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1

Inflation

Inflation (CPI) refers to a situation in which the economy’s overall price level is rising.

2

inflation rate

The inflation rate is the percentage change in the price level from the previous period.

3

consumer price index (CPI)

The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.

The Australian Bureau of Statistics reports the CPI each month.

4

What is the CPI used for

The CPI is used to monitor changes in the cost of living over time.

When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

5

5 steps of CPI Calculation

Fix the basket

Find the prices

Calculate the basket's cost

Choose a base year and compute the index

Compute inflation rate

6

Fix the basket

Determine which prices are most important to the typical consumer.
The Australian Bureau of Statistics (ABS) identifies a market basket of goods and services the typical consumer buys.
The ABS conducts regular consumer surveys to determine what they buy and how much they pay.

7

Find the prices

Find the prices of each of the goods and services in the basket for each point in time.

8

Calculate the basket's cost

Use the data on prices to calculate the cost of the basket of goods and services at different times.

9

Choose a base year and compute the index

Designate one year as the base year, making it the benchmark against which other years are compared.
Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

10

Compute inflation rate

The inflation rate is calculated as follows

Inflation rate year 2 = (CPI Year 2 - CPI year 1)/(CPI Year 1) * 100

11

Calculating the CPI and the inflation rate: An example

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12

Calculating the CPI: another example

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13

Problems in measuring the cost of living

The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.

problems include
substitution bias
introduction of new goods
unmeasured quality changes

14

Substitution bias

The basket does not change to reflect consumer reaction to changes in relative prices.
Fixed line vs mobile phones
Consumers substitute toward goods that have become relatively less expensive.
The index overstates the increase in cost of living by not considering consumer substitution.

15

Introduction of new goofs

The basket does not reflect the change in purchasing power brought on by the introduction of new products.
New products result in greater variety, which in turn makes each dollar more valuable.
Consumers need fewer dollars to maintain any given standard of living.

16

Unmeasured quality changes

A new DVD player
If the quality of a good rises (falls) from one year to the next, the value of a dollar rises (falls), even if the price of the good stays the same.

17

What do the CPI measuring problems cause

The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living.
The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices.

18

The GDP deflator versus the CPI intro

Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising.

There are two important differences between the indexes that can cause them to diverge.

19

The GDP deflator versus the CPI point 1

First, the GDP deflator reflects the prices of all goods and services produced domestically, whereas ...

… the consumer price index reflects the prices of all goods and services bought by consumers.

20

The GDP deflator versus the CPI point 2

Second, the consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year...

… whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

21

Correcting economic variables for the effects of Inflation

Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times.

When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation (eg, your salary)

22

Correcting economic variables

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23

Real and nominal interest rates

Interest represents a payment in the future for a transfer of money in the past.
The nominal interest rate is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays.
The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

24

Real and nominal interest rate example

For example, you borrow $1000 for one year.
Nominal interest rate was 15 per cent.
During the year inflation was 10 per cent.

Real interest rate = Nominal interest rate – Inflation

5 per cent real interest rate = 15 per cent nominal interest rate − 10 per cent inflation rate.

25

Formulas

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