Price Level
The CPI
• We would like to measure the aggregate price
level (how prices today compare on average to
prices in previous years). We can use this
information to:
– express past dollar amounts in current dollars
– index government (and other) payments to stay
constant in real value
– calculate the inflation rate, which is just the growth
rate of the price level
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The CPI
• To measure the price level, we use a statistic
called a price index. All price indices take the
form:
price index = 100*(cost of some goods in current year)
/(cost of the same goods in the base year)
– The price index always equals 100 in the base year.
– Unlike GDP (measured in dollars), price indices do not have units
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The CPI
• There are many price indices, but the most
important one is called the Consumer Price
Index (CPI).
– The CPI is based on the cost of a market basket
(shopping list) aimed at representing the purchases
of the typical household
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What’s in the CPI’s Basket?
https://www.bls.gov/cpi/
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The CPI
• Applying our general definition, we get:
CPI = 100*(cost of market basket in current year)
/(cost of market basket in the base year)
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The CPI
• Let’s return to our example:
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The CPI
Price Market Cost of
basket market basket
Good 2015 2016 2015 2016
Hats $20 $25 10
Cattle $1,000 $1,100 0.1
Total cost of market basket
CPI (2015 base year)
CPI (2016 base year)
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The CPI
Price Market Cost of
basket market basket
Good 2015 2016 2015 2016
Hats $20 $25 10 $200 $250
Cattle $1,000 $1,100 0.1 $100 $110
Total cost of market basket $300 $360
CPI (2015 base year)
CPI (2016 base year)
Cost of market basket in 2015 = (10 hats)*($20/hat) + (0.1 cattle)*($1,000/cattle)=$300
Cost of market basket in 2015 = (10 hats)*($25/hat) + (0.1 cattle)*($1,100/cattle)=$360
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The CPI
Price Market Cost of
basket market basket
Good 2015 2016 2015 2016
Hats $20 $25 10 $200 $250
Cattle $1,000 $1,100 0.1 $100 $110
Total cost of market basket $300 $360
CPI (2015 base year) 100 120
CPI (2016 base year)
If we use 2015 as the base year:
2015 CPI = 100*($300)/($300) = 100 (CPI is always 100 in the base year)
2016 CPI = 100*($360)/($300) = 120
Inflation rate = 100%*(120-100)/100 = 20%
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The CPI
Price Market Cost of
basket market basket
Good 2015 2016 2015 2016
Hats $20 $25 10 $200 $250
Cattle $1,000 $1,100 0.1 $100 $110
Total cost of market basket $300 $360
CPI (2015 base year) 100 120
CPI (2016 base year) 83.3 100
Note that the inflation rate does not change when we use a different base year
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Other price indices
• Core CPI is
– less variable than total CPI
– a better indicator of the impact of policy on inflation
– a better predictor of general trends in prices
• Total CPI is
– a better indicator of the actual cost of living
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Other price indices
• The GDP deflator is calculated by the formula
100*(current nominal GDP)
/(current real GDP)
• The “basket” for the GDP deflator is the current year’s
production
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Let’s Think: CPI vs. GDP deflator
In each scenario, determine the effects on the CPI and the GDP
deflator.
A. Starbucks raises the price of hot choclate.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial tractors it
manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not
C. Armani raises the price of the Italian jeans it sells in the U.S.
The CPI rises, the GDP deflator does not.
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Contrasting the CPI and GDP Deflator
• Imported consumer goods:
– Included in CPI
– Excluded from GDP deflator
• Capital goods:
– Excluded from CPI
– Included in GDP deflator (if produced domestically)
• The basket:
– CPI uses fixed basket
– GDP deflator uses basket of currently produced goods & services
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Using the CPI
• The CPI is often used to index payments so that
they are kept constant in terms of purchasing
power.
– Government benefits are often indexed
– So are union wage contracts and other business
contracts that operate over many years.
• Why index? To manage or share the risk of
inflation.
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Using the CPI
Indexing example Salary calculation
• In 2015 a union negotiates • Salary in 2015 = $50,000
an annual salary of $50,000, • Salary in 2016 =
indexed to inflation. $50,000*(1.024) = $51,200
• The (CPI) inflation rate • Salary in 2017 =
from 2015 to 2016 is 2.4% $51,200*(1.017)= $52,070
• The (CPI) inflation rate
from 2016 to 2017 is 1.7%
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Using the CPI
• The CPI is also used to
express historical dollar
amounts in modern
terms
– Example, the Atari 2600
cost US$200 in 1977
– The CPI in 1977 was 27.8
– The CPI in 2018 is 115.4
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Using the CPI
• The CPI is also used to • That US$200 in 1977 is
express historical dollar equivalent to
amounts in modern
terms 200*115.4/27.8 = US$830
– Example, the Atari 2600
in 2018 dollars.
cost US$200 in 1977
– The CPI in 1977 was 27.8 • At current exchange rates
– The CPI in 2018 is 115.4 that would be C$1,100.
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Using the CPI
• The general formula for that would be:
𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 𝐴
𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝐴 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 = 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝐵 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 ∗
𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 𝐵
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