Measuring the Cost of Living

Measuring the Cost of Living

Inflation refers to a situation in which the economys overall price level is rising. The inflation rate is the percentage change in the price level from the previous period.

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. The Bureau of Labor Statistics reports the CPI each month. It is used to monitor changes in the cost of living over time.

THE CONSUMER PRICE INDEX

When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

How the Consumer Price Index Is Calculated

Fix the Basket: Determine what prices are most important to the typical consumer.
The

Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

The

How the Consumer Price Index Is Calculated

Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

How the Consumer Price Index Is Calculated

Compute the Baskets Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

How the Consumer Price Index Is Calculated

Choose a Base Year and Compute the Index:

Designate

one year as the base year, making it the benchmark against which other years are compared. the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

Compute

How the Consumer Price Index Is Calculated

Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

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

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

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

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

CPI = COST OF THE BASKET IN THE CURRENT YEAR/ COST OF THE BASKET IN THE BASE YEAR X 100

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

How the Consumer Price Index Is Calculated

Calculating the Consumer Price Index and the Inflation Rate: Another Example
Base

Year is 2002. of goods in 2002 costs $1,200.

Basket The CPI

same basket in 2004 costs $1,236. = ($1,236/$1,200) 100 = 103. increased 3 percent between 2002 and

Prices

2004.

How the Consumer Price Index Is Calculated

The Inflation Rate

The

inflation rate is calculated as follows:

C P I in Y e a r 2 - C P I in Y e a r 1 In fla tio n R a te in Y e a r 2 = 100 C P I in Y e a r 1

Whats in the CPIs Basket?

16% Food and beverages 17% Transportation 41% Housing

Education and communication

6%

6% 6% 4% 4%

Medical care Recreation Apparel Other goods and services

Copyright2004 South-Western

Problems in Measuring the Cost of Living

The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.

Problems in Measuring the Cost of Living

Substitution bias Introduction of new goods Unmeasured quality changes

Problems in Measuring the Cost of Living

Substitution Bias
The

basket does not change to reflect consumer reaction to changes in relative prices.
Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution.

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.
New products result in greater variety, which in turn makes each dollar more valuable. Consumers need fewer dollars to maintain any given standard of living.

Problems in Measuring the Cost of Living

Unmeasured Quality Changes

If

the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.

If

Problems in Measuring the Cost of Living

The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate 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. CPI overstates inflation by about 1 percentage point per year.

The

The GDP Deflator versus the Consumer Price Index

The GDP deflator is calculated as follows:

N o m in a l G D P G D P d e fla to r = 100 R eal G D P

The GDP Deflator versus the Consumer Price Index

The BLS calculates other prices indexes:

The The

index for different regions within the country.

producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

The GDP Deflator versus the Consumer Price Index

Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. There are two important differences between the indexes that can cause them to diverge.

The GDP Deflator versus the Consumer Price Index

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.

The GDP Deflator versus the Consumer Price Index

The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)... whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

How is it Measured?

Consumer Price Index Wholesale Price Index

Wholesale Price Index

WPI

was published in 1902,and was one of the economic indicators available to policy makers until it was replaced by most developed countries by the CPI market. index in the 1970. WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. countries (like India and The Philippines) use WPI changes as a central measure of inflation. However, India and the United States now report a producer price index instead.

Some

Problems with WPI

In present day service sector plays a key role in Indian economy. Consumers are spending loads of money on services like education and health. And these services are not incorpated in calculation of WPI. WPI measures general level of price changes either at level of wholesaler or at the producer and does not take into account the retail margins. Therefore we see here that WPI does give the true picture of inflation.

Problems with WPI

WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index.

Weight edge to CPI & WPI

International Parity Relationships & Forecasting Exchange Rates

Chapter Objective: This chapter examines several key international parity relationships, such as interest rate parity and purchasing Second Edition power parity.

Introduction

Exchange rates matter in many different ways to many different constituencies in the world economy Much of this section on international finance will be directly or indirectly concerned with exchange rates

The Nominal Exchange Rate

Relative price of two currencies

Often expressed as number of units of local or home currency required to buy a unit of foreign currency

We will usually view India (Rupees) as our home country and United States (dollar) as our foreign country local currency rupees Nominal or e= = rate (e) is currency exchange foreign currency dollar If e increases the value of the rupees (home

currency) falls If e decreases the value of the rupees (home currency) rises e and the value of the peso are inversely related
of the rupees

e is often graphed as its inverse which is equal to the value

The Real Exchange Rate

Measures the rate at which two countries goods trade against each other Makes use of the price levels in the two countries under consideration
PMoverall

price level in India (the home

country)
PUSoverall

price level in US the United States (the P foreign country)

re = e

PI

The Real Exchange Rate

Suppose that the price level in the United States rises

Takes more Indian goods to purchase US goods Represents a fall in the real value of the Rupees

Suppose that the price level in India rises

Takes fewer Indian goods to purchase US goods Represents a rise in the real value of the Rupees

Suppose that the nominal exchange rate increases

Takes more Indian rupees to buy a US dollar and, therefore, more Indian goods to buy US goods Represents a fall in the real value of the Rupees

Real exchange rates affected by both nominal exchange rates and price levels

Business and Economic Forecasting

Demand Forecasting is a critical managerial activity which comes in two forms:

Quantitative Forecasting +2.1047%

Gives the precise amount or percentage

Qualitative Forecasting
Gives the expected direction Up, down, or about the same

Significance of Forecasting
Both

public and private enterprises operate under conditions of uncertainty. wishes to limit this uncertainty by predicting changes in cost, price, sales, and interest rates. forecasting can help develop strategies to promote profitable trends and to avoid unprofitable ones. forecast is a prediction concerning the future. Good forecasting will reduce, but not eliminate, the uncertainty that all managers feel.

Management

Accurate

Hierarchy of Forecasts

The selection of forecasting techniques depends in part on the level of economic aggregation involved. The hierarchy of forecasting is:

National

Economy (GDP, interest rates, inflation, etc.)

sectors

of the economy (durable goods)

(all automobile manufacturers)

industry forecasts

firm forecasts (Ford Motor Company)

Product forecasts (The Ford Focus)

10. Barometric Techniques

PEAK peak

Qualitative Forecasting
Direction of sales can be indicated by other variables.

Motor Control Sales

Index of Capital Goods

TIME 4 Months

Example: Index of Capital Goods is a leading indicator There are also lagging indicators and coincident indicators

Time given in months from change

LEADING INDICATORS*
M2
COINCIDENT INDICATORS

money supply (-12.4)

Nonagricultural

S&P

500 stock prices (11.1) permits (-14.4)

payrolls (+.8)
Index

Building Initial

unemployment claims (-12.9) and orders for plant and equipment (-7.4)

of industrial production (-1.1) income less transfer payment (-.4)

LAGGING INDICATORS

Personal

Contracts

Prime

rate (+2.0)

Change

in labor cost per unit of output (+6.4)

Handling Multiple Indicators

Diffusion Index : Wall Street With Louis Ruykeyser has eleven analysts. If 4 are negative about stocks and 7 are positive, the Diffusion Index is 7/11, or 63.3%. above 50% is a positive diffusion index Composite Index : One indicator rises 4%
and another rises 6%. Therefore, the Composite Index is a 5% increase. used for quantitative forecasting

Econometric Models

Specify the variables in the model Estimate the parameters

single

equation or perhaps several stage methods

Qd

= a + bP + cI + dPs + ePc

But forecasts require estimates for future prices, future income, etc.

Often

combine econometric models with time series estimates of the independent variable.

example

Qd = 400 - .5P + 2Y + .2Ps

anticipate Income

pricing the good at P = $20

(Y) is growing over time, the estimate is: Ln Yt = 2.4 + .03T, and next period is T = 17.
Y = e2.910 = 18.357

The

prices of substitutes are likely to be P = $18.

Find Qd by substituting in predictions for P, Y, and Ps Hence Qd = 430.31