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Measuring Inflation: The Consumer Price Index (CPI)

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Inflation

Measures the rate of CHANGE in prices.


Is calculated from a price index, for different time periods: months, quarters, years.

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Price Index
A price index is a number that represents overall prices for a given period of time say a year.

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The Consumer Price Index (CPI)


Principal source of information for trends in consumer prices and inflation. Used for escalation of contract amounts and payments among individuals and organizations. Used to adjust payments to: Social Security recipients Federal and Military retirees Food Stamps and School Lunches Used to adjust individual income tax brackets.

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The Consumer Price Index


The CPI is a measure of prices for a fixed basket of goods and services of constant quantity and quality purchased by consumers.

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The Consumer Price Index

Measures the overall cost of the goods and services bought by a typical consumer.

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The CPI
1. Fix the basket: select the most commonly purchased items by conducting surveys.
1 computer

2 tuitions

5 Doctor visits 3 trips

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The CPI
2. Find the prices of the items included in the basket: scouts go every month looking for these prices.
Ticket = $600

Computer=$1200

Tuition =$20,000

Doctor Visit=$100

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The CPI
3. Compute the cost of the items in the basket each year.

3 Tickets = $1800

1 Computer= $1200 5 Doctor Visits= $500

2 Tuitions = $40,000
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Cost of the Basket Y2000

$43,500
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The CPI
4. Choose a base year the benchmark for comparison- and compute the cost of the basket in the base yearSay 1995

Ticket Price in 1995 =500

Computer Price in 1995 =$1500

Doctor Visit in 1995 =$90

Tuition in 1995 =$20,000

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Cost of the Basket in the Base Year (1995)


Note: Same items, same quantities, same qualities we used for 2000

$43,450
$1,500
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The CPI
5. Compute the CPI.
CPI (Year 2000) = Cost of Basket in 2000

Cost of Basket Base Year

x100

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Calculating the CPI


1. Fix the quantities and items in the basket. 2. Find the prices of these items. 3. Compute the cost of the items in the basket at each years prices. 4. Choose a base year -the benchmark for comparison-

CPI (Year 2000) = Cost of Basket in 2000 Cost of Basket Base Year
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x100
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Updating the Market Basket


CPI revisions occur approximately every 10 years. The most important revision is the introduction of a new market basket The last revision to the CPI started in 1998 and completed in 2000.

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The CPI: Example


Year 2000 2001 2002 Price X Quantity X Price Y Quantity Y 1 2 3 4 5 6
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2 3 4

2 3 5
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The CPI: Example


Year 2000 2001 2002 Price X Quantity X Price Y Quantity Y 1 2 3 4 5 6
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2 3 4

2 3 5
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Use 4 units of X and 2 units of Y as the representative quantities (the basket)

Year 2000 2001 2002

Price X Quantity X Price Y Quantity Y 1 2 3 4 5 6


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2 3 4

2 3 5
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Calculate Cost of basket in each year Year Price X Quantity X Price Y Quantity YPx *4 Py*2 Basket

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2000 1 X 2001 2 X 2002 3 X

4 5 6

2X 2 3X 3 4 5

4+ 4 8+ 6 12 + 8

8 = 14 = 20
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CPI = Basket cost Year X /Basket cost base year.


Year
Cost of the Basket

CPI
(8/8)*100 = 100

2000 2001 2002

8
14

(14/8)*100 = 175
(20/8)*100 = 250

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Calculating the Inflation Rate


Year 2000 2001 2002 CPI 100 175 250 75 42.86
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Inflation rate

175 - 100 100 X 100=75%

250 - 175 175 X 100=43%

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What goods and services does the CPI cover?


All goods and services purchased for consumption are classified into 200 categories, arranged into eight major groups.

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The CPI includes the following categories of goods and services:


FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks); HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture); APPAREL (men's shirts and sweaters, women's dresses, jewelry); TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance); MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services); RECREATION (televisions, cable television, pets and pet products, sports equipment, admissions); EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Although not a price CPI includes


Also included are various government-charged user fees: water and sewerage charges, auto registration fees, and vehicle tolls. The CPI also includes taxes: such as sales and excise taxes that are directly associated with the prices of specific goods and services. The CPI excludes taxes: such as income and Social Security taxes that are not directly associated with the purchase of consumer goods and services. The CPI does not include investment items: such as stocks, bonds, real estate, and life insurance. Because these items relate to savings and not to day-today consumption expenses.

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The Core Consumer Price Index


Measures what consumers are paying for goods and services at malls, grocery stores and other retail locations. Unlike the overall CPI, it excludes food and energy prices, which can bounce around enough each month to distort the overall price trend picture. Buyers should pay attention to the report because it's one of the most important indicators of inflation. High inflation equals high interest rates. Low inflation allows interest rates to fall.

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Inflation

Inflation refers to an INCREASE in the price level from one period to the next. Inflation can be high (20%) or low (2%) When inflation drops from 20% to 2% prices still INCREASE, but not as much as the previous time period.

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Deflation

Deflation refers to a DECREASE in the price level from one period to the next. Deflation shows up as a NEGATIVE number for the inflation rate: a 5% inflation means that prices DECREASED by 5%. This is not only a slowing down of inflation but a DROP in prices.

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The GDP Deflator vs. The CPI


GDP Deflator reflects the prices of all goods and services produced domestically bought by consumers, the government and other countries.

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The GDP Deflator vs. The CPI


The CPI reflects prices of goods purchased by consumers only. The CPI does not take into account prices of goods and services bought by the government or foreigners.

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The GDP Deflator vs. The CPI


2. The CPI uses a fixed basket whereas the GDP deflator uses prices of currently produced goods.

5 3
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2
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Moving dollar values forward in time


CPI (1930) = 16.7 1930 $100

CPI (2000) =172.2


Multiply by 10.31 (172.2)/(16.7) =10.31 2000 $1,031 ?

Prices in 2000 are 10.31 times larger than in 1930


You need to have 10.31 times as much money in 2000
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Moving dollar values back in time


CPI (1930) = 1930 $ 9.70 ? (172.2)/(16.7) Divide by 10.31 =10.31
16.7
CPI (2000) = 172.2

2000 $100

Prices in 1930 were one tenth what they are in 2000


You need a tenth of the money in 1930
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If you want to know what is the equivalent in todays dollars of an $80,000 salary in 1931, 1. Find the ratio of prices: CPI in 2000 / CPI in 1931 = 172.2/16.7 = ___ 2. Multiply 80,000 by that # =________

Example

10.31 An $80,000 salary in 1931 is equivalent to a $_________salary in 2000. 824,910.2

824,910.2 33

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Using the Inflation Calculator

The Presidential salary from 1909-1949 was $75,000 annually (President Hoover 1929 - 1933) CPI = 17.1 George W. Bush salary is $200,000 annually. CPI = 179.9

Do we pay our president a salary equivalent to that of President Hoover?

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Moving dollar values forward in time


CPI (1929) = 17.1 1929 $75,000 (179.9)/(17.1) Multiply by 10.52 =10.52
CPI (2002) = 179.9

2002 $? 789,035

President Hoovers salary is equivalent to $789,035 while Bushs salary is $200,000 35

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Moving dollar values back in time


CPI (1929) = 17.1 1929
CPI (2002) = 179.9

2002 (179.9)/(17.1) Divide by 10.52 =10.52 $200,000

$ 19,011 ?

President Hoover made $75,000 while the equivalent of Bushs salary is $19,011
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Problems Measuring the Cost of Living


1. Substitution Bias: Because the basket is fixed, the CPI does not account for substitutions consumers do in response to higher prices.

Substitution away from frozen desserts to cake-like desserts.

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Geometric Mean Estimator


Employs a set of fixed expenditure proportions as weights in averaging the prices of individual items within a CPI basic index. Fixing the relative expenditure proportions rather than the relative quantities implies that consumers can alter the quantities of goods and services they buy within the narrow range of a CPI category, when the relative prices of those goods and services change.

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Problems with CPI


2. New Goods Bias: new goods mean greater variety and thus consumers need to spend less to attain the same (or higher) standard of living. CPI does not reflect this change in the purchasing power of a dollar. 3. Unmeasured Quality change: If quality improves, the value of the dollar rises.

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