CPI, Cost of Living, Inflation
CPI, Cost of Living, Inflation
CPI, Cost of Living, Inflation
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
3
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
cost of basket in current year
100 x
cost of basket in base year
price of price of
year cost of basket
pizza latte
2010 $10 $2.00 $10 x 4 + $2 x 10 = $60
2011 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2012 $12 $3.00 $12 x 4 + $3 x 10 = $78
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
5
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 1
Calculate the CPI price
price of
of
chicken
CPI basket: lamb
{10 lbs lamb, 2010 $4 $4
20 lbs chicken}
2011 $5 $5
The CPI basket cost $120
in 2010, the base year. 2012 $9 $6
© 2013 ©Cengage
2013 Cengage
Learning.Learning.
All Rights
AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
6
permitted
permitted
in a license
in a distributed
license distributed
with a certain
with a certain
productproduct
or service
or service
or otherwise
or otherwise
on a password-protected
on a password-protected
website website
for classroom
for classroom
use. use.
ACTIVE LEARNING 1
Answers
price
price of
CPI basket: of
chicken
{10 lbs lamb, lamb
20 lbs chicken} 2010 $4 $4
The CPI basket cost $120 2011 $5 $5
in 2010, the base year.
2012 $9 $6
A. Compute the CPI in 2011:
Cost of CPI basket in 2011
= ($5 x 10) + ($5 x 20) = $150
CPI in 2011 = 100 x ($150/$120) = 125
© 2013 ©Cengage
2013 Cengage
Learning.Learning.
All Rights
AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
7
permitted
permitted
in a license
in a distributed
license distributed
with a certain
with a certain
productproduct
or service
or service
or otherwise
or otherwise
on a password-protected
on a password-protected
website website
for classroom
for classroom
use. use.
ACTIVE LEARNING 1
Answers price
price of
of
CPI basket: chicken
lamb
{10 lbs lamb,
20 lbs chicken} 2010 $4 $4
The CPI basket cost $120 2011 $5 $5
in 2010, the base year. 2012 $9 $6
B. What was the inflation rate from 2011–2012?
Cost of CPI basket in 2012
= ($9 x 10) + ($6 x 20) = $210
CPI in 2012 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
© 2013 ©Cengage
2013 Cengage
Learning.Learning.
All Rights
AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
8
permitted
permitted
in a license
in a distributed
license distributed
with a certain
with a certain
productproduct
or service
or service
or otherwise
or otherwise
on a password-protected
on a password-protected
website website
for classroom
for classroom
use. use.
What’s in the CPI’s Basket?
Food and bev. 7.1%
16.9% 6.0%
Housing
3.2%
Apparel 3.6%
3.6% 3.4%
Transportation
Medical care
Recreation
Education 15.3%
Communication
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
9
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 2
Substitution bias
© 2013 ©Cengage
2013 Cengage
Learning.Learning.
All Rights
AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
11
permitted
permitted
in a license
in a distributed
license distributed
with a certain
with a certain
productproduct
or service
or service
or otherwise
or otherwise
on a password-protected
on a password-protected
website website
for classroom
for classroom
use. use.
ACTIVE LEARNING 2
Answers
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
13
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Problems with the CPI:
Introduction of New Goods
The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
The CPI misses this effect because it uses a
fixed basket of goods.
Thus, the CPI overstates increases in the cost of
living.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
14
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Problems with the CPI:
Unmeasured Quality Change
Improvements in the quality of goods in the
basket increase the value of each dollar.
The BLS tries to account for quality changes
but probably misses some, as quality is hard to
measure.
Thus, the CPI overstates increases in the cost of
living.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
15
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Problems with the CPI
Each of these problems causes the CPI to
overstate cost of living increases.
The BLS has made technical adjustments,
but the CPI probably still overstates inflation
by about 0.5 percent per year.
This is important because Social Security
payments and many contracts have COLAs tied
to the CPI.
© 2013 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.
Two Measures of Inflation, 1960–2012
15
Percent change per year
10
-5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
17
GDP deflator
© 2013 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 certain product or service or otherwise on a password-protected website for classroom use. CPI
Contrasting the CPI and GDP Deflator
Imported consumer goods:
included in CPI
excluded from GDP deflator
Capital goods:
excluded from CPI
included in GDP deflator
The basket:
(if produced domestically)
CPI uses fixed basket
GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
18
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 3
CPI vs. GDP deflator
© 2013 ©Cengage
2013 Cengage
Learning.Learning.
All Rights
AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
19
permitted
permitted
in a license
in a distributed
license distributed
with a certain
with a certain
productproduct
or service
or service
or otherwise
or otherwise
on a password-protected
on a password-protected
website website
for classroom
for classroom
use. use.
ACTIVE LEARNING 3
Answers
© 2013 ©Cengage
2013 Cengage
Learning.Learning.
All Rights
AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
20
permitted
permitted
in a license
in a distributed
license distributed
with a certain
with a certain
productproduct
or service
or service
or otherwise
or otherwise
on a password-protected
on a password-protected
website website
for classroom
for classroom
use. use.
Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
21
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
In our example,
“year T” is 12/1964, “today” is 12/2010
Min wage was $1.15 in year T
CPI = 31.3 in year T, CPI = 220.3 today
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
23
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1960–2012
$12.00
2012 dollars
$10.00
Dollars per hour
$8.00
$6.00
$4.00
$2.00
current dollars
$0.00
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
24
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 4 HOMEWORK
Example:
Deposit $1,000 for one year.
Nominal interest rate is 9%.
During that year, inflation is 3.5%.
Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
The purchasing power of the $1000 deposit
has grown 5.5%.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
28
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Real and Nominal Interest Rates in the U.S.,
1950–2012
15
10
(percent per year)
Interest rate
-5
-10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Nominal Real
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
29
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
S U M MA RY