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## Price Indices and inflation

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# Example question calculating CPI and inflation

AP Macro: MEA‑1 (EU), MEA‑1.F (LO), MEA‑1.F.1 (EK), MEA‑1.F.2 (EK), MEA‑1.F.3 (EK), MEA‑1.F.4 (EK), MEA‑1.G (LO), MEA‑1.G.1 (EK)

## Video transcript

- [Instructor] The CPI,
or Consumer Price Index, is used to measure the cost
of a typical basket of goods. The typical household in
the nation of Jacksonia buys four loaves of bread, three pounds of cream cheese, and eight books each week. The prices of these goods in years 2015, 2016, and 2017 are given in the table below. And then they ask us some questions. Calculate the CPI in 2017,
using 2016 as the base year. Calculate the CPI in 2015,
using 2016 as the base year. Calculate the rate of inflation
between 2015 and 2016. Calculate the rate of inflation
between 2016 and 2017. And then describe a reason
why the inflation rate between 2016 and 2017
might overstate the changes in cost of living. So pause this video, and see if you can work through
it before I do it with you. All right, now let's
just do it step by step. So these first two letters,
they want us to calculate the CPIs in 2017 and 2015, using 2016 as a base year. So the way I'm going to do it, I'm going to set up a new
column here, which is cost of the weekly basket, and they tell us how
much they buy each week, cost of weekly, weekly basket. Let's see, in 2015, they buy four loaves of bread at $1 each. So it's going to be four times one, plus they buy three pounds of
cream cheese at $3 a pound, plus three times three, plus they buy eight books a week, these people like to read, and so, and each book in 2015 is
$10, so eight times 10, eight times 10. And this is going to be equal
to four times one is four, plus nine is 13, plus 80 is going to be $93. Now, that same basket,
that weekly basket in 2016, where we're buying four
loves of bread at $2 now, four times two, plus we're buying three pounds of cream cheese at $6 a pound now, plus three times six, plus eight books per week at $20 per book, eight times 20. This is going to be equal to
eight plus 18, which is 26, plus 160 is 186. So this is going to be $186. And now we're going to do
the same thing in 2017. Each week, you're going to
get four loaves of bread. Now it's $3 per loaf, plus we're buying three pounds
of cream cheese per week, three, it's still at $6 per pound, plus eight books per week at $25 per book. And so this is going to be equal
to 12 plus 18, which is 30, plus 200, which is going to be $230. And now we can calculate the CPIs. So the CPI, it's typical that it's going
to be 100 in your base year, should be 100, so I could
just put that there. And for the other years, you
could say the basket cost, cost in year, divided by the cost in base year, cost in base year, year, times 100. So obviously, in 2016, that's
going to be the cost in 2016 divided by the cost in 2016 times 100. You'll get 100. But for 2015, it will be the
cost of the basket in 2015, which is $93, divided by the cost in
2016, which is $186, times 100. This one is actually
pretty straightforward. 93 is half of 186, so this
is going to be equal to 50. And then in 2017, it's going to be the cost
of the basket in 2017 divided by the cost of the basket in 2016, times 100, which is going to be equal to, I'm going to use the
calculator for this one. 230 divided by 186 is equal to approximately 1.24. If we multiply that times 100,
we'll say it's approximately, it is approximately 124. So calculate the CPI in 2017,
using 2016 as the base year. It would be 124. Calculate the CPI in 2015,
using 2016 as the base year. That is 50. Calculate the rate of inflation
between 2015 and 2016. So how much do prices grow if we take this basket of
goods from 2015 to 2016? Well, you could look at your CPI. It went from 50 to 100, so prices doubled. And so if something is
double, it grew by 100%. And the rate of inflation
is the growth in prices. And so this is 100% inflation. Things doubled in price,
and you could see it here. Everything doubled in
price right over here. Calculate the rate of inflation
between 2016 and 2017. Well, if you start at
100 and you grow to 124, you have just grown by 24%. One way to think about it
is you multiply by 1.24, which is the same thing as growing by 24%. So that 24% growth is
the rate of inflation. Describe a reason why the inflation rate between 2016 and 2017, so that's what we answered
right here in part d, might overstate changes
in the cost of living. And if you haven't answered
that part yet, I encourage you, given all that we've done,
try to pause the video, and try to think about that. So let's look at what
happened from 2016 to 2017. The price of a loaf of
bread increases by 50%. The price of a book increases
by $5 on a base of 20. That's an increase of 25%. But the price of cream cheese
does not change, plus 0%. It experiences no inflation
from 2016 to 2017. And so you could imagine a
scenario where if some goods, their prices increased a
lot while others don't, the basket of goods might change. People might buy less
bread and fewer books and more cream cheese. And so we could say the typical basket might get more weighted to goods that had less inflation, had less inflation, example, in this case,
would be cream cheese, cream cheese because they look relatively, relatively cheaper to the goods that had more inflation. And if that happened, you would
have a lower actual growth, actual growth in cost of living. And this last question
really alludes to the fact that the CPI isn't necessarily
a perfect indicator, that as different goods in the basket have a price inflation at different rates, you could have a substitution effect between the various goods. Now, in countries, they try to
rebalance the basket of goods based on a perception of what is typical. But once again, that is not
necessarily going to be perfect.

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