Consumer Price Index. What prices have changed over your lifetime? What items cost more? What items cost less?

Consumer Price IndexConsumer Price Index

What prices have What prices have changed over your changed over your lifetime?lifetime?

What items cost more?What items cost more?

What items cost less?What items cost less?

Question: How do we Question: How do we know if something know if something “really” costs more?“really” costs more?

First, we need First, we need correct terminology.correct terminology.

Nominal price:Nominal price:

list or actual cost list or actual cost given current value of given current value of moneymoney

Nominal price:Nominal price:Useful for comparisons Useful for comparisons within same time periodwithin same time periodand in same locationand in same location

Problem with nominal Problem with nominal prices:prices:

Cannot make meaningful Cannot make meaningful comparisons of prices comparisons of prices across time periods across time periods or locations. or locations.

Prices of products in Prices of products in 1962:1962: $0.05 for a Hershey bar$0.05 for a Hershey bar $0.05 for a copy of New York Times$0.05 for a copy of New York Times $0.04 for first class postage stamp$0.04 for first class postage stamp $0.31 for gallon of regular gas$0.31 for gallon of regular gas $0.28 for McDonalds double $0.28 for McDonalds double

hamburgerhamburger $2,529.00 for full-size Chevrolet$2,529.00 for full-size Chevrolet

Why can’t one compare Why can’t one compare 1962 prices with prices 1962 prices with prices for same or similar for same or similar products today? products today?

More precisely, why are More precisely, why are such comparisons such comparisons meaningless? meaningless?

Real price:Real price:

Cost relative to general Cost relative to general economic conditions economic conditions in a place and time.in a place and time.

Why?Why?

Because the price of an Because the price of an item only has meaning in item only has meaning in terms of what one terms of what one passes up to buy it.passes up to buy it.

Similarly with wages:Similarly with wages:

Income only can be Income only can be evaluated in terms of evaluated in terms of what can be purchased what can be purchased with it. with it.

Inflation:Inflation:

A general rise in prices A general rise in prices in an economy. in an economy.

Deflation:Deflation:

A general decrease in A general decrease in prices in an economy.prices in an economy.

Inflation and deflationInflation and deflationcreate disparities create disparities between real and between real and nominal prices.nominal prices.

Suppose a young person Suppose a young person gets an allowance of $10 gets an allowance of $10 per week. per week.

Her allowance allows her Her allowance allows her a certain level of a certain level of consumption.consumption.

Suppose that the prices Suppose that the prices of goods she normally of goods she normally buys increase by 20% buys increase by 20% and her father increases and her father increases her allowance to $11. her allowance to $11.

Has her allowance Has her allowance increased?increased?

Answer:Answer:

Her nominal allowance Her nominal allowance has increased buthas increased buther real allowance her real allowance has decreased. has decreased.

Key Question: Are people Key Question: Are people better off now than they better off now than they used to be?used to be?

To answer this, you To answer this, you need a way to need a way to standardize prices (and standardize prices (and wages), so that you can wages), so that you can compare across time.compare across time.

CPI: Consumer Price CPI: Consumer Price IndexIndex

Economists use Economists use Consumer Price Index Consumer Price Index [CPI] [CPI] to estimate real wages to estimate real wages and costs from nominal and costs from nominal wages and costs.wages and costs.

Computation of CPIComputation of CPI

An army of economists gathers An army of economists gathers prices on a standard “market prices on a standard “market basket” of goods at fixed time basket” of goods at fixed time periods (month, year)periods (month, year)

Computation of CPIComputation of CPI

An army of economists gathers An army of economists gathers prices on a standard “market prices on a standard “market basket” of goods at fixed time basket” of goods at fixed time periods (month, year). periods (month, year).

The prices of the baskets is The prices of the baskets is compared. compared.

Computation of CPIComputation of CPI

An army of economists gathers prices An army of economists gathers prices on a standard “market basket” of on a standard “market basket” of goods at fixed time periods (month, goods at fixed time periods (month, year). year).

The prices of the baskets is compared. The prices of the baskets is compared.

The prices are converted to index The prices are converted to index numbers. numbers.

What’s in the CPI?What’s in the CPI?

Housing (41.4%)Housing (41.4%) Transportation (17.8%)Transportation (17.8%) Food (16.2%)Food (16.2%) Energy (8.2%)Energy (8.2%) Medical Care (6.4%)Medical Care (6.4%) Apparel & Upkeep (6.1%)Apparel & Upkeep (6.1%) Other (3.9%)Other (3.9%)

Current CPICurrent CPI

NYTimesNYTimes Graphic Graphic

Creating the CPICreating the CPI

Cost of bundle in a base year = 100 (on Cost of bundle in a base year = 100 (on index)index)

Cost of the bundle for other years is Cost of the bundle for other years is then calculatedthen calculated

Ex: 1982 = base year; bundle = Ex: 1982 = base year; bundle = $1103.46$1103.46

In 1983, bundle = $1138.91In 1983, bundle = $1138.91 SO: $1138.91 (1983) = SO: $1138.91 (1983) =

$1103.46 (1982)$1103.46 (1982)

OR:OR:

$1138.91 (1983) = $1103.46 (1982)$1138.91 (1983) = $1103.46 (1982) Then 1 (1982$) = 1138.91/1103.46Then 1 (1982$) = 1138.91/1103.46

=1.032 (1983$)=1.032 (1983$) So…1 (1982$) = 1.032 (1983$)So…1 (1982$) = 1.032 (1983$)

1982 = base year; index = 1001982 = base year; index = 100 1983; index = 103.21983; index = 103.2

And we get an INDEXAnd we get an INDEX

YearYear 19801980 19811981 19821982 19831983 19841984 19851985 19861986 19871987

CPICPI 85.485.4 94.294.2 100.0100.0 103.2103.2 107.7107.7 111.5111.5 113.6113.6 117.7117.7

FORMULA for the Conversion FORMULA for the Conversion FactorFactor

Notice that those relative values can Notice that those relative values can be computed using this formula:be computed using this formula:

CPI of base year / CPI of object year CPI of base year / CPI of object year

(Object year is the year being (Object year is the year being compared to the base year)compared to the base year)

Conversion factor = Conversion factor =

CPI of base year / CPI of object CPI of base year / CPI of object yearyear

Use the conversion Use the conversion factor to adjust the factor to adjust the prices:prices:

Price * conversion factor Price * conversion factor = adjusted price= adjusted price

An ExampleAn Example

1990, gas costs $1.16/gallon (on avg)1990, gas costs $1.16/gallon (on avg) 1997, gas costs $1.23/gallon (on avg)1997, gas costs $1.23/gallon (on avg)

Was gas more or less expensive in Was gas more or less expensive in 1997?1997?

Nominal price (current price) = MORENominal price (current price) = MORE But, what about in constant/real $?But, what about in constant/real $?

Converting PricesConverting Prices

From the CPI table, we know thatFrom the CPI table, we know that $130.70 (1990) = $160.50 (1997)$130.70 (1990) = $160.50 (1997)

If something costs $1.16 in 1990, If something costs $1.16 in 1990, what would that amount to in 1997?what would that amount to in 1997?

160.50 (1997)160.50 (1997) = = x (1997 $)x (1997 $)

130.70 (1990) 1.16 (1990 $) 130.70 (1990) 1.16 (1990 $)

Another way to think Another way to think of thisof this Conversion Factor Conversion Factor = = CPI of base year/CPI of object yearCPI of base year/CPI of object year

160.50160.50130.70130.70

(how much more one dollar in 1990 is (how much more one dollar in 1990 is worth in 1997)worth in 1997)

=1.228 * $1.16 = $1.42 =1.228 * $1.16 = $1.42 So, $1.16 in 1990 = $1.42 in 1997So, $1.16 in 1990 = $1.42 in 1997

Using previous terminology:Using previous terminology:

Nominal price * conversion factor Nominal price * conversion factor = =

real price (relative to base year)real price (relative to base year)

Combining the formula for Combining the formula for adjusted price with that for the adjusted price with that for the conversion factor:conversion factor:

Nominal price * (CPI base year / Nominal price * (CPI base year / CPI object year) = real priceCPI object year) = real price

Another ExampleAnother Example

Converting Prices in Converting Prices in ExcelExcel

Freezing the CellFreezing the Cell

Remember that you can “freeze” Remember that you can “freeze” the value in a cell so that the the value in a cell so that the reference stays the samereference stays the same

When you convert prices, you When you convert prices, you want to freeze the value of the want to freeze the value of the base year (1998)base year (1998)

F4 freezes the value – F4 freezes the value – B2*$C$10/C2B2*$C$10/C2

Additional Additional terminology:terminology:

Current values (prices, wages, etc.) Current values (prices, wages, etc.) are prices (nominal values) at the are prices (nominal values) at the value of the currency at that timevalue of the currency at that time

Constant values (prices, etc.) are Constant values (prices, etc.) are prices in real values, i.e., as if the prices in real values, i.e., as if the currency had the value of the base currency had the value of the base year. year.

Inflation RateInflation Rate

Percentage Change in the annual Percentage Change in the annual CPICPI

Ex: Inflation Rate in 1996:Ex: Inflation Rate in 1996: