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Prices, Inflation and Interest Rates

Measuring the Cost of Living


Consumer Price Index (CPI)
calculates the cost of living for a typical consumer by;
Fix the basket of goods.
Find the prices of these goods.
Compute the Cost of the basket of goods.
Choose a base year and compute the index.
Compute the inflation rate from the index.
Many other indexes can be calculated using this methodology, i.e. Producer Price
Index (PPI)

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Problems with CPI
CPI measures how much a persons income must change to maintain a
constant standard of living as measured by a standard (fixed) basket of
goods and services.
Problem 1: Substitution Bias
higher prices mean buy less of those goods.
Problem 2: Introduction of New Goods
greater variety not reflected in fixed basket.
Problem 3: Unmeasured Quality Change
quality improves with price unchanged.

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Inflation and Interest Rates
Two Interest Rates
Nominal Interest Rate, i: return in current dollars.
Real Interest Rate, r: increase in purchasing power.
Relationship:
Expected Real Interest Rate
= Nominal Interest Rate Expected Inflation Rate

rE = i - p E
Where expected inflation rate is the average expected inflation rate through the maturity date
of the loan.

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Inflation and Interest Rates
Fisher Effect
In the long run, real interest rate determined by equilibrium in loanable funds,
savings = investment.
Re-arranging above
Nominal Interest Rate
= Real Interest Rate + Inflation Rate
i=r+p
A 1% rise in inflation rate results in 1% rise in the nominal interest rate as real
interest rate fixed when the Fisher Effect holds.

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Two Real Interest Rates
Inflation rate over the loan term is unknown when borrower and lender set
nominal interest rate. (ex ante)
Ex Ante Real Interest Rate
Is the real interest rate expected at the start of a loan given expected inflation rate,
pe.
ex ante r = i - pe

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Two Real Interest Rates
Inflation rate over the loan term is known at the end of the loan period (ex
post)
Ex Post Real Interest Rate
Is the real interest rate received from the loan given the inflation rate that actually
occurs, p.
ex post r = i - p
In periods where actual and expected inflation differ, ex ante and ex post real
interest rates will differ also.

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