Module 4 Lecture – The CPI and the Cost of Living
In the previous three modules, we’ve looked at two specific indicators of an economy’s economic health: unemployment levels and real GDP. In this module, we’ll add two more elements used to help measure the health of the US economy: The Consumer Price Index (CPI), and inflation. Either directly or indirectly, the combination of the above four indicators may give us an indication of the direction and amount that interest rates will rise or fall in the future. This is important to gauge economic health because as interest rates rise, the price of borrowing money increases, stifling investment and slowing economic growth. These combined measurements may also give us a fairly good idea as to whether an entire economy is expanding or contracting. In other words, interest rates and economic fluctuations (ch. 14) are intertwined to some degree with unemployment, inflation, GDP, and CPI. If anything, the combination of the above, especially REAL GDP and CPI measurements may actually reflect not only the economic health of an economy but also its physical health as the following chart illustrates*:
Correcting Price and Income Levels For Inflation or How Much Was Your Father’s Income Worth in Today’s Dollars?
I remember in 1960 that my father received a raise in pay. His new salary was $10,000 a year. That was quite a bit of money then. We hear that phrase quite a bit. Well, let’s see how much money it really was by today’s dollars. We can do that by using a formula:
AMOUNT IN TODAY’S DOLLARS = (AMOUNT IN YEAR T DOLLARS X PRICE LEVEL TODAY) ÷ PRICE LEVEL IN YEAR T.
We may use CPI to calculate the effects of inflation. So, let’s see how much my father’s salary was in today’s dollars:
We’ll modify the formula a little: salary in 2009 dollars = salary in 1960 dollars x CPI 2009 ÷ CPI 1960 (CPI in 1960 was about 29.6). $10,000 X 215.3 ÷ 29.6 which is about $73,000 (rounded). Not bad!
This ability to use price indexes such as CPI to correct the effects of inflation becomes important when negotiating long- term contracts with labor unions and using indexes to automatically adjust the laborers’ wages to reflect the cost of living increases. Social Security payments are also indexed to keep retirees payments abreast of the rising cost of living. These adjustments are commonly referred to as cost-of-living allowances or COLA. If you are using dated industry data to get an idea of what your sales, cost of purchases, administrative and operating expenses should be, using the above formula will convert your industry’s past performances into today’s dollars.
So What Does This Have To Do With Interest Rates?
Inflation and interest rates are inextricably entwined. As CPI increases, we see a corresponding increase in the inflation rate (by definition in Module 2, inflation means the purchasing power of your dollar goes down because of an overall increase in prices).
Let’s suppose you invest $5,000 by purchasing a certificate of deposit (also called a CD) earning 10% interest per year.
Also, assume that at that time you could purchase your favorite DVDs for an average of $10 each. Let’s now look at the different possible scenarios:
- No or Zero inflation: At the end of one year, your $5,000 investment has grown by $500 (10% X $5,000). Since inflation is zero, you may still purchase your favorite DVDs for $10 each. Your purchasing power has actually increased by 10% (you could buy 500 DVDs for $5,000, now you could buy 550 DVDs for $5,500).
- Assume inflation rate of 8%. DVDs are now selling for $10.80 (10$ X 8% = $.80 + $10 = $10.80). Your dollars have grown from $5,000 to $5,500 which means you may now purchase a total of 509 DVDs ($5,500 ÷ $10.80). You may not be able to purchase as many DVDs when there was zero inflation, but you’re still ahead of the game by being able to purchase nine more DVDs than when you had the original $5,000.
- Assume now that the inflation rate is 14%. The price of DVDs has now risen to $11.40, and the $5,500 you have at the end of the year will only purchase a total of 482 DVDs. Your purchasing power has decreased by about 4% ((11.40 – 10) ÷ 10) or the inflation rate of 14% minus the interest rate of 10%).
The above example brings us to two important definitions:
Nominal Interest Rate: this is usually a stated rate of interest and represents the change in the dollar amount of your investment. In the above example the nominal rate is 10% (($5,500 – $5,000) ÷ $5,000).
Real Interest Rate: this measurement calculates the speed with which your purchasing power grows over a period of time. The Real interest rate is just the Nominal Rate – Inflation Rate. In the above example, at an inflation rate of 8%, the Real rate of interest is 2% (10% nominal rate – 8% inflation rate).
Do Interest and Inflation Rates Move in the Same Direction?
Nominal interest rates (the rate of interest quoted by lenders) will move upward as inflation moves upward and downward as inflation decreases. The simple reason is that lending institutions want to keep ahead of inflation. If they see inflation moving from 5% to 6% in the next year, they’ll raise their interest rates to compensate for the loss in the purchasing power of the dollar they lend to businesses and consumers.
Real interest rates will always be lower than nominal rates (assuming there is some rate of inflation). As Nominal rates move upward to combat inflation, we may find real rates actually decreasing and even moving into the negative area. The 1970’s illustrated this much to the displeasure of consumers and borrowers. The Nominal interest rate in the 1970’s was extremely high (reaching 15% in the late 70’s) which reflected a high inflation rate, while the Real interest rates were low and even negative between 1974 and 1980 because the inflation rate ate away at people’s savings faster than the Nominal interest rate could increase them.
Assume for example that your savings are earning interest at 5% and the inflation rate is 3%. Your Real interest rate is really 2% (5%-3%). The chart 16A below from pg. 439 gives you a good idea of the differences between Real and Nominal interest rates from 1973-2013:
Chart 16A
Now let’s compare the above figure to a chart of CPI for the same time period (Figure 16.2 reproduced from pg. 426):
Chart 16B
In Chart 16b above, notice how the Nominal rate of interest in the late 1970’s (Chart 16A) corresponds with the spike in both CPI (1a) and inflation (1b) in the 1970’s. By contrast, notice that the CPI between 2003-2013 (3a) was still rising but at a much slower pace and the rate of inflation paralleled this slowing by actually becoming negative (3b). You might also note the corresponding dip into the negative area in Chart 16A of Nominal interest while the Real interest rate actually climbed above Nominal interest. This illustrates a time period when prices, consumption, inflation, and nominal interest rates were all falling, signaling an economic recession.
What does the CPI tell us about wages?
Just as there are a Nominal interest rate and a Real interest rate (nominal rate less the inflation rate), there is also a Nominal wage rate and a Real wage rate. Remember the example I opened the lecture with (my father’s raise to $10,000 a year in 1960)? In order to accurately measure how much your wages will purchase at a given time, we need to calculate the Real wage rate. Just take the nominal wage rate divided by the CPI index number of a base year and multiply by 100.
Assume your nominal wage rate is $40 per hour in 2013. Using the CPI index number for 2013 we can calculate the Real wage rate. In other words the actual purchasing power of your wages: ($40÷232.1) x 100 = $17.23 Real wage per hour. The difference between the $40 per hour nominal wage and the $17.23 per hour Real wage rate is inflation, the steady increase in prices over time. This Real wage is the number of goods or services that can be purchased (not $40 worth but $17.23 worth of goods or services).
Labor can make a fairly decent case against corporate pay scales not really increasing over time as illustrated in the figure below:
As you can see from the above chart, the average annual Nominal wage rate per hour has increased fairly steadily over the last 35 years; however, the Real wage per hour has remained fairly stagnant.
So Why Should We Care?
From business, employment, and investment standpoints understanding and utilizing the above concepts is extremely important:
- Owning a business requires using assets to their fullest economic potential. A business will only borrow money that it can afford (the market interest rate). If the rates are extremely high, businesses will not borrow and will not expand (hiring more labor, increasing rental space, purchasing newer technology etc.)
- As an employee, you sign an employment agreement which outlines your pay rate. You can use the CPI to calculate how much your real wage will be and use this to compare to other potential job prospects and their pay schedules
- When investing your money in stocks, bonds, retirement accounts, pension funds etc., you need to calculate your Real interest rate, not the nominal rate. This can also be used when comparing investment options.
FORMULA REVIEW
Below I’ve included a review of the formulas from the text which will help you in both the homework and test.
Calculating CPI
Market basket of goods in present period ÷ market basket in base period x 100.
Example:
Year 2010 market basket = $50
Year 2014 market basket = $70
CPI = $70 ÷ $50 x 100 = 140
Measuring Inflation: (CPI present – CPI previous year) ÷ CPI previous year
Example: CPI in 2014 = 140.
- CPI in 2013 = 120
Inflation = (140 – 120) ÷ 120 which = 16.7%
Measuring the % change in the inflation rate:(Inflation rate present – inflation rate past) ÷ inflation rate past
Example:
Inflation rate 2013 = 2%
Inflation rate 2014 = 3%
Inflation rate increase = (3% – 2%) ÷ 2% or 50% increase (much greater than just taking the difference of the two).
Real Wage Rate: (Nominal wage rate in the present year ÷ CPI in the present year) x 100.
Example:
Nominal wage rate present year 2014 = $30 per hour
CPI in the present year 2014 = 245.2
Real Wage Rate = (30 ÷ 245.2) x 100 or $12.23 per hour
A basic formula you might want to remember when finding % increase or decrease (no matter what you’re comparing) is:
(New – Old) ÷ Old
Example:
Prices increased from $10 to $12; what is the % increase?
($12 – $10) ÷ $10 or a 20% increase