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Macroeconomics
Lecture 6
Measuring the Cost of Living
Questions?
StudentIntroductions
1. What is the key component of health and nutrition in human capital?
2. What is a bit?
3. What is the difference between atoms and bits?
4. Are there a fixed number of keys on a piano?
5. Are there a fixed number of songs you can play on a piano?
6. What can be digitized?
7. Why is digitizing so important to developing an economy?
8. What innovation made the West more peaceful and prosperous?
9. What two things can a seller do if there is a line waiting to buy her
product?
10. What is the difference between nominal prices and real prices?
11. What is the equation for the GDP Deflator?
12. What does CPI stand for?
Recession
two successive quarters of negative
GDP growth
Measuring the Cost of Living
GDP DeflatorCPI
Interest Rates
1930
5 cents
10 cents per hour
30 minutes
2016
$1 dollar
$8 per hour
7.5 minutes
75 Percent Cheaper
TimePrice
DollarPrice
How much time will it cost me?
12 item food basket
1919 9.8 hours
1997 1.9 hours
- 80%
Air Conditioner
1952 213 hours
1997 23 hours
- 90%
Refrigerator
1916 3,162 hours
1997 68 hours
- 98%
Clothes Washer
1911 553 hours
1997 26 hours
- 95%
Gallon of Gasoline
1920 34 minutes
1997 6 minutes
- 82%
Contact Lenses
1971 95 hours
1997 4 hours
- 96%
New York to Los Angeles Flight Time Price
1930 366 hours
1997 16 hours
- 96%
Big Mac
1940 27 minutes
1997 9 minutes
- 67%
Color TV
1954 562 hours
1997 23 hours
- 96%
Microwave Oven
1967 176 hours
1997 15 hours
- 91%
Phone call
New York to Los Angeles
1915 90 hours
1997 1 second
- 99.99%
Time Price Change Time Year 1997 % Change
12 -item food basket 9.5 h 1919 1.9 h - 80%
Air-Conditioner 213 h 1952 23 h - 90%
Refrigerator 3,162 h 1916 68 h - 98%
Clothes Washer 553 h 1911 26 h - 95%
Gallon of Gas 34 m 1920 6 m - 82%
Contact lenses 95 h 1971 4 h - 96%
NY to LA Flight 366 h 1930 16 h - 96%
Big Mac 27 m 1940 9 m - 67%
Color TV 562 h 1954 23 h - 96%
Microwave 176 h 1967 15 h - 91%
3-minute NY-LA call 90 h 1915 1 s - 99.999%
Source: Dallas Federal Reserve Bank, 1997
Michael Cox
innovation reduces prices
inflation increases prices
Nominal vs.
Real
InflationCause:
Printing money faster than making goods
Effect: Rising prices
Nominal Current prices
Current quantity
Real will always have
a base year
Real Constant prices Current quantity
Pizza Soda
Year Price Qty Total Price Qty Total TotalTotal
%Change
2010 $5 100 $500 $1.00 50 $50 $550
2011 $6 134 $804 $1.50 40 $60 $864 57.1%
2011* $5 134 $670 $1.00 40 $40 $710 29.1%
2012 $10 150 $1500 $2.00 30 $60 $1,560 80.6%
2012* $5 150 $750 $1.00 30 $30 $780 9.9%
* Prices adjusted to 2010 Rates
Real versus Nominal GDP
GDP DeflatorNominal GDP
Real GDP= x 100
GDP Deflator$1,560$780= x 100
= 200 Prices have doubled
If the the GDP Deflator is 178 and a Pizza cost $15, what was the price in the
base year?
$15 ÷ 1.78 = $8.43
GDP Inflation Rate
GDP Delflator Year 2 - GDP Delflator Year 1
GDP Delflator Year 1= x 100
If the the GDP Deflator is 178 in 2010 and 192 in 2011,
what was the rate of inflation?
192-178178
x 100 =7.86%
CPI Consumer Price Index
The market value of a typical basket of goods.
GDPwhat
consumersbuy
GDPDeflator
CPI
ConsumerPriceIndex
ConsumerPriceIndex
CPI
CPI Consumer Price Index
The market value of a typical basket of goods.
Measure CPI - Five Steps
1. Select items for Basket
2. Find Prices
3. Total Cost
4. Pick Base Year and compute Index
5. Compute Inflation Rate
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9 9
What’s in the CPI’s Basket?
! Food and beverages
! Tobacco
! Clothing and footwear
! Housing
! Water & fuels
! Furnishings and house repairs
! Health
! Transportation
! Communication
! Leisure
! Education
! Restaurant & hotels
! Miscellaneous
The basket will vary from country to country. The following is an example of the basket in Lebanon
select items
find prices
total the cost
pick base year and compute
index
CPITotal Cost this Year
Total Cost in base yearx 100
CPI Inflation Rate
CPI Year 2 - CPI Year 1
CPI Year 1= x 100
Year Total CPI Inflation
2010 522 100.0
2011 544 104.2 4.2%
2012 532 101.9 -2.2%
2013 560 107.3 5.3%
2014 577 110.5 3.0%
2015 600 114.9 4.0%
Converting to Today
Price level today
Price level in prior year
Amount in prior
yearX
I earned 100,000 in 2010 and the CPI was 175.
In 2014 I earned 150,000 and CPI was 250.
What year was I better off?
Year CPI Income
2010 175 100,000
2014 250 150,000
%Chg 42.9% 50.0%
Problems with CPI
1. Substitution
2. New goods
3. Changes in Quality
Substitution
Price
Quantity
New Goods
1983
New Goods
Added in 1998
Quality
2007 - $600 2016 - $600
1. Starbucks raises the price of Frappuccinos.
2. A local manufacturer raises the price of the industrial tractors it produces.
3. Armani raises the price of the Italian jeans it sells (in your own country).
1. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. 2. A local manufacturer raises the price of the
industrial tractors it produces. The GDP deflator rises, the CPI does not.
3. Armani raises the price of the Italian jeans it sells (in your own country).
The CPI rises, the GDP deflator does not.
NominalReal
Interest Rates
Nominal = Real + Inflation
Interest Rates
Real = Nominal - Inflation
Inflation = Nominal - Real
If the inflation rate is 2.0%, and the real rate is 4.0% what is the
nominal interest rate?
6.0% = 4.0% + 2.0%
Nominal = Real + Inflation
If the nominal interest rate is 5.5% and the inflation rate is 2.0%, what is the real interest
rate?
3.5% = 5.5% - 2.0%
Real = Nominal - Inflation
If the nominal interest rate is 4.5% and the real interest rate is 2.0%, what is the inflation rate?
1.5% = 4.5% - 2.0%
Inflation = Nominal - Real
If the nominal interest rate is 1.5% and the inflation rate is 2.3%, what is the real interest
rate?
-0.8% = 1.5% - 2.3%
Real = Nominal - Inflation
Remember:Real Interest Rates can
be negative
Because of inflation
