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Chapter 6 Summary.pdf

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McMaster University
Bridget O' Shaughnessy

Summary of Lecture Notes from Chapter 6 and Practice Questions KEY POINTS: 1. The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate. 2. The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers’ ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates true inflation. 3. Although the GDP deflator also measures the overall level of prices in the economy, it differs from the consumer price index because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes. 4. Dollar figures from different points in time do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index. 5. Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation. 6. A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation. I. The Consumer Price Index A. Definition of consumer price index (CPI) : a measure of the overall cost of the goods and services bought by a typical consumer. B. How the Consumer Price Index Is Calculated 1. Determine the basket a. Statistics Canada uses surveys to determine a representative bundle of goods and services purchased by a typical consumer. b. Example: 4 hot dogs and 2 hamburgers. 1 2 ☞ Chapter 6/Measuring the Cost of Living 2. Find the prices a. Prices for each of the goods and services in the basket must be determined for each time period. b. Example: Year Price of Hot Price of Hamburgers 2001 DDogs$1gs $2 2002 $2 $3 2003 $3 $4 3. Compute the basket’s cost. a. By keeping the basket the same, only prices are being allowed change. This allows us to isolate the effects of price changes over time. b. Example: Cost in 2001 = ($1 × 4) + ($2 × 2) = $8. Cost in 2002 = ($2 × 4) + ($3 × 2) = $14. Cost in 2003 = ($3 × 4) + ($4 × 2) = $20. 4. Choose a base year and compute the index. a. The base year is the benchmark against which other years are compared. b. The formula for calculating the price index is: cost of basket in current year  CPI =   × 100  cost of basket in base year  Chapter 6/Measuring the Cost of Living ☞ 3 c. Example (using 2001 as the base year): CPI for 2001 = ($8)/($8) × 100 = 100. CPI for 2002 = ($14)/($8) × 100 = 175. CPI for 2003 = ($20)/($8) × 100 = 250. 5. Compute the inflation rate. a. Definition of inflation rate: the percentage change in the price index from the preceding period. b. The formula used to calculate the inflation rate is:  CPI Year 2- CPI Year 1 inflation rate =  CPI  × 100%  Year 1  c. Example: Inflation Rate for 2002 = (175 – 100)/100 × 100% = 75%. Inflation Rate for 2003 = (250
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