Section 3B- Modules 14/15- Inflation and the Business Cycle

Module Checklist

When you have completed your study of these modules, you will be able to

Explain what the Consumer Price Index (CPI) is and how it is calculated.

1

Explain the limitations of the CPI as a measure of the cost of living.

Adjust money values for inflation and calculate real wage rates and real interest rates.

2

3

Inflation

Inflation

An upward movement in the average level of prices

Deflation

A downward movement in the average level of prices

Inflation

Purchasing Power

The value of money for buying goods and services

Varies with prices and income

Disposable Income

*During inflation purchasing power of a dollar falls

*During deflation purchasing power of a dollar rises

Inflation

Nominal Value

Price expressed in today’s dollars

Real Value

Varies with the rate of inflation

Value expressed in purchasing power which varies with inflation

Inflation

Inflation- Measured by computing a price index which is defined as the cost of a market basket today, expressed as a percentage of the cost of that market basket in some starting or base year. In the base year the price index is always equal to 100. Inflation is measured by the rise in a price index.

Base year chosen as a point of reference for comparison.

THE CONSUMER PRICE INDEX

Consumer Price Index (CPI)

•A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services.

•Allows you to compare the cost of a market basket from one year to another year in terms of inflation

Inflation

Market Basket

Representative bundle of goods and services

Reference Base Year (Period)

The point of reference for comparison of prices in other year.

A period for which the CPI is defined to equal 100. Currently, the reference base period is 19821984.

THE CONSUMER PRICE INDEX

In May 2005, the CPI was 194.4.

The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 94.4 percent higher in May 2005 than it was on the average during 19821984.

In April 2005, the CPI was 194.6.

The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services decreased by 0.2 of a percentage point in May 2005.

THE CONSUMER PRICE INDEX

Constructing the CPI

Three stages:• Stage 1: Selecting the CPI basket• Stage 2: Conducting the monthly price survey• Stage 3: Calculating the CPI

Stage 1: The Market Basket

Figure below shows the CPI basket.This shopping cart is filled with the items that an average household buys.

Stage 2: Monthly Price Survey

The Monthly Price Survey

Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas.

Because the CPI measures price changes, it is important that the prices recorded refer to exactly the same items.

Stage 3: Calculating the CPI

Calculating the CPI

The CPI calculation has three steps:• Find the cost of the CPI basket at base period

prices.• Find the cost of the CPI basket at current period

prices.• Calculate the CPI for the base period and the

current period.

Stage 3: Calculating the CPI

Note- Always use the same quantity to determine the CPI for each year.The only thing that is changing is the price.

Base year Quantity X Current Year Price = CPI Basket

Stage 3: Calculating the CPI

CPI = Cost of CPI basket at current period pricesCost of CPI basket at base period prices

x 100

For 2000, the CPI is: = 100$50

$50x 100

For 2003, the CPI is: = 140$70

$50x 100

The CPI for the base period is always 100. Always!!!

Once we determine the CPI for these yearswe can now determine the inflation for these years!

Formula for the Rate of Inflation

Measuring Inflation

Inflation rate

The percentage change in the price level from one year to the next.

Inflation rate = = 40% percent140 100

100x 100

CPI in current year CPI in previous year

CPI in previous year

x 100Inflation rate =

This means there has been a 40% increase in inflation between the previous year and current year. But that is easy because you are working from the base year. Try this!

Formula for the Rate of Inflation

Measuring Inflation

Inflation rate- CPI for 2002 is 120 and CPI for 2003 is 140

What is the rate of inflation between 2002 and 2003?

Inflation rate = = 16.7 percent140 120

120x 100

CPI in current year CPI in previous year

CPI in previous year

x 100Inflation rate =

This means there has been a 16.7% increase in inflationbetween the previous year and current year.

Dollar Figures from Different Times

In 1931, Babe Ruth made $80,000. What is his salary equal to in 2007 dollars.

Need to know the CPI in 1931 and in 2007. CPI in 1931 is 15.2 CPI in 2007 is 207

Formula to convert dollar amounts from different times.

Amount in today’s dollars

= Amount in old dollars

X CPI todayCPI in past

Dollar Figures from Different Times

In 1931, Babe Ruth made $80,000. What is his salary equal to in 2007 dollars.

Need to know the CPI in 1931 and in 2007. CPI in 1931 is 15.2 CPI in 2007 is 207

Formula to convert dollar amounts from different times.

Amount in today’s dollars

= $80,000 X20715.2

Answer is $1,089,474

THE CONSUMER PRICE INDEX

Figure shows the CPI in part (a) and the inflation rate in part (b).

THE CONSUMER PRICE INDEX

In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.

THE CONSUMER PRICE INDEX

In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.