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2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in hole or in part, e!cept "or use as

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%eventh &dition

Macroeconomics

Principles of

N. Gregory Mankiw

CHAPTER

11

Measuring the

Cost of Living

W

ojciechGerson(1831-1

901)


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In this chapter,

look for the answers to these questions

What is the Consumer Price Index (CPI)?How is it calculated? Whats it used for?

What are the pro!lems with the CPI? Howserious are the"?

How does the CPI differ from the #$P deflator?

How can we use the CPI to compare dollaramounts from different "ears? Wh" would wewant to do this, an"wa"?

How can we correct interest rates for inflation?




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3

%he Consumer Price Index (CPI)

measures the t"pical consumers cost of li&in' the !asis of cost of li&in' adustments (C*+s)

in man" contracts and in ocial ecurit"


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4

How the CPI Is Calculated

1. Fix the basket.%he -ureau of *a!or tatistics (-*) sur&e"sconsumers to determine whats in the t"picalconsumers .shoppin' !asket/0

2. Find the prices.

%he -* collects data on the prices of all the'oods in the !asket/

3. Compute the baskets cost.1se the prices to compute the total cost of the!asket/


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5

How the CPI Is Calculated4. Choose a base year and compute the index.

%he CPI in an" "ear equals

5. Compute the infation rate.

%he percenta'e chan'e in the CPI from the

precedin' period/

233 xcost of !asket in current "ear

cost of !asket in !ase "ear

CPI this "ear4 CPI last "ear

CPI last "ear

Inflation

ratex23356


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78+9P*7 !asket: ;< pi==as, 23 lattes>

2@ x < A B x 23 6 D

22 x < A @/E x 23 6 FG

23 x < A @ x 23 6 F3

cost of basket

B/33

@/E3

@/33

price of

latte

2@@32@

22@322

23@323

price of

pizzayear

Compute CPI in each "ear

@323: 233 x (F3F3) 6 233

@322: 233 x (FGF3) 6 22E

@32@: 233 x (DF3) 6 2B3

Inflation rate:

2E5

22E4233

233 x23356

2B52B3422E

22Ex23356

usin' @323 !ase "ear:


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A C T I V E L E A ! I ! G 1

Calculate the CPI



CPI !asket:;23 l!s !eef,

@3 l!s chicken>

%he CPI !asket cost 2@3

in @323, the !ase "ear/

A. Compute the CPI in @322/

B. What was the CPI inflation rate from @3224@32@?

price

of beef

price of

chicken

@323 <

In @323 and @322,

households!ou'ht CPI !asket/

In @32@, households !ou'ht ;E l!s !eef, @E l!s chicken>/

beef chicken cost of CPIbasket

@323 < < 2@3

@322 E E 2E3@32@ G F @23

A. Compute cost of the @32@ household !asket/

B. Compute 5 increase in cost of household !asket

o&er @32242@, compare to CPI inflation rate/


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A C T I V E L E A ! I ! G "

+nswers



A. Compute cost of the @32@ household !asket/(G x E) A (F x @E) 6 2GE

CPI !asket: ;23 l!s !eef,

@3 l!s chicken>

Household

!asket in @32@: ;E l!s !eef,

@E l!s chicken>

beef chicken cost of CPIbasket

@323 < < 2@3

@322 E E 2E3@32@ G F @23


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A C T I V E L E A ! I ! G "

+nswers



B. Compute 5 increase in cost of household !asketo&er @32242@, compare to CPI inflation rate/

Jate of increase: (2GE 4 2E3)2E3 6 B35

CPI inflation rate from pre&ious pro!lem 6

Household

!asket in @32@: ;E l!s !eef,

@E l!s chicken>


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$4

Pro!lems with the CPI:Substitution Bias

&er time, some prices rise faster than others/

Consumers su!stitute toward 'oods that !ecomerelati&el" cheaper, miti'atin' the effects of price

increases/ %he CPI misses this su!stitution !ecause it uses

a fixed !asket of 'oods/

%hus, the CPI o&erstates increases in the cost ofli&in'/


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$5

Pro!lems with the CPI:Introduction of New Goods

%he introduction of new 'oods increases &ariet",allows consumers to find products that moreclosel" meet their needs/

In effect, dollars !ecome more &alua!le/

%he CPI misses this effect !ecause it uses afixed !asket of 'oods/



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$

Pro!lems with the CPI:Unmeasured Quality Chane

Impro&ements in the qualit" of 'oods in the!asket increase the &alue of each dollar/

%he -* tries to account for qualit" chan'es

!ut pro!a!l" misses some, as qualit" is hard tomeasure/



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$!

Pro!lems with the CPI

7ach of these pro!lems causes the CPI to

o&erstate cost of li&in' increases/

%he -* has made technical adustments,!ut the CPI pro!a!l" still o&erstates inflation

!" a!out 3/E percent per "ear/ %his is important !ecause ocial ecurit"

pa"ments and man" contracts ha&e C*+s tiedto the CPI/


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$"

2GF3 2GFE 2G3 2GE 2GD3 2GDE 2GG3 2GGE @333 @33E @323KE

3

E

23

2E

GDP deflator CPI

%wo 9easures of Inflation, 2GF34@32B

Percentchange

peryear


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$#

Imported consumer 'oods:

included in CPI excluded from #$P deflator

%he !asket:

CPI uses fixed !asket #$P deflator uses !asket of

currentl" produced 'oods L ser&ices

%his matters if different prices are

chan'in' !" different amounts/

Capital 'oods:

excluded from CPI included in #$P deflator

(if produced domesticall")

Contrastin' the CPI and #$P $eflator


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CPI &s/ #$P deflator

In each scenario, determine the effects on theCPI and the #$P deflator/

A. tar!ucks raises the price of rappuccinos/

B. Caterpillar raises the price of the industrialtractors it manufactures at its Illinois factor"/

C. +rmani raises the price of the Italian eans it

sells in the 1//




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+nswers

A. tar!ucks raises the price of rappuccinos/!he C"# and $%" defator both rise.

B. Caterpillar raises the price of the industrial

tractors it manufactures at its Illinois factor"/!he $%" defator rises& the C"# does not.

C.+rmani raises the price of the Italian eans it

sells in the 1//!he C"# rises& the $%" defator does not.




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22

Correctin' Maria!les for Inflation:

Comparin' $ollar i'ures from $ifferent %imes

Inflation makes it harder to compare dollaramounts from different times/

7xample: the minimum wa'e

2/@E in $ec 2GFB

/@E in $ec @32B

$id min wa'e ha&e more purchasin' power in$ec 2GFB or $ec @32B?

%o compare, use CPI to con&ert 2GFB fi'ure into.@32B dollars0N


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In our example,

."ear !0 is 2@2GFB, .toda"0 is 2@@32B

9in wa'e was 2/@E in "ear !

CPI 6 B3/G in "ear !, CPI 6 @B


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24

Correctin' Maria!les for Inflation:

Comparin' $ollar i'ures from $ifferent %imes

Jesearchers, !usiness anal"sts, and polic"makersoften use this technique to con&ert a time series ofcurrentKdollar (nominal) fi'ures into constantKdollar(real) fi'ures/

%he" can then see how a &aria!le has chan'edo&er time after correctin' for inflation/

7xample: the minimum wa'eN


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2GF32GFE2G32GE2GD32GDE2GG32GGE@333@33E@3233

@

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