15. Principles of Economics (Brief Edition)_2e (12)

Chapter 12: Inflation and the Price. . Explain how the Consumer Price Index is. constructed and use it to calculate the inflation . Show how the CPI is used to adjust economic data. to eliminate the effects of . Discuss the two most important biases in the . Distinguish between inflation and relative price. changes to find the true cost of . Summarize the connections among inflation,. nominal interest rates, and real interest rates. McGraw­Hill/Irwin Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved. Measuring the Price Level.• The Consumer Price Index (CPI) is a measure. of the cost of living during a particular period.• The CPI measures. – The cost of a standard basket of goods and. services in a given year. – relative to the cost of the same basket of goods and. services in the base year.• 2005 is the base year for the CPI. – Base year changes periodically. 12­2 Calculating the CPI.• CPI is the ratio of the cost of the basket of goods. in the current year to the cost in the base year. – Base year cost $680. – 2011 cost $850. CPI = (850 / 680) (100) = .• Cost of living in 2011 is 25% higher than in 2005. – CPI for the base year is always 1. – CPI for a given period is the cost of living in that. period relative to what it was in the base year. – BEA uses CPI as a percentage – the ratio times. 100. 12­3 Price Index.• A price index measures the average price of a. given class of goods and services relative to the. price of the same goods and services in a base. year.• CPI measures the change in consumer prices.• Other indices. – Core inflation is CPI without energy and food. – Producer price index. – Import / export price index. 12­4 Inflation.• The rate of inflation is the Year CPI Inflation. 2005 . annual percentage change. 2006 . in the price level. 2007 .• Inflation in 2006 2008 . ( – ) / 2009 0%. = = Year00 CPI Inflation.• The Great Depression 1929 . – Period of falling output 1930 –. and prices 1931 –. – When inflation rates are 1932 – negative there is deflation 1933 – 12­5 Adjusting for Inflation.• A nominal quantity is measured in terms of its. current dollar value.• A real quantity is measured in physical terms. – Quantities of goods and services.• To compare values over time, use real quantities. – Deflating a nominal quantity converts it to a real. quantity. • Divide a nominal quantity by its price index to. express the quantity in real terms. 12­6 Indexing.• Indexing increases a nominal quantity each. period by the percentage increase in a specified. price index. – Indexing prevents the purchasing power of the. nominal quantity from being eroded by inflation.• Indexing automatically adjusts certain values,. such as Social Security payments, by the. amount of inflation. – If prices increase 3% in a given year, the Social. Security recipients receive 3% more. • No action by Congress required. – Indexing is sometimes included in labor contracts. 12­7 Adjusting for Inflation.• An indexed labor contract.