# Macroeconomics Chapter 25

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### What is the job of a consumer price index?

turning dollar figures into meaningful measures of purchasing power

### What is a consumer price index used for?

to monitor change in the cost of living over time

### When the consumer price index rises...

the typical family has to spend more money to maintain the same standard of living

### Consumer price index is a more common gauge of inflation because...

it better reflects the goods and services bought by customers

### What is the definition of CPI?

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

### Who computes and reports the CPI, and how often do they do it?

the Bureau of Labor Statistics, which is part of the Department of Labor

### What are the five steps of calculating CPI?

1) Fix the basket (which product has more weight?)
2) Find the prices at each year
3) Compute the basket's cost at each year
4) Choose a base year and compute the index
5) Compute the inflation rate

### What is the equation for CPI?

(price of basket in current year/price of basket in base year) x 100

### What is the equation for inflation rate?

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

### producer price index

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

### Why are changes in the PPI often thought to be useful in predicting changes in the CPI?

Because firms eventually pass on their costs to consumers in the form of higher consumer prices

### The CPI tries to gauge...

how much incomes must rise to maintain a constant standard of living

### Because CPI is based on a fixed basket of goods and services, three problems arise

substitution bias, introduction of new goods, and unmeasured quality change

### substitution bias

when prices change from one year to the next, they do not change proportionately; consumers substitute toward goods that have become relatively less expensive (BLS uses a fixed basket, fixed quantities even when prices change)

### 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, making each dollar more valuable

### unmeasured quality change

when a product increases or decreases in quality, price stays the same, dollar value changes

### A CPI reflects the prices of goods and services....

bought by consumers

### whereas the GDP deflator reflects the prices of goods and services...

produced domestically

### Explain the Volvo and airplane examples

Volvo - not in GDP because foreign produced, but in consumers basket
Airplanes - in GDP, but not in consumers basket because we don't buy the airplane

### Explain the oil example

Much of the oil is imported, so does not impact our country's GDP much, but impacts consumer basket because we buy a lot of it

### What is the equation for turning dollar figures from year T into today's dollars?

Amount in year T dollars x (price level today/price level in year T)

inflation

### indexation

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

### COLA

automatically raises the wage when the CPI rises; stated in contracts between firms and unions

### The higher the rate of inflation...

the smaller the increase in your purchasing power

### If the rate of inflation exceeds the interest rate

purchasing power actually falls

### If there is deflation...

purchasing power rises by more than the interest rate

### nominal interest rate

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

### real interest rate

the interest rate corrected for the effects of inflation

### equation for real interest rate

nominal interest rate - inflation rate

### What does the nominal interest rate tell you?

how fast the number of dollars in your bank account rises over time

### What does the real interest rate tell you?

how fast the purchasing power of your bank account rises over time

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