The Consumer and Producer Price Indexes (MACROECONOMICS)

 The consumer price index (CPI) measures the cost of buying a fixed basket of goods and services representative of the purchases of urban consumers.The CPI differs in three main ways from the GDP deflator. First, the deflator measures the prices of a much wider group of goods than the CPI does. Second, the CPI measures the cost of a given basket of goods, which is the same from year to year. The basket of goods in-cluded in the GDP deflator, however, differs from year to year, depending on what is produced in the economy in each year. When corn crops are large, corn receives a rela-tively large weight in the computation of the GDP deflator. By contrast, the CPI mea-sures the cost of a fixed basket of goods that does not vary over time. Third, the CPI directly includes prices of imports, whereas the deflator includes only prices of goods  produced  in the United States.

  The discussion of inflation mismeasurement is an example of how scientific work in economics has an immediate policy impact. To reduce the kind of criticism about political decision making hinted at above, in 1996 the Senate appointed a panel of blue-ribbon economists to review measurements of the CPI. † The panel reported that current CPI mea-surements overstate inflation by about 1.1 percent a year. As a dramatic example of how CPI measurement affects spending, the panel estimated that a 1 percent overesti-mate of cost-of-living increases would, between 1996 and 2008, increase the national debt by $1 trillion through overindexing of tax and benefit programs. A 1 percent mismeasurement of the price level would matter less if the errors didn’t build up year after year. Cumulative mismeasurement at the 1 percent annual level makes a very large difference. Leonard Nakamura gives a good example in terms of real wages.  ‡   According to official statistics, between 1970 and 1995 the average real (measured in 1982 dollars) wage in the economy declined from about $8 an hour to just under $7.50. Correcting for a 1 percent annual bias in inflation would change this pic-ture from a drop to an increase, from $8 to about $9.50 an hour. 

  The GDP deflator and the CPI differ in behavior from time to time. For example, at times when the price of imported oil rises rapidly, the CPI is likely to rise faster than the deflator. However, over long periods the two produce quite similar measures of inflation. The personal consumption expenditure (PCE) deflator    measures inflation in consumer purchases based on the consumption sector of the national income accounts. Because it is a chain-weighted index, the Federal Reserve often focuses on this indicator rather than the CPI. The producer price index (PPI) is the fourth price index that is widely used. Like the CPI, the PPI is a measure of the cost of a given basket of goods. However, it differs from the CPI in its coverage; the PPI includes, for example, raw materials and semifin-ished goods. It differs, too, in that it is designed to measure prices at an early stage of the distribution system. Whereas the CPI measures prices where urban households actu-ally do their spending that is, at the retail level the PPI is constructed from prices at the level of the first significant commercial transaction. 

This makes the PPI a relatively flexible price index and one that frequently signals changes in the general price level, or the CPI, some time before they actually material-ize. For this reason, the PPI and, more particularly, some of its subindexes, such as the index of “sensitive materials,” serve as one of the business cycle indicators that are closely watched by policymakers. To return to the question posed at the beginning of the chapter, a dollar today buys measured by the CPI a bit more than what a dime would have bought in 1947.

    Core Inflation  

Policymakers are interested in measuring ongoing inflationary trends. The prices of some goods are very volatile, suggesting that price changes are often temporary. For this reason policymakers focus on core inflation, which excludes changes to food and energy prices. Core inflation measures are reported for both the CPI and the PCE deflator.

INTEREST RATES AND REAL INTEREST RATES   

The interest rate states the rate of payment on a loan or other investment, over and above principal repayment, in terms of an annual percentage. If you have $1,000 in the bank and the bank pays you $50 in interest at the end of each year, then the annual in-terest rate is 5 percent. One of the simplifications we make in studying macroeconom-ics is to speak of “the” interest rate, when there are, of course, many interest rates. These rates differ according to the creditworthiness of the borrower, the length of the loan, and many other aspects of agreement between borrower and lender. Short-term U.S. Treasury bills are among the most heavily traded assets in the world.

EXCHANGE RATES   

In the United States, things monetary are measured in U.S. dollars. Canada uses Cana-dian dollars. Much of Europe uses the euro. The exchange rate is the price of foreign currency. For example, the exchange rate with the Japanese yen (April 2010) is a little bit more than one U.S. cent. The British pound is worth about US$1.53. Some countries allow their exchange rates to float, meaning the price is determined by supply and demand. Both Japan and Britain follow this policy, so their exchange rates fluctuate over time. Other countries fix the value of their exchange rate by offering to exchange their currency for dollars at a fixed rate. For example, the Bermuda dollar is always worth exactly one U.S. dollar and the Hong Kong dollar is set at US$0.13. In practice, many countries intervene to control their exchange rates at some times but not at others, so their exchange rates are neither purely fixed nor purely floating. Whether a particular currency is worth more or less than a dollar has nothing to do with whether goods are more expensive in that country, as every tourist quickly learns. The Bermuda dollar is worth exactly one U.S. dollar, but even Bermuda onions are more expensive in Bermuda than in the United States. In contrast, there are about 12 Mexican pesos to the dollar, but for many goods you can buy more for 12 pesos in Mexico than you can for one dollar in the United States.

SUMMARY  

1. GDP is the value of all final goods and services produced in the country within a given period.

2. On the production side, output is paid out as factor payments to labor and capital. On the demand side, output is consumed or invested by the private sector, used by the government, or exported.

 3. Y = C + I + G + NX .

4. C + G + I + NX = Y = YD + ( TA - TR ) =  C + S + ( TA - TR ).

5. The excess of the private sector’s saving over investment is equal to the sum of the budget deficit and net exports.

6. Nominal GDP measures the value of output in a given period in the prices of that period, that is, in current dollars.

7. Inflation is the rate of change in prices, and the price level is the cumulation of past inflations.

8. Nominal interest rates give the return on loans in current dollars. Real interest rates give the return in dollars of constant value.

 9. The unemployment rate measures the fraction of the labor force that is out of work and looking for a job.

10. The exchange rate is the price of one country’s currency in terms of another’s. 

Written by: Adetoro Abdulhakeem