Measuring The Cost of Living: Principles: Chapter 21

Measuring the Cost of Living
Principles: Chapter 21
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
1
The Consumer Price Index
• Consumer price index (CPI)
– Measure of the cost of living
– For a typical consumer
– Reported monthly by the Bureau of Labor
Statistics
• Track price changes for on a fixed basket of
goods and services
2
Calculating CPI
3
Calculating CPI
Chose a base year and compute the CPI
– Base year = benchmark
• Price of basket of goods & services in current
year
• Divided by price of basket in base year
• Times 100
Compute the inflation rate

CPI in year 2 - CPI in year 1
Inflation rate in year 2   100
CPI in year 1
4
Figure 1
The Typical Basket of Goods and Services
This figure shows how

the typical consumer
divides spending
among various
categories of goods
and services. The
Bureau of Labor
Statistics calls each
percentage the “relative
importance” of the
category.
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a 5
certain product or service or otherwise on a password-protected website for classroom use.
Consumer price index of Azerbaijan
6
Producer price index
•producer prices index (PPI), which measures

the
•prices of a basket of goods and services bought
by firms rather than consumers. Because firms
eventually
•pass on their costs to consumers in the form of
higher consumer prices, changes in the PPI are
often
•thought to be useful in predicting changes in the
CPI.
7
•CPI tries to gauge how much incomes
must rise in order to maintain a constant
standard of living.
•Income $100 burger $2
•Income $100 burger $3
•How much should the income rise to
maintain the same standard of living?
8
The Consumer Price Index
• Problems in measuring the cost of living
– Substitution bias
• Prices do not change proportionately
• Consumers substitute toward goods that have become relatively less
expensive
• If a price index is computed assuming a fixed basket of goods, it ignores the
possibility of consumer substitution and, therefore, overstates the increase in
the cost of living from one year to the next.
– Introduction of new goods
• More variety of goods (videogames decreased the cost of living)
– Unmeasured quality change
• Changes in quality
-Relevance of the CPI (Personal Inflation Calculator)
9
Figure 2
Two Measures of Inflation
This figure shows the inflation rate—the percentage change in the level of prices— as
measured by the GDP deflator and the consumer price index using annual data since 1965.
Notice that the two measures of inflation generally move together.
10
Differences between GDP and CPI
•GDP-goods produced domestically/CPI bought by

consumers (French aero plane, Sweden Volvos and oil
prices -when the price of oil rises, the CPI rises by much
more than does the GDP deflator
•CPI compares prices of a fixed basket vs base
year/GDP compares price of currently produced g&s vs
base year
11
CORRECTING ECONOMIC VARIABLES FOR
THE EFFECTS OF
INFLATION: comparing monetary figures
through time
•Was the salary of ￡ 400 a year, first paid to MPs in 1911, high or low compared to the
salaries of today’s MPs?
•A price index determines the size of this inflation correction
•We find that the salary paid to an MP in 1911 is

equivalent to a salary today of ￡ 40,567
12
Indexation
•indexed the automatic correction of a money

amount for the effects of inflation by law or
contract
•For example, many long-term contracts
between firms and unions include partial or
complete indexation of the wage to the CPI.
Such a provision is called a cost-of-living
allowance, or COLA. A COLA automatically
raises the wage each year based on the CPI
13
•nominal interest rate the interest rate as usually reported without a
correction for the effects of inflation
•real interest rate the interest rate corrected for the effects of inflation
•Real interest rate = Nominal interest rate − Inflation rate
14
15
•Homework: article on page 469-470, read and
answer the questions
•Problems and applications page 471-472
•Homework should be submitted on A4 paper, writing
should be by hand
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 16
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Measuring the Cost of Living

Compute the inflation rate

This figure shows how

•producer prices index (PPI), which measures

•GDP-goods produced domestically/CPI bought by

•We find that the salary paid to an MP in 1911 is

•indexed the automatic correction of a money

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