Macroeconomics Chapter: 16

is a measure of the overall cost of the goods and services bought by a typical consumer. Each month, the Bureau of Labor Statistics (BLS), which is part of the Department of Labor, computes and reports the consumer price index.

1. fix the basket (weigh the goods based on usage) 2. find the prices 3. compute the baskets costs 4. choose one year as base year and calculate CPI 5. compute inflation rate

CPI = (price of basket of goods in current year) / (price of basket in base year) X 100

inflation rate in year 2 = (CPI in year 2 - CPI in year 1) / (CPI in year 1) X 100

1. housing 2. transportation 3. food and beverage

a measure of the cost of a basket of goods and services bought by firms

1. substitution bias 2. introduction of new goods 3. unmeasured quality change

When prices change from one year to the next, they do not all change proportionately: Some prices rise more than others. That is, consumers substitute toward goods that have become relatively less expensive. If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution and, therefore, overstates the increase in the cost of living from one year to the next.

When a new good is introduced, consumers have more variety from which to choose, and this in turn reduces the cost of maintaining the same level of economic well-being. Yet because the consumer price index is based on a fixed basket of goods and services, it does not reflect the increase in the value of the dollar that arises from the introduction of new goods.

If the quality of a good deteriorates from one year to the next while its price remains the same, the value of a dollar falls, because you are getting a lesser good for the same amount of money. Similarly, if the quality rises from one year to the next, the value of a dollar rises. BLS does it best to adjust for quality change but sometimes cannot keep up

The first difference is that the GDP deflator reflects the prices of all goods and services produced domestically, whereas the consumer price index reflects the prices of all goods and services bought by consumers.

amount in today's dollars = amount in year T dollars X (price level today) / (price level in year T)

the automatic correction by law or contract of a dollar amount for the effects of inflation

the interest rate as usually reported without a correction for the effects of inflation

the interest rate corrected for the effects of inflation

real interest rate = nominal interest rate - inflation rate