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Chapter #6 ECN.doc

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ECN 204
Christopher Gore

Chapter #6 - The consumer price index is used to monitor changes in the cost of living overtime - consumer price index rises = typical family has to spend more dollars to maintain the same standard of living o Economists use the term Inflation to describe a situation in which the economy’s overall price level is rising o The inflation rate is the percentage change in the price level from the previous period - The basis of cost of living adjustments (COLAs) in many contracts and in Social Security Consumer price index (CPI)- is a measure of the overall cost of the goods and services bought by a typical consumer How CPI is calculated 1. Determine the “basket. - Statistics Canada surveys consumers to determine what is in the typical consumer’s “shopping basket.” - Which price is most important to the typical customer - If the typical consumer buys more hot dogs than hamburgers  then the price of hot dogs is more important than the price of hamburgers and, therefore, should be given greater weight in measuring the cost of living 2. Find the prices. - computing the consumer price index is to find the prices of each of the goods and services in the basket for each point in time 3. Compute the basket’s cost. - use the data on prices to calculate the cost of the basket of goods and services at different times - Use the data on prices to compute the total cost of the basket. 4. Choose a base year and compute the index. - The fourth step is to designate one year as the base year, which is the benchmark against which other years are compared. CPI = 100 * [Cost of basket in current year/Cost of basket in previous year] 5. Compute the inflation rate. - use the consumer price index to calculate the inflation rate - which is the percentage change in the price index from the preceding period - That is, the inflation rate between two consecutive years is computed as follows: Inflation Rate in year #2 = 100 * [(CPI year #2 – CPI year #1)/CPI year #1] - Determines how fast the cost of living of a typical consumer is rising - Calculates the rate of “core” inflation  Which excludes the most volatile components from the CPI basket of goods and services. Core inflation - is often thought to be useful in predicting the underlying trend of changes in the consumer price index Problems with CPI 1. Commodity Substitution Bias  Over time, some prices rise faster than others.  Consumers substitute toward goods that become relatively cheaper.  The CPI misses this substitution because it uses a fixed basket of goods.  Thus, the CPI overstates increases in the cost of living. 2. Introduction of New Goods  The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs.  The CPI misses this effect because it uses a fixed basket of goods.  Thus, the CPI overstates increases in the cost of living.  Choose between a $100 gift certificate at a large store that offered a wide array of goods and a $100 gift certificate at a small store with the same prices but a more limited selection. Which would you prefer? Most people would pick the store with greater variety. In essence, the increased set of possible choices makes each dollar more valuable. The same is true with the evolution of an economy over time: As new goods are introduced, consumers have more choices and each dollar is worth more. 3. Unmeasured Quality Change  Improvements in the quality of goods in the basket increase the value of each dollar.  Statistics Canada tries to account for quality changes but probably misses some, as quality is hard to measure.  Thus, the CPI overstates increases in the cost of living. - Each of these problems causes the CPI to overstatecost of living increases. - The CPI probably
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