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Week of Jan 24

This document defines and explains key concepts related to price indices and measuring inflation. It discusses: - What a price index is and how it compares the price of a market basket of goods over time - How nominal GDP is measured using current prices while real GDP uses fixed base year prices - How the GDP deflator is calculated as a price index that compares nominal and real GDP to measure inflation - How the Consumer Price Index (CPI) measures inflation by comparing the cost of a basket of consumer goods over time - How price indices like the GDP deflator and CPI are used to deflate dollar values and adjust payments for inflation over time

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Fabian Gonzalez
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36 views

Week of Jan 24

This document defines and explains key concepts related to price indices and measuring inflation. It discusses: - What a price index is and how it compares the price of a market basket of goods over time - How nominal GDP is measured using current prices while real GDP uses fixed base year prices - How the GDP deflator is calculated as a price index that compares nominal and real GDP to measure inflation - How the Consumer Price Index (CPI) measures inflation by comparing the cost of a basket of consumer goods over time - How price indices like the GDP deflator and CPI are used to deflate dollar values and adjust payments for inflation over time

Uploaded by

Fabian Gonzalez
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Aggregate: Price Level

Measured using a Price Index


What is a

price index?

Distinguish between Nominal and Real GDP. Nominal GDP:


Measured using current $ prices:

(Q P

current

)
2 2

Real GDP:
Measured using base year $ prices; that is, prices that are fixed at a chosen base year level Shows how the economys overall real production of goods & services changes over time.

(Q P

base

)
3 3

All Goods and Services Produced in the Current Year

Valued at current year prices = Nominal GDP

Valued at base year prices = Real GDP


4 4

(1)

(2)

(3) Prices of 2005 market basket in 2005 $12 $18 $8 $14

(4) Expenditures on 2005 market basket in 2005 (3) X (2) $24 $18 $8 $14 $64

(5) Prices of 2005 market basket in 2000 prices (base year) $5 $20 $6 $14

(6)

Product

Quantities in market basket in 2005 2 1 1 1

Expenditures on 2005 market basket in 2005 prices (5) X (2) $10 $20 $6 $14 $50

Pizzas Robots Pencils CDs TOTAL

Nominal GDP

Real GDP
5 5

Real GDP: constant base year prices provide the basis for comparing real quantities (output) in different years.

Calculation of a price index that is used to measure the overall price level
From nominal GDP & real GDP we can compute a

Price index: GDP Deflator

GDP Deflator & the Price Level


The GDP Deflator compares Real and Nominal GDP for the same year any rise in nominal GDP is attributable to a rise in the price level since quantities stay the same the GDP Deflator compares the current level of prices to the level of prices in a base period

The GDP Deflator n o m G D P G D P d e fl a t o r05 = r e al G D P

'0 5 '0 5

1 0 0

b a s e y r '0 0

(only the prices are different in calculating nominal & real GDP in 05) a price level change is reflected by the GDP deflator price index and the GDP deflator can be used to monitor changes in the overall level of prices in the economy
By convention the ratio formed in the calculation of the GDP deflator is multiplied by 100 for ease of use 9 9

For example:

Nominal GDP

GDP deflator 05, 2000=100

64 100 = 128 50
Real GDP

i.e. the price level rose 28% from 2000 to 2005

10

Summary In General a Price Index


compares the $ value of some market basket of goods & services in a specific or current period to the $ value of an identical market basket in a reference or base period

the GDP deflator is a price index


11

GDP Deflator: is an Implicit Price Index


total $ cost of current output at current prices GDPdeflator = 100 total $ cost of same output at base year prices

GDP deflator = '05

(P (P

'05 '00

Q'05) Q'05)

100

note GDP deflator and a price index in general = 100 in the base year.

12

12

Recent Updates: GDP Deflator


In May of 2001, Statistics Canada adopted a more complicated method for calculating Real GDP: chain Fisher method. This results in a GDP deflator which is less sensitive to the particular base year chosen. The Implicit Chain Price Index form of the GDP deflator is set at 100 for the first quarter of 1997 and then changes continuously.

www.statcan.ca and search for chain Fisher


13

Calculation of the Inflation Rate Using the GDP Deflator

Inflation Rate =
=

Price Index Yr2 PI Yr 1 PI Yr 1


128 100 = 28% inflation 100

Adjusting GDP for Changes in the Price Level

Real GDP =

nominal GDP GDP deflator

100
14

The Consumer Price Index


Relevant to all who earn an income
Measures the overall price level for consumer goods by comparing the $ value of a fixed basket of commodities purchased by Canadian consumers in a given year with the $ value of the same basket in the base year

15

Current CPI Weights & Base Period


About 600 commodities chosen for the CPI basket are weighted according to their relative importance in the total expenditures of consumers p CPI commodities and their relative importance are determined on the basis of surveys conducted every ten or fewer years. The current weights were introduced in 2005. The current base period is 2002=100
www.statcan.ca/english/sdds/2301.htm
16

Constructing and Calculating a Simple CPI


1. Determine the market basket contents and the base year. 2. Find prices for the items in the basket both in the base year and the current year. 3. Find the $ value of the basket in the base y year and the current year.

Now calculate the CPI

17

Calculate a Simple CPI Union of University Provinces


Good 2000 2000 2001 2001 Qn P Qn P $ $ 10$50 100 $ 1 100 100$ 5 2002 2002 Qn P $

Books Pencils P il Pens

12.$50 100....$60 200. $ 1 50 200 50.. $1 50 $1.50 50..$10 20..$20

CPI 2002 (base year 2000) Bottom 2000 Q's x 2000 P's = $1100 Top 2000 Qs x 2002 Ps = $2750

18

Calculating a Simple CPI

(P Q (P Q (P 02 Q 00 basket CPI 02 = (P 00 Q 00 basket


CPI =
current base yr

base yr basket )

100

base yr basket )

) x 100 )

P00 x Q00

$50 x 10 = $500 $1.00 x 100 = $100 P02 x Q00 $5 x 100 = $500 $1100

$60 x10 = $600 $1.50 x100 = $150 $20 x100 = $2000 $2750
19

Calculating a Simple CPI

CPI02 =

$2750 100 $1100


(Base year 00 = 100)

= 250

note CPI= 100 in the base year.

One more major price index is calculated: PPI (producer price index) market basket of goods & services bought by firms.
20

Problems in Measuring CPI


1. Substitution bias
Consumers respond to relative price changes by buying more of the relatively cheap goods Index overstates inflation

2. Introduction of new goods


Index overstates inflation

3. Unmeasured quality change.


Index overstates inflation
21

Inflation in Canada

http://www.bankofcanada.ca/en/inflation_calc.htm

22

The Consumer Price Index


the inflation rate is high when the price level is rising rapidly and low when the price level is rising slowly.

23

The CPI Used in Four Specific Ways


1. Tool for deflating current dollar estimates to obtain constant dollar estimates that eliminate the effects of price change over time

Constant $ Estimates: g p Using the CPI to compare $ values over time


e.g. price of a tin of butterscotch candies was $.45 in 1978 and $1.00 in 2008. In 2008 $s, how much would you pay for the candies? What would be the purchasing power of your 2008 $s in 1978?
24

Suppose
CPIbaseyr.02 in 1978= 37.6 CPI 2002=100 in 2008 = 114.5

CPI = 1978 Price CPI


Value in 2008 $s of

Base _ year _ 2002

Base _ year _ 2002

2008 1978Price 1978

114.5 37.6 = $1.37 =

$0.45

Candy was more in 1978.

25

The CPI Used in Four Specific Ways


2. Escalate a given dollar value over time to preserve the purchasing power of that value
Adjust contracted payments such as wages, rents, leases, child support: private and public pension programs, personal income tax deductions

26

Use the CPI to Compare $ Values Over Time


Annual family expenses
Nominal
Current $ 1997 2000 2004 2007 $20,000 $25,000 $30,000 $35,000 CPI 2002 = 100 90.5 96.6 105.6 111.9

Real
Constant 2002, $s $22,099 $25,879 $28,409 $31,278

constant 2002, $' s =

Current $ 100 CPI for " current" year

27

Use the CPI to adjust payments over time


e.g. Divorce Agreement The basic child support payment is $600/month effective May 1, 2003. Every May 1 thereafter, payments will be adjusted by the percentage change over 12 months in the March CPI for Canada. Suppose the CPI increased 2.2% in the first year, 1.4% in the second. On May 1, 2004, payment increases by 2.2% x $600 = $13.20 On May 1, 2005, payment increases by 1.4% x $613.20 = $8.58 28

The CPI Used in Four Specific Ways


3. Real & Nominal Interest Rates
Interest: payment of money income in the future for a transfer of money in the past. Interest rate paid by the bank nominal rate of interest. interest Interest rate corrected for inflation real rate of interest.

real interest rate = nominal interest rate inflation rate.


29

The CPI Used in Four Specific Ways


4. Setting and evaluating economic policies Bank of Canada uses the CPI to evaluate its policies Economic analysis and research

30

10

Inflation Inflation is a process of rising prices. We measure the inflation rate as the percentage change in the average level of prices or the price level level. Why do we care about inflation?

31

Costs of Inflation
Inflation erodes the purchasing power of money?????
A fall in purchasing power of money?

The inflation fallacy. fallacy Inflation of prices goes hand in hand with inflation of incomes.
32

Costs of Inflation 1. Inflation Tax: shoe leather costs


Inflation is like a tax imposed on everyone who holds money. Avoidance of this tax uses up resources. resources

2. Menu costs
Updating price lists & posted prices; printing new menus, catalogues, etc.
33

11

3. Increased variability of relative prices causes reduced efficiency of the price system. Confusion & Inconvenience
*Serious Costs of Inflation

4. Hyperinflation and economic breakdown

5. Special costs associated with unexpected inflation


34

Costs of Inflation
Unexpected inflation leads to a random redistribution of income having nothing to do with merit or need. g p for debtors who gain at the expense of creditors for people on fixed incomes for those workers whose wages dont keep up with inflation.
*Serious Cost of Inflation
35

12

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