Week 5 econ - chapter 7

• Consumer Price Index (CPI)

  A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services

  
• Reference base period


  A period for which the CPI is defined to equal 100
• The reference base period is currently 2011/12
• Interpreting CPI numbers


  • The CPI is defined to equal 100 for the reference base period
  • If the CPI is 113.5, the average of the prices paid for the fixed market basket was 13.5% higher than in the reference base period

  
• The CPI increased by 0.5 percentage points in the third quarter of 2018
• Constructing the CPI


  • Selecting the CPI basket to match the budget of an average urban household
  • The CPI basket is not updated each quarter, it is based on the 2016/17 Household Expenditure Survey
• Items in the CPI basket

  • The items that an average household buys
• Quarterly price survey


  1. ABS employees check the prices of the goods and services in the CPI basket in all the major cities

  2. Prices recorded refer to exactly the same items

  
• Calculating the CPI


  1. Find the cost of the CPI basket at base period prices

  2. Find the cost of the CPI basket at current period prices

  3. Calculate the CPI for the base period and the current period

  
• Inflation rate


  The percentage change in the price level from one year to the next
• Deflation is a situation in which the inflation rate is negative
• Inflation and price level over time

  • Rapid price rises in 1970s and 1980s
  • Slow price rises in 1990s and 2000s
  • Price level fell in 1997
• Cost of living index

  A measure of changes in the amount of money that people would need to spend to achieve a given standard of living
• The CPI does not measure the cost of living because it does not measure all the components and some components are not measured exactly

  
• Sources of bias in the CPI

  • New goods bias
  • Quality change bias
  • Commodity substitution bias
  • Outlet substitution bias
• New goods bias


  New goods do a better job than the old goods they replace, but cost more, putting an upward bias in the CPI
• Quality change bias


  Better products cost more than the versions they replace, but this is measured as inflation rather than quality improvement
• Commodity substitution bias


  The CPI basket doesn't change to allow for the effects of substitution between goods when relative prices change
• Outlet substitution bias


  The CPI basket doesn't change to allow for the effects of people using more discount stores when prices rise
• The Reserve Bank estimates the substitution bias in the CPI is about 0.5 percentage points
• The Boskin Commission estimated the U.S. CPI bias to be 1.1 percentage points per year
• If the measured inflation is 3.1% a year, the actual inflation rate is likely 2.0% a year
• Distortion of private contracts

  If the CPI is biased, wage contracts linked to the CPI may deliver an outcome different from that intended
• Increases in government outlays and decreases in taxes

  The CPI bias adds billions to government outlays on benefits and decreases taxes paid due to income tax bracket adjustments
• Alternative measures of the price level and inflation rate

  • GDP deflator
  • Chain price index for household final consumption expenditure (HFCE)
  • Trimmed-mean CPI

  
• GDP deflator


  • An average of current prices of all goods and services in GDP expressed as a percentage of base-year prices
  • The percentage change in the GDP deflator is a measure of the inflation rate
• Because tax rates on large incomes are higher than those on small incomes


  As incomes rise the burden of taxes would rise relentlessly if these adjustments were not made
• To the extent that the CPI is biased upward

  The tax adjustments overcompensate for rising prices and decrease the amount paid in taxes
• GDP deflator


  An average of current prices of all the goods and services included in GDP expressed as a percentage of base-year prices

  
• GDP deflator formula


  Nominal GDP ÷ Real GDP × 100
• GDP deflator


  A measure of the price level

  
• Percentage change in GDP deflator


  A measure of the inflation rate
• The GDP deflator includes new goods and quality improvements and even allows for substitution effects of both commodities and retail outlets
• The GDP deflator is not subject to the biases of the CPI
• Chain price index (HFCE)

  An average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices

  
• The chained price index, like the GDP deflator, uses current information on quantities and prices and to some degree overcomes the sources of bias in the CPI

  
• The chained price index is a possible measure of the cost of living
• Trimmed-mean CPI


  The CPI excluding the 15 per cent of items whose prices rose fastest and the 15 per cent whose prices rose slowest
• Core inflation rate


  The percentage change in the trimmed-mean CPI
• The core price index (trimmed-mean CPI) increases more quickly than the GDP deflator or chained price index