N.

GREGORY MANKIW NINTH EDITION

PRINCIPLES OF
MACRO
ECONOMICS
CHAPTER
Measuring the
Cost of Living
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
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 IN THIS CHAPTER
• What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
• What are the problems with the CPI? How
serious are they?
• How does the CPI differ from the GDP
deflator?
• How can we use the CPI to compare dollar
amounts from different years? Why would we
want to do this, anyway?
• How can we correct interest rates for inflation?
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 The Consumer Price Index
• Consumer price index (CPI)
– Measure of the overall cost of goods and
services bought by a typical consumer
– Monitor changes in the cost of living over time
• Core CPI
– A measure of the overall cost of consumer
goods and services excluding food and energy
• Producer price index (PPI)
– A measure of the cost of a basket of goods and
services bought by firms
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 How the CPI Is Calculated – 1
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.
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 How the CPI Is Calculated – 2
4. Chose a base year and compute the CPI
• Designate a year as base year (benchmark)
CPI = [Basket’s cost in current year / Basket’s
cost in base year] × 100
5. Compute the inflation rate
• Percentage change in the CPI from the
preceding period
CPI this year−CPI last year
Inflation rate
CPI last year

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 EXAMPLE 1: Market basket: 10 pizzas, 5 shirts
Price of Price of
year Cost of basket
pizza shirts
2017 $12 $18
2018 $14 $20
2019 $16 $22
Compute CPI in each year (2017 base year)

2017:
2018:
2019:
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 The typical basket of goods and services

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 Active Learning 1: Calculate CPI & inflation rate
CPI basket: year
Price of Price of
10 lbs of beef, beef chicken
2017 $3 $3
20 lbs of chicken
2018 $4 $4
Base year: 2017 2019 $8 $5

A. Calculate CPI for all years

B. What was the inflation rate from 2018-
2019?

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 Active Learning 2: A new basket, CPI & inflation rate

New CPI basket for 2019: year

Price of Price of
5 lbs of beef, beef chicken
2017 $3 $3
25 lbs o f chicken
2018 $4 $4
Base year: 2017 2019 $8 $5

A. Calculate cost of the new basket for 2019

and the CPI for 2019.
B. What’s the new inflation rate from 2018-
2019?
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 Problems with the CPI – 1
• Substitution Bias
– Over time, some prices rise faster than
others
– Consumers substitute toward goods that
become relatively cheaper, mitigating the
effects of price increases.
– The CPI misses this substitution because it
uses a fixed basket of goods.
– Thus, the CPI overstates increases in the
cost of living.
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 Problems with the CPI – 2
• Introduction of New Goods
– The introduction of new goods increases
variety, allows consumers to find products
that more closely meet their needs.
– In effect, dollars become more valuable.
– The CPI misses this effect because it uses
a fixed basket of goods.
– Thus, the CPI overstates increases in the
cost of living.

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 Problems with the CPI – 3
• 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.

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 Two measures of inflation, 1965–2019

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 GDP Deflator vs. CPI
• Imported consumer goods:
– Included in CPI but excluded from GDP deflator
• Capital goods:
– Excluded from CPI but included in GDP deflator
(if produced domestically)
• The basket:
– CPI: fixed basket; prices of all goods and
services bought by consumers
– GDP deflator: prices of all goods and services
currently produced domestically
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 Active Learning 3: CPI vs. GDP deflator
In each scenario, determine the effects on
the CPI and the GDP deflator.
A. Starbucks raises the price of muffins.
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.

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 Dollar Figures From Different Times
• Comparing dollar figures from different
times:
– Inflation makes it harder to compare dollar
amounts from different times.

Amount in today′s dollars

Price level today
Amount in year T dollars
Price level in year T

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 EXAMPLE 2: Great-grandpa’s salary
Your great grandpa’s first full time job was as
a car mechanic in 1963, and he was earning
$310/month.
CPI in 1963: 30.9
CPI in 2019: 256.6
• How much great grandpa’s earnings are in
current dollars?

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 Active Learning 4: Comparing tuition increases
Tuition and Fees at U.S. Colleges and Universities
1990 2018
Private non-profit 4-year $9,340 $35,830

Public 4-year $1,908 $10,230

Public 2-year $906 $3,660

CPI 130.7 251.1
A. Express the 1990 tuition figures in 2018 dollars, then
compute the percentage increase in real terms for all
three types of schools.
B. Which type experienced the largest increase in real
tuition costs?
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 Indexation
• Indexation
– A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
• The increase in CPI automatically
determines:
– The COLA in many multi-year labor
contracts.
– Adjustments in Social Security payments and
federal income tax brackets.
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 Real and Nominal Interest Rates
• The nominal interest rate:
– Interest rate not corrected for inflation
– Rate of growth in the dollar value of a deposit or
debt
• The real interest rate:
– Corrected for inflation
– Rate of growth in the purchasing power of a
deposit or debt
Real interest rate =
= (nominal interest rate) – (inflation rate)
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 Example 3: Real vs. nominal interest rates
Amir received a $1,000 end-of-year bonus at his
job. He deposits the $1,000 in his savings
account for one year. The nominal interest rate is
9%. During that year, inflation is 3.5%.
• At the end of the year, is Amir able to buy more
or fewer goods with his money? How much?

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 Real & nominal interest rates, the U.S., 1965–2019

Real
Nominal
Interest rate (percent per year)

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 THINK-PAIR-SHARE
Your grandfather quit smoking cigarettes
in 1995. When you ask him why he quit, you
get a surprising answer. Instead of reciting
the health benefits of quitting smoking, he
says, “I quit because it was just getting too
expensive. I started smoking in 1965 in
Vietnam and cigarettes were only 45 cents a
pack. The last pack I bought was $2.00 and I
just couldn’t justify spending more than four
times as much on cigarettes as I used to.”

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 THINK-PAIR-SHARE
A. In 1965, the CPI was 31.5. In 1995, the CPI was
152.4. While it is commendable that your
grandfather quit smoking, what is wrong with his
explanation?
B. What is the equivalent cost of a 1965 pack of
cigarettes measured in 1995 prices?
C. What is the equivalent cost of a 1995 pack of
cigarettes measured in 1965 prices?
D. Do both methods give you the same conclusion?

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 CHAPTER IN A NUTSHELL
• The consumer price index (CPI) shows the
cost of a basket of goods and services
relative to the cost of the same basket in the
base year.
• Used to measure the overall level of prices in
the economy.
• The percentage change in the CPI measures
the inflation rate.

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 CHAPTER IN A NUTSHELL
• The CPI overstates true inflation:
• It does not take into account consumers’ ability
to substitute toward goods that become
relatively cheaper over time
• It does not take into account increases in the
purchasing power of the dollar that result from
the introduction of new goods.
• It is distorted by unmeasured changes in the
quality of goods and services

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 CHAPTER IN A NUTSHELL
• Like the CPI, the GDP deflator measures the
overall level of prices in the economy.
• The two price indexes usually move together
• The GDP deflator differs from the CPI because it
reflects the prices of goods and services
produced domestically rather than of goods and
services bought by consumers.
• While the CPI uses a fixed basket of goods, the
group of goods and services reflected in the
GDP deflator automatically changes over time
as the composition of GDP changes.
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 CHAPTER IN A NUTSHELL
• To compare a dollar figure from the past with
a dollar figure today, the older figure should
be inflated using a price index.
• Various laws and private contracts use price
indexes to correct for the effects of inflation.
Tax laws, however, are only partially
indexed for inflation.

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 CHAPTER IN A NUTSHELL
• Correcting for inflation is especially
important when looking at data on interest
rates.
• The nominal interest rate is the rate at which the
number of dollars in a savings account
increases over time.
• The real interest rate is the rate at which the
purchasing power of a savings account
increases over time. It equals the nominal
interest rate minus the rate of inflation.

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