Unit 3 Measuring The Cost of Living

Unit 3
Measuring the Cost of Living

Measuring the Cost of Living
• Inflation refers to a situation in which the economy’s overall price
level is rising.
• The inflation rate is the percentage change in the price level from the
previous period.
The Consumer Price Index
• The consumer price index (CPI) is a measure of the overall cost of
the goods and services bought by a typical consumer.
• It is used to monitor changes in the cost of living over time.
How the Consumer Price Index
The Consumer Price Index Is Calculated
Step 1 - Fix the basket: The General Statistics Office (GSO) identifies a
market basket of goods and services the typical consumer buys.
Step 2 - Find the prices: Find the prices of each of the goods and
services in the basket for each point in time.
Step 3 - Compute the Basket’s Cost: Use the data on prices to calculate
the cost of the basket of goods and services at different times.
How the Consumer Price Index
The Consumer Price Index Is Calculated
Step 4 - Choose a Base Year and Compute the Index:

• Designate one year as the base year, making it the benchmark against which
other years are compared.
• Compute the index by dividing the price of the basket in one year by the price
in the base year and multiplying by 100.
• Step 5 - Compute the inflation rate: The inflation rate is the
percentage change in the price index from the preceding period.
• The Inflation Rate (π)
• The inflation rate is calculated as follows:
t 1
CPI  CPI t
 t
t 1
 100%
CPI
How the Consumer Price Index Is Calculated
• Calculating the Consumer Price Index and the Inflation Rate: Another
Example
• Base Year is 2002
• Basket of goods in 2002 costs $1,200.
• The same basket in 2004 costs $1,236.
• CPI = ($1,236/$1,200)  100 = 103.
• Prices increased 3 percent between 2002 and 2004.
• The BLS calculates other prices indexes:

• The index for different regions within the country.
• The producer price index, which measures the cost of a basket of goods and
services bought by firms rather than consumers.
Problems in Measuring the Cost of Living
• The CPI is an accurate measure of the selected goods that make up the
typical bundle, but it is not a perfect measure of the cost of living.
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
• Substitution Bias
• The basket does not change to reflect consumer reaction to changes in relative
prices.
• Consumers substitute toward goods that have become relatively less expensive.
• The index overstates the increase in cost of living by not considering consumer
substitution.
• The CPI misses this substitution because it uses a fixed basket of goods.
• Thus, the CPI overstates increases in the cost of living.
• Introduction of New Goods
• The basket does not reflect the change in purchasing power brought on by the
introduction of new products.
• New products result in greater variety, which in turn makes each dollar more valuable.
• Consumers need fewer dollars to maintain any given standard of living.
• The CPI misses this effect because it uses a fixed basket of goods.
• Unmeasured Quality Changes
• If the quality of a good rises from one year to the next, the value of a dollar
rises, even if the price of the good stays the same.
• If the quality of a good falls from one year to the next, the value of a dollar
falls, even if the price of the good stays the same.
• The BLS tries to adjust the price for constant quality, but such differences are
hard to measure.
• The substitution bias, introduction of new goods, and unmeasured
quality changes cause the CPI to overstate the true cost of living.
• The issue is important because many government programs use the CPI to
adjust for changes in the overall level of prices.
• The CPI overstates inflation by about 0.5 to 1 percentage point per year.
CPI basket: {10 lbs beef, 20 lbs chicken}
In 2014 and 2015, households bought CPI
cost of CPI
basket. beef chicken
basket
In 2016, households bought {5 lbs beef, 25
2014 $4 $4 120
lbs chicken}.
2015 $5 $5 150
A. Compute cost of the 2016 household
basket. 2016 $9 $6 210
B. Compute % increase in cost of household
basket over 2015–2016, 30%
compare to CPI inflation rate. 40%
The GDP Deflator versus the Consumer Price Index
• The GDP deflator is calculated as follows:
N o m in al G D P
G D P d eflato r = 1 0 0
R eal G D P
• Economists and policymakers monitor both the GDP deflator and the
consumer price index to gauge how quickly prices are rising.
• There are two important differences between the indexes that can
cause them to diverge.
• The GDP deflator reflects the prices of all goods and services
produced domestically, whereas...
• …the consumer price index reflects the prices of all goods and
services bought by consumers.
• The consumer price index compares the price of a fixed basket of

goods and services to the price of the basket in the base year (only
occasionally does the GSO change the basket)...
• …whereas the GDP deflator compares the price of currently produced
goods and services to the price of the same goods and services in the
base year.
In each scenario, determine the effects on the CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial tractors it manufactures
at its Illinois factory.
C. Armani raises the price of the Italian jeans it sells in the U.S.
Dollar figures from different times
• Inflation makes it harder to compare dollar amounts from different
times.
• Example: the minimum wage
• $1.25 in Dec 1963
• $7.25 in Dec 2013
• Did min wage have more purchasing power in Dec 1963 or Dec
2013?
• To compare, use CPI to convert 1963 figure into “2013 dollars”…
• Dollar figures from different times
• In our example:
• “year T ” is 1963, “today” is 2013
• Min wage was $1.25 in year T
• CPI = 30.9 in year T, CPI = 234.6 today
• The minimum wage in 1963 was $1.25 x 234.6/30.9 = $9.49 in 2013 dollars.
• Researchers, business analysts, and policymakers often use this
technique to convert a time series of current-dollar (nominal)
figures into constant-dollar (real) figures.
• They can then see how a variable has changed over time after
correcting for inflation.
• Example: the minimum wage…
Comparing tuition increases
• Express the 1990 tuition Tuition and Fees at U.S. Colleges and Universities
figures in 2015 dollars,
1990 2015
then compute the
percentage increase in real Private non-profit 4-year $9,340 $32,405
terms for all three types of
schools. Public 4-year $1,908 $9,410
• Which type experienced Public 2-year $906 $3,435

the largest increase in real
CPI 130.7 237.7
tuition costs?
Indexation
Indexation
• When some dollar amount is automatically corrected for inflation by
law or contract, the amount is said to be indexed for inflation.
• The increase in CPI automatically determines:
• The COLA (Cost Of Living Allowance) in many multi-year labor contracts.
• Adjustments in Social Security payments and federal income tax brackets.
Real and Nominal Interest
Real and Nominal InterestRates Rates
• Interest represents a payment in the future for a transfer of money in
the past.
• The nominal interest rate is the interest rate usually reported and not
corrected for inflation.
• It is the interest rate that a bank pays.
• The real interest rate is the nominal interest rate that is corrected for
the effects of inflation.
Real and Nominal Interest
Real and Nominal InterestRates Rates
• You borrowed $1,000 for one year.
• Nominal interest rate was 15%.
• During the year inflation was 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%
Real and Nominal Interest Rates

Unit 3 Measuring The Cost of Living

Uploaded by

Copyright:

Available Formats

Unit 3 Measuring The Cost of Living

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Unit 3 Measuring The Cost of Living

Uploaded by

Copyright:

Available Formats

Unit 3

Measuring the Cost of Living

Step 4 - Choose a Base Year and Compute the Index:

• The BLS calculates other prices indexes:

• The GDP deflator is calculated as follows:

• The consumer price index compares the price of a fixed basket of

• Which type experienced Public 2-year $906 $3,435

You might also like