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Government, Business and

Measuring Cost of Living

Module- 2
Macroeconomic Framework
• Contents
– National Income Analysis: Circular flow of Income,
Concepts of national income and measurement.
– Consumption Function, Investment Function,
Concept of Multiplier and Accelerator, Aggregate
Demand & Aggregate Supply National Income
Equilibrium, Inflationary & Deflationary gaps, Real
Business cycles, Application of above in business
and society.

• Inflation rate is percentage change in the price level from previous period.• How we calculate overall cost of living? • Converting monetary figures into meaningful purchasing power • Consumer price index • Inflation describe a situation in which economy’s overall price level is rising. .

The Consumer Price Index • Consumer price index (CPI) – Measure of the overall level of prices – Measure of the overall cost of goods and services – Bought by a typical consumer 4 .

Compute the basket’s cost – By keeping same basket of goods effects of price changes is isolated 5 .Calculating CPI 1. Find the prices – At each point in time 3. Fix the basket – Which prices are most important to the typical consumer – Different weight 2.

Chose a base year and compute the index – Base year = benchmark • Price of basket of goods & services in current year • Divided by price of basket in base year • Times 100 5.CPI in year 1 ×100 CPI in year 1 6 . Compute the inflation rate Inflation rate in year 2 = CPI in year 2 .Calculating CPI 4.

7 .Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

8 .Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

Economists calls each percentage the “relative importance” of the category.The Typical Basket of Goods and Services This figure shows how the typical consumer divides spending among various categories of goods and services. 9 .


Other measures • Producer price index. wholesale margin and transport cost from manufacturing units to wholesale establishment • Many countries have switched over from the WPI to PPI Because the PPI can track price changes at primary and intermediate stages before it gets built into the finished goods stages 11 . WPI • Captures the movements in the wholesale prices . Very close to the PPI – Differs from the PPI to the extent of tax. PPI – Measure of the cost of a basket of goods and services bought by firms – Changes in PPI are often thought to be useful in predicting changes in CPI • Wholesale price index.Inflation.

Problems in measuring the cost of living – Substitution bias • Prices do not change proportionately • Consumers substitute toward goods that have become relatively less expensive – Overstates the increase in cost of living from one year to next – Introduction of new goods • More variety of goods – Unmeasured quality change • Changes in quality 12 .

Reflects prices of goods & services bought by consumers – Compares price of a fixed basket of goods and services to the price of the basket in the base year 13 .GDP deflator versus CPI • GDP deflator – Ratio of nominal GDP to real GDP – Reflects prices of all goods & services produced domestically – Compares the price of currently produced goods and services to the price of the same goods and services in the base year • CPI – Cost of the basket.

14 .Two Measures of Inflation This figure shows the inflation rate—the percentage change in the level of prices— as measured by the GDP deflator and the consumer price index using annual data since 1965. Notice that the two measures of inflation generally move together.

Correcting Economic Variables • Dollar figures from different times Amount in today's dollars = Price level today Amount in year T dollars × Price level in year T • Indexation – Automatic correction by law or contract – Of a dollar amount – For the effects of inflation – DA (Dearness allowance or Cost of living allowance) 15 .


Real and Nominal Interest Rates • Nominal interest rate – Interest rate as usually reported – Without a correction for the effects of inflation • Real interest rate – Interest rate corrected for the effects of inflation = Nominal interest rate – Inflation rate 17 .

Interest rates in a typical Economy • Nominal interest rate – Always exceeds the real interest rate – Economy experiences rising consumer prices in every year • Inflation is variable – Real and nominal interest rates do not always move together • Periods of deflation – Real interest rate exceeds the nominal interest rate 18 .

19 . The real interest rate is the nominal interest rate minus the inflation rate as measured by the consumer price index. Notice that nominal and real interest rates often do not move together. The nominal interest rate is the rate on a 3-month Treasury bill.Real and Nominal Interest Rates This figure shows nominal and real interest rates using annual data since 1965.

Price Indices in India 20 .

of 5. national 2004-05 No of items in 676 basket Major items i)Primary articles covered ii)Fuel. bedding & footwear iv) miscellaneous 600 1181 3 weeks 250 year 2004-05 n. tobacco& intoxicants iii) fuel&light iv) housing v) clothing. CSO 2010 225 GDP Deflators Passche Current quantities Purchase price paid by the consumers Weighted average of the centre indices No.482 78 Centres/Quotatio ns Time Lag 2 weeks/ 1 month 1 month Frequency CPI-AL All All items included in the GNP Benchmark surveys 2 years Yearly 21 .a. i)food beverages & tobacco ii)fuel & light iii) clothing. Commodity Composition and Method of Computation WPI Source/ Agency Office of the Economic Advisor/ MOI Method Laspeyres Weights allocated Wholesale on the basis of transactions Weighting diagram Price Quotations Nature of the index Current Base Year Country-wide. bedding & footwear vi)miscellaneous i i)food beverages & tobacco ii)fuel & light iii) clothing. Supari. bedding & footwear iv)miscellaneous i)food beverages & tobacco ii)fuel & light iii) clothing. unique Bulk transactions Single. n. light & lubricants iii)Manufactured products CPI-IW Labour Bureau/ MOL Weekly: Primary articles and Fuel. Monthly: Overall and all sub-heads CPI-RL CPI-Rural Labour Bureau/ MOL Labour Bureau/ MOL CPI-Urban CPI-Combined (Rural +Urban) CSO Laspeyres Consumer Expenditure Survey First 1958-59 Latest: 2001 First 1956-57 First 1983 round NSS Latest: 1983 Latest 1983 Horizontal summation of weights of centre specific indices 61st 2001 1986-87 120-360 260 i)food ii)Pan. power. light & lubricants. power.a. Base Year.Price Indices: Sources of Data. bedding & footwear iv) housing v) miscellaneous 310 1491 1 month Monthly NAS.

Planning Commission. Other govt org • Deflating Macroeconomic aggregates • Forecasting variables for which prices are prime indicators • Working out escalation costs of projects Govt. NGOs Social security and welfare allowances CPI(IW) : wage & dearness allowances of workers & CPI (RL) & CPI (AL): Fixing minimum wages Dearness Allowances Researchers Government Main Use Estimation of Inflation Deflating Macroeconomic Indicators 22 . Pvt org.Price Indices in India Uses of Price Indices Users Purpose WPI CPI GDP Deflator RBI.

agriculture / manufactured products is better • Wider coverage of commodities: less volatile to relative price • Available at monthly frequency • Lag of one month • Constructed for specific centres • Some consumer services are also included • Lesser coverage of commodity: subject to higher volatility 23 .Price Indices in India WPI Vs CPI CPI – IW WPI • WPI (Overall): available on monthly frequency • WPI (Primary Articles) and WPI (Fuel Group) available at weekly frequency • Lag of a fortnight • Computed on all India basis • Coverage of non.

Price Indices in India 24 .