Macroeconomics CPI

The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. CPI is used to find the inflation rate. The CPI affects nearly all Americans because of the many ways it is used. It is used as an economic indicator, as a deflator of other economic series, as a means of adjusting dollar values.

The CPI is calculated by dividing the price of basket of goods and services by the price of basket in base year, then multiple that by 100. To find the price of the basket of goods and services, you multiply the goods by their prices and add them up. For example, if you were buying 4 hot dogs and 2 hamburgers, and each hot dog cost $1 while each hamburger cost $2, it would be ($1per hot dog X 4 hot dogs) + ($2 per hamburger 2 hamburgers) = $8. So, ($8/$8) X100 = a CPI of 100

Substitution bias: When prices change form one year to the next, they do not all change proportionately. Some prices rise more that others. Consumers respond to these differing prices by buying less of the goods whose prices have risen less.

Introduction of new goods: 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.

Unmeasured quality change: If the quality of a good deteriorates from one year to the next, the value of a dollar falls, even if the price of the good stays the same, because you are getting a lesser good for the same amount of money.

The inflation rate is the percentage change in the price index from the preceding period. It is important to be able to calculate the inflation rate. Employees should at least get a raise equal to the inflation rate each year because the cost of living goes up. If they do not get a raise, then their money can buy fewer things, even though they are being paid the same. Also, The USA finds it healthy to have some inflation, but not too much.

(CPI in year 2 - CPI in year 1)/ CPI in year 1 x 100

The Producer Price Index (PPI) is a measurement of the cost of a basket of goods and services bought by a firm. Because firms eventually pass on their costs to consumers through higher consumer prices, changes in the PPI are often thought to be useful in predicting changes in the CPI.

Indexation is the automatic correction of a dollar amount for the effects of inflation by law or contract. Many long-term contracts between firms and unions include partial or complete indexation of the wage to the CPI. Such a provision is called a cost-of-living allowance, or COLA. A COLA automatically raises the wage when the consumer price index rises.

Nominal interest rate is the interest rate as usually reported without a correction for the effects of inflation. Real interest rate is the interest rate corrected for the effects of inflation. To find the real interest rate, you subtract the inflation rate from the nominal interest rate.

The consumer price index tries to measure the overall cost of the goods and services bought by atypical consumer. It is constructed by surveying consumers to determine a basket of goods and services that the typical consumer buys. Prices of these goods and services are used to compute the cost of the basket at different times, and a base year is chosen. To compute the index, we divide the cost of the market basket in the current year by the cost of the market basket in the base year and multiply by 100

Since Henry Ford paid his workers $5 a day in 1914 and the consumer price index was 10 in1914 and 195 in 2005, then the Ford paycheck was worth $5 x (195 / 10) = $97.50 a day in 2005 dollars.