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Lesson

# What Does A Dollar Really Buy?

Updated: July 24 2015,

### Concepts

Students will describe the purpose of a price index, and how it is calculated. Then students will describe the weaknesses of the CPI, and interpret CPI data as a measure of economic health. Finally, students will identify who is harmed and who is helped by inflation.

### Introduction

Key Economic Concepts to know:

• Price index: a number used to measure the price level. The value of the index is set at 100 in the base year or period.
• Consumer Price Index (CPI): the price index most commonly used to measure the impact of changes in prices on households. The index is based on a standard market basket of goods and services purchased by a typical urban family.
• Inflation: the rate of upward movement in the price level for goods and services. By inflation economists mean a sustained rate of increase in the price level over time. Over the long haul, the fundamental cause of inflation is the growth rate of the money supply.

(The following activities may be used together or individually, to supplement a lecture or discussion. Students will use several Internet sites and may work in groups or individually.)

You hear the phrases on the news: "The CPI is up", "inflation is down." Though your first impulse may be to change the channel, the CPI is at least as relevant to most consumers' lives as the latest sports scores.

The CPI, or Consumer Price Index, is used to measure price changes in the economy. It is a measure of the average change in prices paid by urban customers for a "market basket" of goods and services. These goods and services include food, clothing, shelter, newspapers and CDs. Items on which the average consumer spends a great deal of money, such as food, are given more weight, or importance, in computing the index than items such as toothpaste and movie tickets, on which the average consumer spends comparatively less. As with any weighted index, the CPI probably won't match your own budget exactly. The increase in the CPI is what most people think of as the "inflation rate." It is used by retailers in predicting future price increases, by employers in calculating salaries and by the government in determining cost-of-living increases for Social Security.

### Learning Objectives

• Describe the purpose of a price index.
• Explain how a price index is calculated.
• Describe the weaknesses of the CPI.
• Interpret CPI data as a measure of economic health.
• Identify who is harmed and who is helped by inflation.

### Process

Activity 1

Activity 1 may be assigned as preliminary work and used in a class discussion as an introduction to the CPI

As you browse the CPI information, answer these important questions:

1) How is the CPI market basket determined?

[The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought.] See website for more.]

2) What goods and services does the CPI cover?

[The CPI represents all goods and services purchased for consumption by the reference population (CPI-U or CPI-W) Bureau of Labor Statistics (BLS) has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows: Food And Beverages (breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks); Housing (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture); Apparel (men's shirts and sweaters, women's dresses, jewelry); Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance); Medical Care (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services); Recreation (televisions, cable television, pets and pet products, sports equipment, admissions); Education and Communication (college tuition, postage, telephone services, computer software and accessories); Other Goods And Services (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Also included within these major groups are various government-charged user fees, such as water and sewerage charges, auto registration fees, and vehicle tolls. The CPI also includes taxes (such as sales and excise taxes) that are directly associated with the prices of specific goods and services. However, the CPI excludes taxes (such as income and Social Security taxes) not directly associated with the purchase of consumer goods and services.

The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance. (These items relate to savings and not to day-to-day consumption expenses.)

For each of the more than 200 item categories, BLS has chosen samples of several hundred specific items within selected business establishments frequented by consumers, using scientific statistical procedures, to represent the thousands of varieties available in the marketplace. For example, in a given supermarket, the Bureau may choose a plastic bag of golden delicious apples, U.S. extra fancy grade, weighing 4.4 pounds to represent the "Apples" category.]

3) How are CPI prices collected and reviewed?

[Each month, BLS data collectors called economic assistants visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States to obtain price information on thousands of items used to track and measure price change in the CPI. These economic assistants record the prices of about 80,000 items each month. These 80,000 prices represent a scientifically selected sample of the prices paid by consumers for the goods and services purchased.

During each call or visit, the economic assistant collects price data on a specific good or service that was precisely defined during an earlier visit. If the selected item is available,the economic assistant records its price. If the selected item is no longer available, or if there have been changes in the quality or quantity (for example, eggs sold in packages of 8 when previously they had been sold by the dozen) of the good or service since the last time prices had been collected, the economic assistant selects a new item or records the quality change in the current item.

The recorded information is sent to the national office of BLS where commodity specialists, who have detailed knowledge about the particular goods or services priced, review the data. These specialists check the data for accuracy and consistency and make any necessary corrections or adjustments. These can range from an adjustment for a change in the size or quantity of a packaged item to more complex adjustments based upon statistical analysis of the value of an item's features or quality. Thus, the commodity specialists strive to prevent changes in the quality of items from affecting the CPI's measurement of price change.]

4) How do you read or interpret an index?

[An index is a tool that simplifies the measurement of movements in a numerical series. Most of the specific CPI indexes have a 1982-84 reference base. That is, BLS sets the average index level (representing the average price level)–for the 36-month period covering the years 1982, 1983, and 1984–equal to 100. The Bureau measures changes in relation to that figure. An index of 110, for example, means there has been a 10-percent increase in price since the reference period; similarly an index of 90 means a 10-percent decrease. Movements of the index from one date to another can be expressed as changes in index points (simply, the difference between index levels), but it is more useful to express the movements as percent changes. This is because index points are affected by the level of the index in relation to its base period, while percent changes are not.]

5) Do the published averages match an individual's inflation experience?

[Not necessarily. It is important to understand that BLS bases the market baskets and pricing procedures for the CPI-U and CPI-W on the experience of the relevant average household, not on any specific family or individual. It is unlikely that your experience will correspond precisely with either the national indexes or those for specific cities or regions. See website for more.]

6) How is the CPI used?

[The Consumer Price Index affects nearly all Americans because of the many ways it is used. Three major uses are:

As an economic indicator.
As a deflator of other economic series.
As a means of adjusting dollar values.
See the

7) What are some limitations of the index?

[The CPI is subject to both limitations in application and limitations in measurement. See the "Consumer Price Indexes" page, question number 19 for more information.

· Limitations of application

The CPI may not be applicable to all population groups. For example, the CPI-U is designed to measure the experience with price change of the US urban population and, thus, may not accurately reflect the experience of people living in rural areas.

Also, the CPI does not produce official estimates for the rate of inflation experienced by subgroups of the population, such as the elderly or the poor.

The CPI cannot be used to measure differences in price levels or living costs between one place and another; it measures only time-to-time changes in each place. A higher index for one area does not necessarily mean that prices are higher there than in another area with a lower index. It merely means that prices have risen faster since their common reference period.

The CPI cannot be used as a measure of total change in living costs because changes in these costs are affected by (such as social and environmental changes and changes in income taxes) that are beyond the definitional scope of the CPI and so are excluded.

· Limitations in measurement

Limitations in measurement can be grouped into two basic types, sampling errors and non-sampling errors.

Sampling errors. Since the CPI measures price change based on only a sample of items, the published indexes differ somewhat from what the results would be if actual records of all retail purchases by everyone in the index population could be used to compile the index. These estimating or sampling errors are limitations on the precise accuracy of the index, not mistakes in index calculation.

Nonsampling errors. These errors occur from a variety of sources. Unlike sampling errors, they can cause persistent bias in the index measurement. Nonsampling errors are caused by problems of price data collection, logistical lags in conducting surveys, and difficulties in handling the problems of quality change and substitutes.

Nonsampling errors can be far more hazardous to the accuracy of a price index than sampling errors. BLS expends much effort to minimize these errors. Highly trained personnel insure comparability of quality of items from period to period; collection procedures are extensively documented and recurring audits are conducted. The CPI program has an ongoing research and evaluation program, to identify and implement improvements in the CPI.]

8) Will the CPI be revised or updated in the future?

[Yes. The CPI will need revisions as long as there are significant changes in consumer buying habits or shifts in population distribution or demographics. The Bureau, by developing annual Consumer Expenditure Surveys and Point-of-Purchase Surveys, has the flexibility to monitor changing buying habits in a timely and cost-efficient manner. In addition, the censuses conducted every 10 years by the Department of Commerce provide information that enables the Bureau to reselect a new geographic sample that accurately reflects the current population distribution and other demographic factors.

As a matter of policy, BLS is continually researching improved statistical methods. Thus, even between major revisions, further improvements to the CPI are made. For example, until recently, the Bureau would continue to price the brand-name version of a prescription drug even after it lost its patent protection, if the brand-name drug was still sold in the selected outlet. Starting in January 1995, BLS changed this policy. Now, 6 months after a drug loses its patent protection, a unique item to be priced is reselected from all therapeutically equivalent drugs (including the original) sold in the selected retail outlet. This gives generic versions of the drug a chance to be selected as a substitute. BLS waits until 6 months after the patent expires to give the emerging generic drugs time to gain market share, because the chance of selection is proportional to the sales of each version of the drug in the retail outlet. This new procedure provides a better reflection of consumers' experience with prescription drug prices, since many consumers switch to generic versions of drugs, as they become available.

Teacher: this activity introduces students to the calculations behind the CPI. With self-starters, it may be used alone. Otherwise, it may be assigned as an enrichment project after a lecture/discussion of CPI calculation.]

Activity 2

There is more than one way to construct a price index. The easiest to understand is probably the weighted average method. This method compares the total cost of a fixed market basket of goods in different years. Before you begin, print out the market_basket.pdf file to help you construct your price index. Complete the following steps below:

A) To construct any price index, some previous period is selected as the base year. We will use the total cost of the "market basket" in this year to compare with successive years.

B) The following table represents the total cost of a market basket in the base year of 1995. Choose a different base year and calculate the total cost of the market basket using the https://www.minneapolisfed.org/community/financial-and-economic-education/cpi-calculator-information/app . Fill out the blank table in the market_basket.pdf. Then multiply the prices of the items in the basket by the average number of units purchased in that year; then compute the sum.

 Market Basket Food and Beverages Year Price Quantity/Year Price X Quantity = Yearly Cost Loaf of Bread 1995 \$1.28 70 \$126.00 Bag of Apples 1995 \$.50 40 \$20.00 Gallon of Milk 1995 \$2.54 104 \$264.16 Jelly (12 oz) 1995 \$1.52 26 \$39.52 Cheerios (1 box) 1995 \$2.71 60 \$162.60 Carrots (1 pound bag) 1995 \$.59 40 \$23.60 Total Cost of Goods: \$635.88

C) Find the total cost of the market basket in the current year using the same approach.
Note: quantities will remain constant, only prices will change for this year.

D) The cost of the basic market basket in the current year is then expressed as a percentage of the cost
of the basic market basket in the current year, using this formula:

Index number (CPI) = Current year cost

[The multiplication by 100 converts the raw numbers to a percentage basis. The base year always has an index number of 100 since the current year cost and the base year cost of the market basket are the same in the base year.]

E) If we subtract the base year index of 100 from the index number we have calculated, we can
measure the percentage change in prices from the base year. (For example: a current year index number of 110 means a 10% change in price level from the base year)

Now that we have some background information, the real Fun can begin! Let's use what we have learned so far to construct our own CPI, following the steps below.

1) To keep things simple, identify just five items/services you purchase in the 1990's.
2) Locate the current prices of these goods /services.
3) We will use 1990 as our base year. Use the https://www.minneapolisfed.org/community/financial-and-economic-education/cpi-calculator-information/app to find the average price level change over time.
4) Now apply the above formula to calculate the CPI, was the Woodrow CPI calculator correct?
5) What is the rate of inflation for your CPI?

[Answers will vary. You should check to be sure that the method of calculation is correct. The teacher may chose to set the 1990 prices and quantities to simplify the process. Teacher may also have the students create a poster or other visual to accompany their report.

This activity can be used to initiate a discussion of the concepts of interpreting the CPI, general trends in inflation, and who is harmed/helped by inflation.]

Activity 3

What exactly does a dollar buy? The CPI is what most people think of as the "inflation rate." It is used by businesses, individuals and government use it to make important decisions. What does it mean to you? Let's use the CPI to see just how much inflation affects our lives.

To calculate a change in prices, we can use the formula from the example below:

How much would \$1.00 worth of goods (or services) purchased in 1950 have cost in 2000?

 2000 price = 1950 price x (2000CPI / 1950CPI) = \$1 x (171/24.1) = \$7.10

1) What is the base year for the data you see here?

[1982-84]

2) What is the general trend of the numbers?

[Upward or inflationary]

3) Would todays dollar buy more or less than a dollar in 1913?

[You can buy less and less with one dollar.]

4) Do you notice anything different about the CPI from 1930-1933? Why do you think this is?

[Deflation, reflecting the onset of the Great Depression]

Using the CPI information at this website, use the above formula to solve the following problems. Show your calculations!

5) How much would a year 2000 model car that costs \$20,000 have cost in…
a) 1933 [\$3,801.17]
b) 1970 [\$11,279.07]
c) 1990 [\$38,216.37]

6) How much did a newspaper (\$1.50 Year 2000) cost in…
a) 1933 [\$.11]
b) 1960 [\$.26]
c) the year you were born [for example: 1981: \$.80]

7) If you had borrowed a dollar in each of the following years (to be paid back in the year 2000) how much would that \$1 worth of goods cost in year 2000 prices?
a) 1920 [\$8.55]
b) 1933 [\$13.15]
c) the year you were born [for example: 1981: \$1.88]
d) 1990 [\$1.31]

What is the value of the goods the lender will be able to buy when you pay him back? [One dollar]

8) Your income in each of the following years is \$1. What is the value of goods you could purchase with that dollar at year 2000 prices?

a) 1920 [\$.06]
b) 1932 [\$.08]
c) 1960 [\$.17]
d) 1990 [\$.76]

### Conclusion

The teacher can review the lesson by conducting a Q & A. Answers can be found in the lesson above.

What is the purpose of a price index?

How is a price index is calculated?

What are the weaknesses of the CPI as a measure of inflation?

What does a high/low level of inflation mean for the economy?

Who is harmed and who is helped by inflation?

### Extension Activity

As Rover delivers the morning paper, you see the following headline glaring at you.

"Inflation expected to rise…"

Wait! Don't throw it away! After all, this information is as important as the football scores. Have the students take a minute to think about what that means.

Assignment: Have the students write a brief reaction to this headline. Be sure that they include, but do not limit their answer to, answers to the following questions:

How is inflation a measure of economic health?
What does this headline say about the current state of the economy?
How will this affect you or those you know? Who will benefit/who will be harmed?

### Assessment

As Rover delivers the morning paper, you see the following headline glaring at you.

"Inflation expected to rise…"

Wait! Don’t throw it away! After all, this information is as important as the football scores. Take a minute to think about what that means to you.