Question

(Related to Solved Problem 20.5 on page 683) In an article in the Wall Street Journal, a professor of financial planning noted the effect of rising prices on purchasing power: "Today, \(\$ 2,000\) a month seems reasonable [as an income for a retired person in addition to the person's Social Security payments], but 40 years from now that's going to be three cups of coffee and a donut." Suppose that in 2016 three cups of coffee and a donut can be purchased for \(\$ 10\). The CPI in 2016 was 240 . What would the CPI have to be in 2056 for \(\$ 2,000\) to be able to purchase only three cups of coffee and a donut? Assume that the prices of coffee and donuts increase at the same rate as the CPI during these 40 years.

Short answer

The CPI in 2056 would need to be 48,000 to equate the purchasing power of $2000 to the cost of three cups of coffee and a donut.

Step-by-step solution

Understand the Concept and Provided Information

CPI, or Consumer Price Index, is a measure that examines the weightage price of a basket of consumer goods and services, and it's used as an indicator of inflation. Here, the cost of three cups of coffee and a donut is going to be the indicator. In 2016, this is $10 and the CPI is 240.

Determine the Value of Money in 2056

In 2056, if $2000 can only buy three cups of coffee and a donut, it means the value of $2000 in 2016 will be equivalent to $10 in 2056. This is due to inflation, as the value of money decreases over time with rising prices.

Calculate the CPI in 2056

Since prices and the CPI increase at the same rate, it can be said that the ratio of the CPI in 2056 to the CPI in 2016 is the same as the ratio of the value of $2000 in 2016 to its value in 2056. In mathematical terms, \((CPI_{2056} / 240) = (2000 / 10)\). Solving this equation gives the CPI required in 2056.

Key concepts

Inflation

Inflation is a crucial economic concept that refers to the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

Consider this simple illustration: if a bottle of milk costs \(2 this year and inflation is 5% per year, the same bottle will cost \)2.10 the next year. Over time, as the cost of goods and services increases, each dollar you own buys a smaller percentage of a product or service. This phenomenon can affect all aspects of the economy, from consumers buying groceries to investors and retirees who rely on fixed incomes.

Purchasing Power

Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Inflation directly affects the purchasing power because as prices increase, the amount of goods or services you would be able to purchase with the same amount of money decreases.

For example, if you had \(1000 today and the rate of inflation was 3% per year, your money would only be worth about \)970 in terms of buying power after one year. The concept of purchasing power is vital for individuals, especially those with fixed incomes like retirees, as it determines their standard of living.

Price Level

Price level is an average of the current prices of goods and services within an economy and is often synthesized into price indices, such as the Consumer Price Index (CPI). As price levels rise, the purchasing power of a unit of currency falls, and vice versa.

Economists monitor the price level to gauge inflation and deflation. The price level doesn't reflect the prices of individual goods and services, but rather the overall pricing trends in the economy, which is essential for long-term planning both by individuals and businesses alike.

Economic Indicators

Economic indicators are statistics about economic activity that allow analysis of economic performance and predictions of future performance. One such indicator is the Consumer Price Index (CPI), which measures changes in the price level of a market basket of consumer goods and services over time.

Economic indicators are used by governments to formulate economic policies and by investors to understand market trends and adjust their investment strategies. Along with CPI, other key indicators include Gross Domestic Product (GDP), unemployment rates, and trade balances. Understanding these indicators is crucial for anyone involved in the economic decision-making process.