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Culture Documents
• 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 changes periodically
• To calculate CPI: (price of BG give year / price of BG base year) X 100
• CPI for the base year is always 1
Price Index
• A price index measures the average price of a given quality 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 the change in prices of goods and services, except for those from the
food and energy sectors (CPI without energy and food)
– Producer price index measures the average change over time in the selling prices received
by domestic producers for their output.
– import / export price index measures changes in the prices of imports of merchandise into
a country.
Inflation
• The rate of inflation is the annual percentage change in the price level
• Inflation is the rate of increase in prices over a given period of time.
• To calculate inflation: (CPI new – CPI old) / CPI old x 100
Real wage
• The real wage is the wage paid to the worker measured in terms of purchasing power
– The real wage for any given period is calculated by dividing the nominal wage by the CPI
for that period
– Real income, also known as real wage, is how much money an individual or entity makes
after adjusting for inflation
Indexing
• Indexing increases a nominal quantity each period by the percentage increase in a specified price
index
– Indexing prevents the purchasing power of the nominal quantity from being eroded by
inflation
• Indexing automatically adjusts certain values, such as Social Security payments, by the amount of
inflation
– If prices increase 3% in a given year, the Social Security recipients receive 3% more
• No action by Congress required
– Indexing is sometimes included in labor contracts
Minimum Wage
Minimum wage is the lowest wage permitted by law or by a special agreement.
• Congress sets the national minimum wage in nominal terms
– Publicized debate results in periodic increases
• Indexing would be simpler and less controversial
• Politicians appear to benefit from the debate
• Minimum wage has increased steeply over the years
– Real minimum wage has decreased by almost 30% since 1970
CPI and Inflation
• CPI and other indexes influence policy decisions and wage increases
• Inflation may be overstated
– Unnecessarily increases government spending
– Underestimates increase in the standard of living
• Suppose CPI indicates 3% inflation when cost of living actually increases
2%
– Real income increases 1%
• The Bureau of Labor Statistics makes great efforts to improve CPI calculations
CPI Biases
• CPI uses a fixed basket of goods and services
– When the price of a good increases, consumers buy less and substitute other
goods
– Failing to account for substitution overstates inflation
• The price level is a measure of the overall level of prices at a particular point in time
– Measured by a price index such as the CPI
• The relative price of a specific good is a comparison of its price to the prices of other goods and
services
– Calculated as a ratio
• Suppose we have a one-time doubling of the gas price
– Overall price level and inflation increase by a small amount
– 2The increase in the relative price of gasoline is large
• Price levels are leading indicators in the economy; rising prices indicate higher demand
leading to inflation while declining prices indicate lower demand or deflation
Relative price
Noisy Prices
Hyperinflation
• Hyperinflation is an extremely high rate of inflation
– In 1923, German employers paid workers twice a day
– Magnifies the costs of inflation
– Minimize your cash holding
Inflation and Interest Rates
• The real interest rate is the annual percentage increase in the purchasing power of financial
assets
– Real interest rate = nominal interest rate – inflation
– r=i–
• The nominal interest rate is the annual percentage increase in the dollar value of an asset
– Nominal interest rates are the most commonly stated rates
• The Fisher effect is the tendency for nominal interest rates to be high when inflation is high and
low when inflation is low