The Consumer Price Index (CPI)

The Bureau of Labor Statistics collects price data on…– 100,000 items– 85 different locations around the country– 19,000 retail establishments

CPI is constructed from these data weighted by each commodity’s relative importance in the average consumer’s budget

The CPI (continued)

It reflects both– the change in individual product/service

prices due to shifts in supply and/or demand (given the product/service’s weight in the market basket)

– the general rise (decline) in market prices

What Does the CPI Look Like?http://research.stlouisfed.org/fred2/series/CPIAUCNS?cid=9

32.356.1

108.6

156.3

210.2

0

50

100

150

200

250

1966 1976 1986 1996 2007

CPI

Relationship Between CPI & Inflation Inflation = the Percentage Change from one

year to the next =

Example:• CPI1992=140.3• CPI1993=144.5• Annual rate of inflation between 1992 and 1993 =

• = 2.99%

100

old

oldnew

100

old

oldnew 100

old

oldnew

100

3.140

3.1405.144

More Examples... Example:

• CPI1979=72.6• CPI1980=82.4• Annual rate of inflation between 1979 and 1980 =•

• = 13.5% Example:

• Overall rate of inflation between 1979 and 1993 =

• = 99%

100

6.72

6.724.82

100

6.72

6.725.144

So what? Why does the CPI Matter

Helps to answer the age-old question: Are you better off now than you were five years ago?

Helps to understand how price changes may lead to shifts in household resource allocation patterns over time

Critical to understanding how costs/benefits may vary through time.

Proverb #6: Only Today’s Dollars are Comparable

We need to account for the fact that the costs and benefits

associated with various alternatives don’t always occur at

the same point in time.

Some Definitions...

Real interest rate - interest rate that compensates individuals for– opportunity cost of lending– risk of lending

Nominal interest rate - interest rate that compensates individuals for– opportunity cost of lending – the risk of lending– inflation

In other words…

The stated nominal interest rate includes monetary compensation for inflation.– What the bank offers you is the nominal interest

rate, it is the price of the money you either loan or lend from them.

Real interest rate adjusts for inflation.– It allows us to compare prices across time,

adjusted for the effect of inflation– A cost of $5 in real dollars in 1950 buys the same

amount of stuff as $5 in real dollars in 2000

Nominal interest rate = real interest rate + inflation

Nominal interest rate =

Real interest rate =

infinf realreal

inf1

inf

nom

Examples...

If the credit union needs to get a real rate of return on loans of 7% to cover costs and inflation is projected to be 9%, what is the nominal interest rate that should be charged on their consumer loans?

Please note: All percentages must be converted to decimals

=.07 + .09 + (.07)(.09) = .1663 = 16.63%

infinf realreal

Examples...

The rate of inflation is forecast to be 10% and the bank is currently offering 7% interest on its passbook savings accounts. What is the real interest rate earned on these accounts?

Please note: All percentages must be converted to decimals

= -.027 = -2.7%

10.1

10.07.

Sample Test Question

Your bank offers you a five year CD with an annual interest rate of 7%; annual inflation rates are forecast at 3% for the next five years. Based on this information, which of the following statements is true:

A. The nominal interest rate is 4% B. The real interest rate is 7% C. The nominal interest rate is 7% D. The real interest rate is 3% E. Both the real and nominal interest rates are

7%