PowerPoint Presentations for Principles of Macroeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by Marc Prud’homme University of Ottawa MEASURING THE COST OF LIVING Chapter 6 Copyright © 2014 by Nelson Education Ltd. 6-2 MEASURING THE COST OF LIVING The consumer price index is used to monitor changes in the cost of living over time. When the consumer price index rises, the typical family has to spend more dollars to maintain the same standard of living. Copyright © 2014 by Nelson Education Ltd. 6-3 MEASURING THE COST OF LIVING Economists use the term inflation to describe a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period. Copyright © 2014 by Nelson Education Ltd. 6-4 THE CONSUMER PRICE INDEX Copyright © 2014 by Nelson Education Ltd. Jirsak/Shutterstock The consumer price index (CPI): the overall measure of the cost of the goods and services bought by a typical consumer 6-5 How the Consumer Price Index Is Calculated Every month, Statistics Canada computes and reports the CPI. It uses data on the prices of more than 600 different goods and services. To see how these statistics are constructed, a simple economy with two goods, hot dogs and hamburgers, is used. Copyright © 2014 by Nelson Education Ltd. 6-6 How the Consumer Price Index Is Calculated Five steps to compute the inflation rate: 1. Determine the basket. 2. Find the prices. 3. Compute the basket’s cost. 4. Choose a base year and compute the index. 5. Compute the inflation rate. Copyright © 2014 by Nelson Education Ltd. 6-7 TABLE 6.1: Calculating the CPI and the Inflation Rate Copyright © 2014 by Nelson Education Ltd. 6-8 How the Consumer Price Index Is Calculated Copyright © 2014 by Nelson Education Ltd. 6-9 FYI: What Is in the CPI Basket? Figure 6.1: The Basket of Goods and Services Copyright © 2014 by Nelson Education Ltd. 6-10 Active Learning Calculate the CPI CPI basket: {10 kg beef, 20 kg chicken} The CPI basket cost $120 in 2008, the base year. A. Compute the CPI in 2009. B. What was the CPI inflation rate from 2009-2010? Copyright © 2014 by Nelson Education Ltd. price of beef price of chicken 2008 $4 $4 2009 $5 $5 2010 $9 $6 6-11 Active Learning Answers CPI basket: {10 kg beef, 20 kg chicken} price of beef price of chicken 2008 $4 $4 2009 $5 $5 2010 $9 $6 The CPI basket cost $120 in 2008, the base year. A. Compute the CPI in 2009: Cost of CPI basket in 2009 = ($5 x 10) + ($5 x 20) = $150 CPI in 2009 = 100 x ($150/$120) = 125 Copyright © 2014 by Nelson Education Ltd. 6-12 Active Learning Answers CPI basket: {10 KG beef, 20 KG chicken} price of beef price of chicken 2008 $4 $4 2009 $5 $5 2010 $9 $6 The CPI basket cost $120 in 2008, the base year. B. What was the inflation rate from 2009-2010? Cost of CPI basket in 2010 = ($9 x 10) + ($6 x 20) = $210 CPI in 2010 = 100 x ($210/$120) = 175 CPI inflation rate = (175 – 125)/125 = 40% Copyright © 2014 by Nelson Education Ltd. 6-13 Problems in Measuring the Cost of Living Commodity substitution bias Introduction of new goods Unmeasured quality change Taken together, these sources of bias cause the CPI to overstate the cost of living by 0.6 percentage points a year according to the Bank of Canada. Copyright © 2014 by Nelson Education Ltd. 6-14 Problems in Measuring the Cost of Living Don't inflate inflation Special to the Financial Post, Financial Post Wednesday, February 16, 2011 http://opinion.financialpost.com/2011/02/16/dont-inflate-inflation/ Copyright © 2014 by Nelson Education Ltd. 6-15 The GDP Deflator versus the Consumer Price Index The GDP deflator reflects the current level of prices relative to the level of prices in the base year. Economists and policy makers monitor both the CPI and the GDP deflator to gauge how quickly prices are rising. Two differences: The GDP deflator reflects prices of goods and services produced domestically. The GDP deflator compares the price of currently produced goods and services with the price of the same goods and services produced during the base year. Copyright © 2014 by Nelson Education Ltd. 6-16 FIGURE 6.2: Two Measures of Inflation Copyright © 2014 by Nelson Education Ltd. 6-17 QuickQuiz Explain briefly what the consumer price index is trying to measure and how it is constructed. Copyright © 2014 by Nelson Education Ltd. 6-18 CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION The purpose of measuring the overall level of prices in the economy is to permit comparison between dollar figures from different points in time. Copyright © 2014 by Nelson Education Ltd. 6-19 Dollar Figures from Different Times Copyright © 2014 by Nelson Education Ltd. 6-20 FYI: BoC Inflation Calculator http://www.bankofcanada.ca/rates/related/inflation-calculator/ A basket of goods and services that cost $100 in 1914 would cost how much in 1973? In 1983? In 1993? In 2003? In 2013? Copyright © 2014 by Nelson Education Ltd. 6-21 Case Study: Mr. Index Goes to Hollywood What is the most popular movie of all time? Gone with the Wind! Copyright © 2014 by Nelson Education Ltd. 6-22 Indexation Indexation: the automatic correction of a dollar amount for the effects of inflation by law or contract COLA: A COLA automatically raises the wage when the CPI raises. Copyright © 2014 by Nelson Education Ltd. 6-23 Real and Nominal Interest Rates Interest rates involve comparing amounts of money at different points in time. Copyright © 2014 by Nelson Education Ltd. alexyndr/Shutterstock To fully understand interest rates, knowing how to correct for the effects of inflation is important. 6-24 Real and Nominal Interest Rates Suppose that you make a deposit of $1000 in a bank account that pays interest at a rate of 10 percent per year. After one year, that bank account now contains $1100 (= Principal of $1000 + Interest of $100). Are you actually wealthier after one year? Copyright © 2014 by Nelson Education Ltd. 6-25 Real and Nominal Interest Rates Nominal interest rate: the interest rate that is usually reported without a correction for the effects of inflation Real interest rate: the interest rate that is corrected for the effects of inflation Copyright © 2014 by Nelson Education Ltd. 6-26 QuickQuiz Henry Ford paid his workers $5 a day in 1914. If the U.S. consumer price index was 10 in 1914 and 195 in 2012, how much is the Ford paycheque worth in 2012? Copyright © 2014 by Nelson Education Ltd. 6-27 Case Study: Interest Rates in the Canadian Economy Figure 6.3: Real and Nominal Interest Rates Copyright © 2014 by Nelson Education Ltd. 6-28 Classroom Activity Create a Student Price Index Take-Home Assignment Pick real transactions prices for goods that you actually purchase. If the indices will be used to calculate the inflation rate, you should save a copy of this assignment in a safe place. You should not use prices from catalogues since such prices won’t be subject to change over the semester. Copyright © 2014 by Nelson Education Ltd. 6-29 Classroom Activity Create a Student Price Index (continued) Your mission: Make up a personalized student price index. 1. Choose five (or more) different products—be specific, for example: unleaded gasoline, Molson Canadian beer 2. Pick a quantity for each product—for example, 15 litres of gasoline, a 12-pack of Molson Canadian beer 3. Find the actual price for each product. 4. Calculate the total cost of buying these products. Copyright © 2014 by Nelson Education Ltd. 6-30 THE END Chapter 6 Copyright © 2014 by Nelson Education Ltd. 6-31