Macroeconomic Measurements: Prices and Inflation

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Macroeconomic Measurements

Prices and Inflation


Measuring the Cost of Living
 Inflation refers to a situation in which the
economy’s price level is rising.
 The inflation rate is the rate of change in
the price level from the previous period
(month or year).

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THE CONSUMER PRICE INDEX
 The consumer price index (CPI) is a
measure of the overall cost of the goods
and services bought by a typical
consumer. CPI is one way of measuring
the price level.
 It is used to monitor changes in the cost
of living over time.

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THE CONSUMER PRICE INDEX
When the CPI increases, the average family has to
spend more money to maintain the same
standard of living.

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How the CPI Is Calculated
1. Fix the basket. Determine the quantity of
each good that the average consumer
buys.
 Identify a basket of goods and services the
typical consumer buys.
 Conduct monthly consumer surveys to
determine the quantities of those goods and
services.

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How the CPI Is Calculated
2. Find the prices. Find the prices of each of
the goods and services in the basket for
each period (month or year).
3. Calculate the cost of the basket. Use the
data on prices to calculate the cost of the
basket of goods and services at each
period.

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How the CPI Is Calculated
4. Choose a base year and compute the
index.
 Choose one year as the base year, so that we
can compare across years more clearly.
 Compute the index by dividing the cost of the
basket in one year by the cost of the basket in
the base year and multiplying by 100.

Current Cost of the basket


CPI  100
Base Year Cost of basket

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How the CPI Is Calculated
5. Calculate the inflation rate. The inflation
rate is the rate of change in the consumer
price index between years (or months).

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How the CPI Is Calculated

 The inflation rate is calculated as follows:

CPI in Year 2  CPI in Year 1


Inflation Rate in Year 2= 100
CPI in Year 1

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Table 1: Calculating the Consumer Price
Index and the Inflation Rate: An Example

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Table 1: Calculating the Consumer Price
Index and the Inflation Rate: An Example

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How the CPI Is Calculated
 Calculating the Consumer Price Index and
the Inflation Rate: Another Example
 Base Year is 2002.
 Basket of goods in 2002 costs 1,200 BTD.
 The same basket in 2004 costs 1,236 BTD.
 CPI = (1,236/1,200)  100 = 103.
 Prices increased by 3 percent between 2002
and 2004. (Remember that base year CPI is
always 100)

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What Is in the CPI’s Basket? (US data)

17%
Transportation

15%
Food and 42%
beverages Housing

Education and
6%
communication 6%
6% 4% 4%

Medical care
Other goods
Recreation Apparel 12
and services
CPI in Bangladesh

GDP Bangladesh

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Problems in Measuring the Cost of Living
 The CPI is a good but not a perfect
measure of the cost of living because it
fixes the basket. Problems include:
 Substitution bias (overestimates inflation)
 Introduction of new goods
 Unmeasured quality changes

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Problems in Measuring the Cost of Living
 Substitution Bias
 The basket does not change to reflect
consumer’s reaction to changes in relative
prices.
 Consumers substitute away from goods that have
become relatively more expensive toward goods that
have become cheaper. Think about benzene
(gasoline) and LPG.
 But CPI ignores this consumer reaction. Therefore the
index overestimates the actual inflation rate by not
considering the substitution effect.

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Problems in Measuring the Cost of Living
 Introduction of New Goods
 The basket does not reflect the change in
purchasing power brought on by the
introduction of new products. Think about a
new Nokia cell phone coming to Bangladesh in
June. Increases standard of living. But the CPI
basket is fixed, ignores new products.
 New products result in greater variety, which
in turn makes each BDT more valuable.

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Problems in Measuring the Cost of Living
 Unmeasured Quality Changes
 If the quality of the same good rises from one
year to the next, and its price does not
change, the value of one BDT rises, Ex1:
Airbags became standard in cars, but assume
that price of a car did not increase much. Ex2:
Cell phones developed a lot in last 10 years
but prices did not increase as much.
 The researchers are working to adjust the
price for constant quality, but it is hard to
measure quality.
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Problems in Measuring the Cost of Living
 The substitution bias, introduction of new
goods, and unmeasured quality changes
cause the CPI to overestimate the true
cost of living.
 The issue is important because many
government programs use the CPI to
adjust for changes in the overall level of
prices. (indexing)
 The CPI overestimates inflation by about 1
percentage point per year.
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Other Indices:
 The producer price index (PPI), which
measures the cost of a basket of goods
and services bought by firms rather than
consumers. PPI is used for predicting
future CPI inflation.
 Wholesale Price Index (WPI)

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The GDP Deflator versus the CPI

 The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP

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The GDP Deflator versus the CPI
 Economists and policymakers monitor
both the GDP deflator and CPI to measure
how quickly prices are rising.
 There are two important differences
between GDP deflator and CPI.

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The GDP Deflator versus the CPI
 GDP deflator measures the prices of all
goods and services produced in this
country, whereas...
 …the CPI reflects the prices of all goods
and services purchased by the average
consumer. So CPI includes prices of
imported goods, such as oil, natural gas,
imported cars, etc. (deflator does not)
 Does CPI include prices of military
equipment produced by Aselsan in
Turkey? Does GDP Deflator include it?
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Figure 2: Two Measures of Inflation in US
Percent
per Year
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CPI

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5 GDP deflator

0
1965 1970 1975 1980 1985 1990 1995 2000 23
2005
Figure 3: GDP deflator Bangladesh (WB)

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