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Chapter 24

Chapter 24 Economics.docx

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Harvard University
Economics 10b
Gregory Mankiw

Chapter 24 Economics • Consumer price index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer; measures changes in cost of living; measures how much incomes must rise to maintain a constant standard of living o When the consumer price index rises, the typical family has to spend more money to maintain the same standard of living o Inflation: the economy’s overall price level is rising o Inflation rate: the percentage change in the price level from the previous period o Because the consumer price index better reflects the goods and services bought by consumers, it is the more common gauge of inflation o Each month, the Bureau of Labor Statistics (BLS), which is part of the Department of Labor, computes and reports the consumer price index • How the Consumer Price Index is Calculated by the BLS o Fix the basket: determine which prices are most important to the typical consumer  Weight of importance is determined by surveying consumers to find a basket of goods and services typically bought by the average consumer o Find the prices of each of the goods and services in the basket at each point in time o Compute the basket’s cost by using the data on prices to calculate the cost of the basket of goods and services at different times  Only the prices should change; the composition and quantity of items in the basket should stay the same • This is done in order to isolate the effects of price changes from the effect of any quantity changes that might be occurring at the same time o Choose a base year (the benchmark against which other years are compared) and compute the index  The choice of base year is arbitrary as the index is used to measure changes in the cost of living o Compute the inflation rate by using the consumer price index • The BLS collects and processes data on the prices of thousands of goods and services every month, determining how quickly the cost of living for the typical consumer is rising • The BLS also computes the consumer price index for specific metropolitan areas within the country and for some narrow categories of goods and services (like food, clothing, energy) • Producer price index: a measure done by the BLS of the cost of a basket of goods and services bought by firms o Because firms eventually pass on their costs to consumers in the form of higher consumer prices, changes in the producer price index are often thought to be useful in predicting changes in the consumer price index • Housing includes the cost of shelter (32%), fuel and other utilities (5%), and household furnishings and operation (5%) • Transportation includes spending on cars, gasoline, buses, subways, etc. • Food and beverages: food at home (8%), food away from home (6%), and alcoholic beverages (1%) • Education and communication includes college tuition and personal computers • Apparel includes clothing, footwear, and jewelry • Other goods and services includes cigarettes, haircuts, and funeral expenses • Problems with the Consumer Price Index: o Substitution bias: When prices change from one year to the next, they do not change proportionately; some prices rise more than others  Consumers substitute toward goods that have become relatively less expensive as well as tend to buy less of a normal good when a price rises  If price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution, overstating the increase in the cost of living from one year to the next o Introduction of new goods: When a new good is introduced, consumers have more variety from which to choose, and this I n turn reduces the cost of maintaining the same level of economic well-being  The increased set of possible choices makes each dollar more valuable • When new goods are introduced, consumers have more choices and their dollar is worth more • Because the consumer price index is based on a fixed
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