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ECON 1BB3 Introduction to Macroeconomics
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Using CPI
Example: your father earned $40,000 in 1972. What isthis salary worth in 2007 dollars?
CPI1972
= 41.8
CPI2007= 132.3
Answer:
CPI2007 = 132.3 = $3.165 the value of $1 from 1972 in terms of 2007 dollars is $3.165
CPI1972 41.8 in 2007, the value of $40,000 earned in 1972 would be (40,000)(3.165)
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Problems with CPIfixed basket that an avg consumer will purchase
there are 3 problems with CPI 1. Substitution bias the CPI ignores the possibility of consumer
substitution and overstates the increase in the cost of living from one
year to the next
2. Introduction of new goods since the CPI is based on a fix basket of
goods and services, a change in the cost of living is not reflected in thepurchasing power of the dollar
3. Unmeasured quality change the CPI cannot measure the change in
quality
Doesnt take into account the externalities such as quality improvement
CPI doesnt actively measure the true economic activities
CPI measure every 15 days
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Comparison of CPI to the GDP deflator
two important differences between CPI and GDP deflator: 1. CPI reflects prices of all goods and services bought by typical
consumers.
GDP deflator reflects prices of all goods and services produced
domestically.
2. CPI compares the price of a fixed basket of goods that
occasionally changes.
GDP deflator compares the price of currently produced goods and
services to the price of goods and services produced in an earlier
period.
Imports would be better reflected in CPI than GDP
Price Indexthe avg of the overall prices tat you see in any
economy
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Interest ratesthe opportunity cost of currently available fundsthe price of loans
Example:suppose you have $100 in a savings accountearning 5% interest per year. How many dollars do you
have after 1 year?
Answer:
(100)(1.05) = 105
$105.00(earning $5 by sacrificing current
consumptions)
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Example:a) If all prices in the economy increased by 3% during the
year, how much stuff can you buy with it?
Answer:
105-(100)(0.03) = $102.00 (need to adjust the value of
dollars)
b) What if the prices in economy increased by 10% during
the year?Answer:
105-(100)(0.10) =$95 (only the value is going dwn, not
your actual amt)
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nominal interest rate:interest rate withoutcorrectionfor inflation measures the increase in the number of
dollars in your bank account. DOLLAR VALUE OF INCOME
real interest rate:interest rate withcorrection for
inflation measures the increase in the purchasingpower of the dollars in your savings account. INDEXATION
real interest rate = nom. interest rate inflation rate
in the end, who is gaining?bank is benefiting cuz it
takes loan of $100, yet only gives/pays back customer
$95.
Lender loses money if inflation arises!
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Extra info. Real Wagepurchasing value of income Real Wage = Nominal WagePrice of labours in labour
Price Index market
