LSP 120: Quantitative Reasoning and Technological Literacy

Section 202

Özlem Elgün

Inflation• On class website , under topic 7, click on Detailed CPI tutorial. Scroll

down to An introduction to Inflation • Inflation is a decline in the value of money in relation to the goods

that it can buy and is a pervasive economic phenomenon. It is so pervasive that it is very difficult to compare this year’s prices to last year’s, much less compare prices over decades. Here is a graph of the buying power of $1.00 since 1938:

The Consumer Price Index (CPI)• Since we have to deal with the inflation factor, how is the "buying power" of $1.00

measured? Given inflation how can we compare prices of an item or items in different years?

• Having established empirically that the value of money changes, the next question is, why should we care? There are many reasons, but the probably the most important reason is that we need to make sure that our wage increases are roughly in line with inflation. If wages are increasing more slowly than prices, then people's incomes are decreasing even though their wages are increasing nominally.

• It was precisely these concerns that led the United States Bureau of Labor Statistics to start publishing the CPI in 1917. Inflation was very high during World War I, and there was considerable labor strife. It was thought that if there was an official inflation rate sanctioned by a neutral third party, it might assist in the negotiation of labor contracts and perhaps even help prevent strikes.

• the consumer price index (CPI) allows us to compare prices of an item in different years

CPI• Below is a simplified explanation of how the indices are created and how we can use

them. [for a detailed explanation see Detailed CPI Tutorial on the class website under Topic 7] Economists choose a base year and determine the price of a "bundle" of goods: food, clothing, housing costs, transportation costs, services, entertainment in varying proportions. The proportions for the index we are using (CPI(U)) are:

• The cost of this bundle in one year is assigned an index number. The next year, the cost of the same bundle is determined. The CPI for that year represents the new cost of the bundle.

Components of the CPI(U) Housing 41.4%Transportation 17.8%Food 16.2%Energy 8.2%Medical Care 6.4%Apparel and Upkeep 6.1%

Other 3.9%

Using the Consumer Price IndexThe table below shows the official CPI since 1990. We will

explore how it is used.

YearCPI

1982-84=1001990 130.71991 136.21992 140.31993 144.51994 148.21995 152.41996 156.91997 160.51998 163.01999 166.62000 172.22001 177.12002 179.92003 184.02004 188.92005 195.32006 201.6

How can you interpret the table?

The beauty of this table is that we can easily compare any two years prices.

For example, from the table we can see that in 1990, it would cost $130.70 for goods and services costing $201.60 in 2006.

But also from the table we can see thatin 1995, it would cost $152.40 for goods and services costing $201.60 in 2006.

We can therefore say that $130.70 in 1990 is equivalent to $152.40 in 1995 which is equivalent to $201.60 in 2006.

A relationship between the factors...

• This information will allow us to calculate how many times more the prices of goods were in one year than in another. Using 1995 and 2006 as an example, we can calculate the ratio of the CPI values for those two years:

• This means that ratio of the CPI values of 2006 to 1995 is 1.32. This means that something that costs 1 dollar in 1995, 11 years later, in 2006 costs $1.32.

• The CPI allows you to convert anything money related (prices, wages, salaries) from one year to another.

Comparing amounts from two different years (converting to Constant Dollars "by hand")

• Example 1: Let's say your boss said she made $18,000 a year at her first job out of college in 1988. That doesn't sound like a lot of money to us today, but we must consider that everything was less expensive in 1988. What is that salary worth in 2006? To answer that, we can convert the $18,000 to 2006 constant dollars using the CPI values for those years (found in CPI.xls on class website).

• The CPI table tells us that 118.3 in 1988 dollars is equivalent to 201.6 in 2006 dollars.

• We wish to know: $18,000 in 1988 dollars is equivalent to how much money in 2006 dollars.

• This ratio tells us that one dollar in 1988 is equivalent to $1.70 in 2006. Another way to think about it is that prices were, on average, 1.7 times more in 2006 than in 1988.

• Multiplying the wage of $18,000 by this ratio completes the conversion: 18,000 * 1.7 = $30,600

• This means that your instructor's $18,000 salary in 1988 is equivalent to making $30,600 a year in 2006.

YearCPI

1982-84=1001990 130.71991 136.21992 140.31993 144.51994 148.21995 152.41996 156.91997 160.51998 163.01999 166.62000 172.22001 177.12002 179.92003 184.02004 188.92005 195.32006 201.6

This interpretation of the CPI also allows us to compare prices in two different years and determine when an item was more expensive. We can calculate whether an item increased in price at the same rate as the "bundle of goods" or at a faster or slower rate.

• Example 2: The price of gasoline in 1981 was $1.38 per gallon on average. In 2005, it averaged $2.30. Was gasoline more expensive or less expensive in 2005?

• On the face of it, it seems that gas is more expensive in 2005. Using the CPI values (found in CPI.xls):

• What this tells us is that $1.38 in 1981 was equivalent to $2.96 in 2005.

• $2.96 is the 1981 price in constant 2005 dollars. • In other words, when Americans paid $1.38 per gallon for

gasoline in 1981, it was equivalent to paying $2.86 in 2005. • We can now compare the actual price in 2005 to the 1981

price in constant 2005 dollars. Since $2.96 is more than the $2.30 that people were actually paying in 2005, gasoline was more expensive in 1981 than it was in 2005.

YearCPI

1982-84=1001990 130.71991 136.21992 140.31993 144.51994 148.21995 152.41996 156.91997 160.51998 163.01999 166.62000 172.22001 177.12002 179.92003 184.02004 188.92005 195.32006 201.6

• Using the F4 Key: As part of activity 11, we learn using the (F4) key or "freezing" the value. By touching the (F4) key after entering a cell reference, a dollar sign is placed before the letter and number. (If you touch the F4 key more than once, it toggles the dollar signs and allows for mixed references.) Using the F4 key is essentially the same as typing in the number but it goes against my motto that "if you see a number you should click on". This shows students how to create absolute references in Excel (as compared to relative references.