APMacro: Measuring Inflation


Consumer Price Index
Inflation is a rise in the general level of prices. When inflation occurs, each dollar of income will buy fewer goods and services than before. Inflation reduces the purchasing power of money. But inflation does not mean that all prices are rising. Even during periods of rapid inflation, some prices may be relatively constant while others are falling.

The main measure of inflation is the Consumer Price Index (CPI), compiled by the Bureau of Labor Statistics (BLS). The government uses this index to report inflation rates each month and each year. It also uses the CPI to adjust Social Security benefits and income tax brackets for inflation. The CPI reports the price of a market basket of some 300 goods and services that are purchased by a typical urban consumer. The BLS updates the composition of the market basket every 2 years so that it reflects the most recent patterns of consumer purchases and captures the inflation that consumers are currently experiencing. The CPI for any particular year is found as follows:

CPI = (market basket in particular year / market basket in base year) x 100

The rate of inflation for a certain year is found by comparing, in percentage terms, that year’s index with the index in the previous year.

Rate of Inflation = [(index of particular year – index of previous year) / index of previous year] x 100

There is a difference between nominal income and real income. Nominal income is the number of dollars received as wages, rent, interest, or profits. Real income is a measure of the amount of goods and services nominal income can buy. It is the purchasing power of nominal income or income adjusted for inflation.

Real  Income = nominal income / price index (in hundredths)

Real interest rate is the percentage increase in purchasing power that the borrower pays the lender. Nominal interest rate is the percentage increase in money that the borrower pays the lender.

Nominal Interest Rate = real interest rate + inflation rate
Real Interest Rate = nominal interest rate – inflation rate


Homework:
1) Read Chapter 7.3 pp.134-137 & 7.4 pp.137-141

Arrows-02-june

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