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Oct 06 note - Should I spend my money now or save for a rainy day.docx

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Hannah Holmes

Should I spend my money now or save for a rainy day? (Ch 6) 10/06/2008 How do we calculate inflation using CPI? Consumer Price index (CPI) - Measures overall cost of goods for a typical urban household CPI is the measure of price level, goal of using CPI is to measure changes in the cost of living Steps to calculating inflation using CPI 1) Fix the basket 2) CPI = cost in current year / cost in base yex 100 Inflation rate = (Pt – (Pt-1)) /pt-1 x 100 Example basket = 10 skates and 20 hockey pucks Year Price of skates Price of hockey pucks 2005 50 3 2006 60 4 2007 70 5 Base year = 2006 Year Cost in current year CPI Inflation rate 2005 10x50+20x3 82.3 ­­­­­­­­­­­­­­­­­­­­­­ 2006 10x60+20x4 100 21.5% 2007 10x70+20x5 117.7 17.7% An example of using CPI You father earned $41,000 in 1972. What is this salary worth in 2007 dollars? CPI of 1972 = 41.8 CPI of 2007= 132.3 Calculating the salary in 2007 = $41,000 x (132.3/41.8) = $129,768 1 There are 3 problems with CPI 1) Substitution bias – the CPI ignores the possibility of consumer in the cost of living from one year to the next Household spending change when the price changes Ie, when price of coffee goes up, we buy less coffee CPI assume that people do not respond to price change 2) Introduction of new goods – since the CPI is based on a fix basket of goods and service, a change in the cost of living is not reflected in the purchasing power of the dollar When a new product is introduced, the consumers have more to choose from; therefore the value of the dollar goes up. When people buys goods more diversely, those goods who was counted less in the fixed basket is now more popular purchase amount the people but using the CPI, the weight is still unchange
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