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Measuring the Cost of
Living
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Measuring the Cost of Living
Inflation refers to a situation in which theeconomys overall price level is rising.
The inflation rate is the percentage change in
the price level from the previous period.
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THE CONSUMER PRICE INDEX
The consumer price index (CPI) is a measureof the overall cost of the goods and servicesbought by a typical consumer.
The Bureau of Labor Statisticsreports the CPIeach month.
It is used to monitor changes in the cost ofliving over time.
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THE CONSUMER PRICE INDEX
When the CPI rises, the typical family has tospend more dollars to maintain the samestandard of living.
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How the Consumer Price Index IsCalculated
Fix the Basket: Determine what prices aremost important to the typical consumer.
The Bureau of Labor Statistics (BLS) identifies amarket basket of goods and services the typicalconsumer buys.
The BLS conducts monthly consumer surveys toset the weights for the prices of those goods andservices.
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How the Consumer Price Index IsCalculated
Find the Prices: Find the prices of each ofthe goods and services in the basket for eachpoint in time.
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How the Consumer Price Index IsCalculated
Compute the Baskets Cost: Use the dataon prices to calculate the cost of the basketof goods and services at different times.
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How the Consumer Price Index IsCalculated
Choose a Base Year and Compute theIndex:
Designate one year as the base year, making itthe benchmark against which other years arecompared.
Compute the index by dividing the price of thebasket in one year by the price in the base yearand multiplying by 100.
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How the Consumer Price Index IsCalculated
Compute the inflation rate:The inflationrate is the percentage change in the priceindex from the preceding period.
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Table Calculating the Consumer Price Index and theInflation Rate: An Example
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Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
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Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
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Table 1 Calculating the Consumer Price Indexand the Inflation Rate: An Example
CPI = COST OF THE BASKET IN THECURRENT YEAR/ COST OF THEBASKET IN THE BASE YEAR X 100
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Table 1 Calculating the Consumer Price Index and theInflation Rate: An Example
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How the Consumer Price Index IsCalculated
Calculating the Consumer Price Index and theInflation Rate: Another Example
Base Year is 2002.
Basket of goods in 2002 costs $1,200.
The same basket in 2004 costs $1,236.
CPI = ($1,236/$1,200) 100 = 103.
Prices increased 3 percent between 2002 and2004.
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How the Consumer Price Index IsCalculated
The Inflation Rate
The inflation rate is calculated as follows:
I n f l a t i o n R a t e i n Y e a r 2 =C P I i n Y e a r 2 - C P I i n Y e a r 1
C P I i n Y e a r 1 1 0 0
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Whats in the CPIs Basket?
16%Food and
beverages
17%
Transportation
Medical care
6%
Recreation
6%
Apparel
4%
Other goods
and services
4%
41%Housing
6%Education and
communication
Copyright2004 South-Western
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Problems in Measuring the Cost ofLiving
The CPI is an accurate measure of theselected goods that make up the typicalbundle, but it is not a perfect measure of thecost of living.
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Problems in Measuring the Cost ofLiving
Substitution bias
Introduction of new goods
Unmeasured quality changes
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Problems in Measuring the Cost ofLiving
Substitution Bias
The basket does not change to reflect consumerreaction to changes in relative prices.
Consumers substitute toward goods that have becomerelatively less expensive.
The index overstates the increase in cost of living by notconsidering consumer substitution.
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Problems in Measuring the Cost ofLiving
Introduction of New Goods
The basket does not reflect the change inpurchasing power brought on by the introductionof new products.
New products result in greater variety, which in turnmakes each dollar more valuable.
Consumers need fewer dollars to maintain any givenstandard of living.
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Problems in Measuring the Cost ofLiving
Unmeasured Quality Changes
If the quality of a good rises from one year to thenext, the value of a dollar rises, even if the priceof the good stays the same.
If the quality of a good falls from one year to thenext, the value of a dollar falls, even if the priceof the good stays the same.
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Problems in Measuring the Cost ofLiving
The substitution bias, introduction of newgoods, and unmeasured quality changescause the CPI to overstate the true cost ofliving.
The issue is important because manygovernment programs use the CPI to adjust forchanges in the overall level of prices.
The CPI overstates inflation by about 1
percentage point per year.
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The GDP Deflator versus theConsumer Price Index
The GDP deflator is calculated as follows:
G D P d e f l a t o r =
N o m i n a l G D P
R e a l G D P 1 0 0
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The GDP Deflator versus theConsumer Price Index
The BLS calculates other prices indexes:
The index for different regions within the country.
Theproducer price index, which measures the
cost of a basket of goods and services bought byfirms rather than consumers.
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The GDP Deflator versus theConsumer Price Index
Economists and policymakers monitor boththe GDP deflator and the consumer priceindex to gauge how quickly prices are rising.
There are two important differences betweenthe indexes that can cause them to diverge.
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The GDP Deflator versus theConsumer Price Index
The GDP deflatorreflects the prices of allgoods and servicesproduced domestically,whereas...
the consumer price indexreflects theprices of all goods and services bought byconsumers.
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The GDP Deflator versus theConsumer Price Index
The consumer price indexcompares theprice of a fixed basketof goods and servicesto the price of the basket in the base year(only occasionally does the BLS change the
basket)...
whereas the GDP deflatorcompares theprice ofcurrently produced goods andservices to the price of the same goods and
services in the base year.
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How is it Measured? Consumer Price Index
Wholesale Price Index
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Wholesale Price Index
WPI was published in 1902,and was one of theeconomic indicators available to policy makersuntil it was replaced by most developed countries
by the CPI market. index in the 1970. WPI is the index that is used to measure the
change in the average price level of goods tradedin wholesale market.
Some countries (like India and The Philippines)use WPI changes as a central measure ofinflation. However, India and the United Statesnow report a producer price index instead.
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Problems with WPI
In present day service sector plays a key rolein Indian economy. Consumers are spendingloads of money on services like educationand health. And these services are not
incorpated in calculation ofWPI.
WPI measures general level of price changeseither at level of wholesaler or at theproducer and does not take into account the
retail margins. Therefore we see here thatWPI does give the true picture of inflation.
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Problems with WPI WPI is supposed to measure impact of priceson business. But we use it to measure theimpact on consumers. Many commodities notconsumed by consumers get calculated in the
index.
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Weight edge to CPI & WPI
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Second Edition
International ParityRelationships &
Forecasting ExchangeRates
Chapter Objective:
This chapter examines severalkey international parityrelationships, such as interestrate parity and purchasingpower parity.
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Introduction
Exchange rates matter in many differentways to many different constituencies in theworld economy
Much of this section on international financewill be directly or indirectly concerned withexchange rates
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The Nominal Exchange Rate
Relative price of two currencies
Often expressed as number of units of local orhome currency required to buy a unit of foreigncurrency
We will usually view India (Rupees) as ourhome country and United States (dollar) asour foreign country
Nominal or currency exchange rate (e) is
If e increases the value of the rupees (homecurrency) falls
If e decreases the value of the rupees (homecurrency) rises
e and the value of the peso are inversely related
e is often graphed as its inverse which is equal to the valueof the ru ees
dollar
rupees
currencyforeign
currencylocale ==
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The Real Exchange Rate
Measures the rate at which two countriesgoods trade against each other
Makes use of the price levels in the two
countries under consideration PMoverall price level in India (the home
country)
PUSoverall price level in the United States (the
foreign country) I
US
P
Pere =
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The Real Exchange Rate Suppose that the price level in the United States rises
Takes more Indian goods to purchase US goods
Represents a fall in the real value of the Rupees
Suppose that the price level in India rises
Takes fewer Indian goods to purchase US goods
Represents a rise in the real value of the Rupees
Suppose that the nominal exchange rate increases
Takes more Indian rupees to buy a US dollar and, therefore,more Indian goods to buy US goods
Represents a fall in the real value of the Rupees
Real exchange rates affected by both nominalexchange rates and price levels
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Business and Economic Forecasting
Demand Forecasting is a critical
managerial activity which comes in two
forms:
Quantitative Forecasting +2.1047%Gives the precise amount
or percentage
Qualitative ForecastingGives the expected direction
Up, down, or about the same
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Significance of Forecasting
Both public and private enterprises operate under conditionsof uncertainty.
Management wishes to limit this uncertainty by predicting
changes in cost, price, sales, and interest rates.
Accurate forecasting can help develop strategies to promoteprofitable trends and to avoid unprofitable ones.
A forecast is a prediction concerning the future. Good
forecasting will reduce, but not eliminate, the uncertainty that
all managers feel.
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Hierarchy of ForecastsThe selection of forecasting techniques depends in part on the level of
economic aggregation involved.
The hierarchy of forecasting is:
National Econom y (GDP, interest rates, inflation, etc.)sectors of the economy(durable goods)
industry forecasts(all automobile manufacturers)
firm forecasts (Ford Motor Company)
Product forecasts (The Ford Focus)
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Direction of sales can be indicated by other variables.
TIME
Index of Capital Goods
peak
PEAK Motor Control Sales
4 Months
Example: Index of Capital Goods is a leading indicatorThere are also lagging indicators and coincident indicators
Qualitative Forecasting10. Barometric Techniques
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LEADING INDICATORS*
M2 money supply (-12.4) S&P 500 stock prices (-
11.1)
Building permits (-14.4)
Initial unemploymentclaims (-12.9)
Contracts and orders forplant and equipment (-7.4)
COINCIDENT INDICATORS
Nonagriculturalpayrolls (+.8)
Index of industrialproduction (-1.1)
Personal income lesstransfer payment (-.4)
LAGGING INDICATORS
Prime rate (+2.0)
Change in labor cost per unitof output (+6.4)
Time given in months from change
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Handling Multiple Indicators
Diffusion Index: Wall Street WithLouis Ruykeyserhas eleven analysts. If4 are negative about stocks and 7 arepositive, the Diffusion Index is 7/11, or63.3%.
above 50% is a positive diffusionindex
Composite Index: One indicator rises 4%and another rises 6%. Therefore, the Composite
Index is a 5% increase.
used for quantitative forecasting
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Econometric Models Specify the variables in the model
Estimate the parameters
single equation or perhaps several stage methods
Qd = a + bP + cI + dPs+ ePc But forecasts require estimates for future prices,
future income, etc.
Often combine econometric models withtime series estimates of the independentvariable.
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example Qd = 400 - .5P + 2Y + .2Ps
anticipate pricing the good at P = $20Income (Y) is growing over time, the
estimate is: Ln Yt = 2.4 + .03T, andnext period is T = 17.
Y = e2.910 = 18.357
The prices of substitutes are likely to be P = $18.
Find Qd by substituting in predictions for P, Y, and Ps Hence Qd = 430.31