bottles of cod liver oil, 101010 loaves of bread, and 888 dog treats every week. A consumer price index tracks changes in the price of this unchanging collection of goods over time to measure changes in the cost of living for this household. Once the CPI is calculated for two years, we can to calculate the rate of inflation.

How the CPI is calculated Let’s use the example above of the “basket of goods” consisting of 2 bottles of cod liver oil, 10 loaves of bread, and 8 dog food treats. Once the prices of the goods are calculated, the price of the basket in that year is compared to the price of the basket in some base year.

How the CPI is used to calculate the rate of inflation The inflation rate is determined by calculating the percentage change in a price index (such as CPI or the GDP deflator). The inflation rate tells us the percentage by which the price level is changing from period to period.

Adjusting nominal variables into real variables Real variables are nominal variables deflated by the price level. Examples of real variables are a real wage or a real interest rate. For instance, the sign at the bank says that they are paying 8\%8%8, percent interest, but what are really earning?

If we want to find the real interest rate (the one that reflects what people are actually earning on money deposited in the bank), then we want to take away the effect of inflation. We do so because inflation reduces the purchasing power of the money deposited.

If the interest rate the bank gives us (the nominal interest rate) is 8\%8%8, percent, but the rate of inflation is 5\%5%5, percent, we are really earning 8\%-5\%=3\%8% −5%=3%8, percent, minus, 5, percent, equals, 3, percent on the money that we put in the bank. Why? Because that is how much more we can buy when we take our money out after a year.

The shortcomings of CPI as a measure of the cost of living Using the CPI as a measure of inflation has some shortcomings. That can cause the CPI to overstate the true inflation rate. For example, substitution bias causes the CPI to overstate increases in the cost of living. When the prices of goods go up, people will substitute other similar goods in place of the good that is now more expensive. But because the CPI assumes that the basket of goods never changes, it makes it appear that people always buy the same amount of a good that is now more expensive.

Another shortcoming of CPI is that it fails to account for changes in quality. For example, one of the reasons a 2013 Volvo Station Wagon costs more than a 1973 Volvo Station Wagon is that the newer model has things like seatbelts in the backseat, FM radio, and air conditioning. The CPI, however, treats these vehicles as identical, which overstates the true rate of inflation.

Common Misperceptions ● If there is 2% inflation every year for five years, then after ten years the price level has gone up to 20%, right? No! Inflation compounds over time. For example, suppose a chicken coop costs $100, 100 and there is 2%, percent inflation, that means that after a year the chicken coop will cost $102. If inflation continues at 2%, percent for another year, the $102 grows by 2%, not the original price. In fact, if there is 2% inflation every year for 10 years, the chicken coop will cost $121.90. ● The term “index” might sound strange, but an index is simply any measure that compares a value in one period to the value in a base year. ● Another common misperception is that once we calculate the CPI, we have the rate of inflation between any two years. That is a necessary step, but it is not the final step. We must then use the CPI in both years to calculate the rate of inflation. ● There are actually several different price indices used to calculate the rate of inflation. The CPI is the one that is used to calculate the official rate of inflation, which is why you’ll often hear it reported in the news.

Discussion Questions: ● What are some reasons that the CPI might not capture the true rate of inflation? ● How might changes in spending habits of households over a 20 year period change? How does this impact CPI as a measure of the cost of living? ● The CPI in the nation of Montrose was 220 in 2016 and 200 in 2015. What is the rate of inflation between 2015 and 2016?...