22. The CPI and the Cost of Living. CHAPTER. C H A P T E R C H E C K L I S T. When you have completed your study of this chapter, you will be able to. 1 Explain what the Consumer Price Index (CPI) is and how it is calculated.
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The CPI and the Cost of Living
When you have completed your study of this chapter, you will be able to
3 Adjust money values for inflation and calculate real wage rates and real interest rates.
Figure 22.1 shows the CPI basket.
This shopping cart is filled with the items that an average household buys.
Table 22.1 on the next slide shows a simplified CPI calculation in which we assume a base period of 2005.
Figure 22.2 shows the CPI in part (a) and the inflation rate in part (b).
In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.
In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.
Suppose that the UAW and GM sign a 3 year wage deal: In the first year, the wage will be $30 an hour and will rise by the inflation rate in the next two years.
If the inflation rate is 5 percent a year, the wage rises to $31.50 an hour in the second year and $33.08 an hour in the third year.
But if the actual inflation rate is 2 percent a year, the intended wages in the second and third years are $30.90 an hour and $31.83 an hour.
The workers’ gain is GM’s loss. With thousands of workers, GM’s loss would be millions of dollars over the 3 years.
Two key differences between the GDP deflator and the CPI result in different estimates of the price level and inflation rate.
Figure 22.3 shows the three measures of inflation in part (a) and the corresponding measures of the price level in part (b).
The three measures of the inflation rate fluctuate together, but the CPI measure rises more rapidly than the GDP deflator measure or the PCE deflator measure.
In part (b), the CPI measure of the price level is the highest and the PCE deflator lies between the CPI and the GDP deflator.
The CPI measure overstates the inflation rate.
Price of stamp in 1907 dollars
CPI in 1907
= 41 cents
= 2 cents x
1022.3 NOMINAL AND REAL VALUES
Price of stamp in 2007 dollars =
Figure 22.4 shows nominal and real wage rates: 1982–2006.
The nominal wage rate has increased every year since 1982.
The real wage rate decreased slightly from 1982 through the mid-1990s, after which increased slightly.
Figure 22.5 shows real and nominal interest rates: 1967–2007.
During the 1970s, the real interest rate became negative.
The nominal interest rate increased during the high-inflation 1980s.