Measuring Inflation:

The Cost of Living

GHNRRT 2023 Ch.4 (159-163)

Outline
• What is inflation? How to measure Inflation?
• Consumer Price Index (CPI)
• Problems with the CPI?
• Other price indices:
• Wholesale price index (WPI),
• Producer Price Index (PPI)
• GDP deflator
• How does the CPI differ from the GDP deflator?
• Correcting nominal variables for inflation
• Using the CPI to compare dollar amounts from different years?
Why we need to do so?
• Nominal vs. Real GDP, wages, interest rates
 Measuring the Cost of Living
• Inflation refers to a situation in which the economy’s overall price level is rising.
• Price level: a weighted average of prices of different goods and services
• Inflation rate = % change in the P level (monthly, quarterly, annual change).

• How to calculate an average price level?

• When the prices of different goods and services are changing at different rates (and
even directions), how does one express the overall change in prices as one single
number, i.e. the rate of inflation?

We use a “PRICE INDEX”

to consolidate diverse changes in prices
as a single number.
THE CONSUMER PRICE INDEX (CPI)

• the most commonly used price index to express the rate of

inflation.
• a measure of the change in the overall prices of the goods and
services bought by a typical consumer.
• measures the changes in a typical consumer’s cost of living.

• The Statistics Institute of Turkey (TÜİK) reports the % change in CPI

(inflation rate) each month.
• CPI: TÜFE (Tüketici Fiyat Endeksi)
How is the CPI calculated?

1. Fix the “basket.”

TÜİK surveys consumers to determine what’s in the typical consumer’s
“shopping basket.”
• TÜİK’s shopping basket consists of 415 goods&services (900+
varieties).

2. Find the prices.

TÜİK collects data on the retail prices of all the goods in the basket.
• TÜİK collects monthly data from 27,980 outlets and follows the rents
of 4,274 real estate units to construct the index.
 CPI data collected by TÜİK
2010 2017 2021

Number of items 446 414 415

Number of varieties 923 910 901

Number of outlets 26 132 27 386 27 980

Number of prices 372 427 400 772 550 632

Number of rents 3 985 4 275 4 274

How is the CPI calculated?

3. Compute the basket’s cost.

Use the prices to compute the total cost of the basket.

4. Choose a base year for which CPI will be set at 100.

Calculate the CPI for other years in reference to the base year.

5. Compute the inflation rate.

The percentage change in the CPI from the preceding period.
How is the CPI calculated?

cost of basket in current year

CPI = 100 x
cost of basket in base year

Inflation CPI this year – CPI last year

rate = x 100%
CPI last year
EXAMPLE: Consumer basket with 2 goods

Pizza Water Cost of Consumer Basket

year
(4 units) (10 bottles) (4 pizzas, 10 bottles)
2007 $10 $2.00 $10 x 4 + $2 x 10 = $60
2008 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2009 $12 $3.00 $12 x 4 + $3 x 10 = $78
Compute CPI in each year using 2007 base year: Inflation rate:
2007: 100 x ($60/$60) = 100 115 – 100 x 100%
15% =
100
2008: 100 x ($69/$60) = 115
130 – 115
2009: 100 x ($78/$60) = 130 13% = x 100%
115
 What’s in the CPI Basket? USA 2016

4% 3% Housing
6%
Transportation
6%
Food & Beverages
6% 43%
Medical care

Recreation

Education and
15%
communication
Apparel

17% Other
What’s in the CPI Basket? Turkey 2021
 Price indices other than the CPI:
GDP Deflator
• The GDP Deflator - a price index entailing the prices of
all goods and services produced in a country.

Nominal GDP
GDP deflator = ´ 100
Real GDP

• The GDP Deflator tells us the rise in nominal GDP that is

attributable to a rise in prices rather than a rise in the
quantities produced.
 GDP Deflator vs. Consumer Price Index

• 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.
 Comparing the CPI and GDP Deflator
Imported consumer goods:
• included in CPI
• excluded from GDP deflator
Capital goods:
§ excluded from CPI
§ included in GDP deflator (if
The basket:
produced domestically)
§ CPI uses fixed basket
§ GDP deflator uses basket of
currently produced goods & services

16
Figure 4.2: Inflation Rate USA (GDP deflator vs. CPI)
1960 -2020

Source: BEA NIPA Tables 1.1.4 and BLS Table on CPI-All urban consumers.
 Inflation Rate Türkiye vs. OECD 1960-2022
CPI annual % change
120

105
100
94
89
8685
80 80
70 72
69 66
6264 63 66 65
60 60
5554
48
45 45
40 38 39
35
2931
26
2421
20 19 22 20
14 1514 17 1615
8 6 8 9 8 109 106 9 6 9 7 9 8 8 11 12
6346 5 5
0 1
60
62
64
66
68
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
16
18
20
22
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
20
-20
Greece Inflation, consumer prices (annual %)
OECD members Inflation, consumer prices (annual %)
Turkiye Inflation, consumer prices (annual %)
 Inflation Rate Türkiye vs. OECD 1960-2022
GDP Deflator annual % change
160

144
140

120
105
100
93 96
86
80 81
77 75 77
69
6568
60 5859
53 54 53
48 48 49
44
40 38
3634
29 2826 29
20 22 21 24 23
17 16 171415
12 9 12
9 11 7 6 57876788
11
466246657
0
61
63
65
67
69
71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
05
07
09
11
13
15
17
19
21
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
-20
Turkiye Inflation, GDP deflator (annual %)
Greece Inflation, GDP deflator (annual %)
OECD members Inflation, GDP deflator (annual %)
Inflation, GDP deflator (annual %)
690
604,95
590

490

390 264,58

290
113,29 235,52

190 116,86
115,65
96,04 53,84 69,47
90 28,97 1,28
4,49 2,976,53 2,69 6,48
40,08 0,33
14,79 1,58 2,98 0,94 1,30 7,04 1,91 1,93
-10
Zimbabwe Sudan Turkiye Argentina Italy Japan United OECD European
States members Union
-0,19
2020 2021 2022

Source: WorldBank (Inflation, GDP deflator (annual %) - Turkiye | Data. (n.d.). Retrieved March 4, 2024, from
https://data.worldbank.org/indicator/NY.GDP.DEFL.KD.ZG?locations=TR)
Average inflation rates (%) in Türkiye
 Price indices other than the CPI:
RCPI, WPI, PPI
• The regional CPI, which measures the cost of the basket of
consumer goods and services based for different regions within
the country, based on local prices.

• The wholesale price index (WPI), which measures the cost of the
basket of goods bought by wholesalers. (Toptan Eşya Fiyat
Endeksi - TEFE) based on wholesale rather than retail prices.

• The producer price index (PPI), which measures the cost of a

basket of goods bought by domestic producer firms (raw
materials, machineries, semi-finished goods) rather than goods
and services bought by consumers; based on producer prices.
(Üretici Fiyat Endeksi - ÜFE)
 Price indices other than the CPI: D-PPI
Domestic Producer Price Index (D-PPI)
(Yurtiçi Üretici Fiyat Endeksi)
• began to be released instead of PPI as of January 2014
to ensure compliance with European Union (EU) norms
• has industry coverage excluding the agricultural sector
(Industrial PPI)
• Mining, Manufacturing, Electricity&Gas, Water
• covers selling prices received by domestic producers in
industry
 Price indices other than the CPI:
ND-PPI, Agricultural Price Index
Non-Domestic Producer Price Index (ND-PPI) (Yurt
dışı ÜFE)
•published in monthly basis to measure the average
change over time in the export prices received by
domestic producers for their output.
Agricultural Price Index (Agriculture-PPI) (Tarım
Ürnleri ÜFE)
•cover the agriculture and hunting, forestry, and
fishing sectors (previously covered in PPI), which are
to be released separately from the industrial PPI.
 Problems with the CPI
as an accurate measure of inflation

• Measured as such the CPI is used to monitor changes

in the cost of living over time.

• When the CPI rises, the typical family has to spend

more dollars to maintain the same standard 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.
 Problems with the CPI

CPI may overestimate inflation due to:

1. Substitution bias
2. Introduction of new goods
3. Unmeasured quality changes

4. The CPI measures the changes in the cost of living for average
consumer household;
• but specific groups of consumers may experience different levels
of cost of living from the average;
• Hence CPI may over- or underestimate inflation for specific groups
of the population.
 Average versus Atypical Households

• Price indexes are average numbers:

• The real changes in cost of living for different groups may vary
according to demographic group, socioeconomic, region of
residence.
• The CPI is based on the “typical” consumer;
• Yet “atypical” consumers are likely to experience different changes
in the cost of living
• Retired couple households likely to be more affected by changes in costs
of healthcare vs. changes in costs of education or transport;
• College students housing together likely to be more affected by changes
in costs of healthcare vs. changes in costs of education or transport.

CPI for specific types of consumers:

The Cost of Living Extremely Well Index (CLEWI)
Regional Price Index
Problems Bias
Substitution in Measuring the Cost of Living
• 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.

• e.g. consumers substituting away from coffee (as its price

increases) towards tea (which has become relatively cheaper).
Introduction of New Goods
Problems in Measuring the Cost of Living
• 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.

• e.g. Internet channels or Netflix to replace cable TV

Problems in
Unmeasured Measuring
Quality Changes the Cost of Living
• If the quality of a good rises from one year to the next
while the price of the good stays the same, the value of a
dollar rises.
• Vice versa if the quality of a good falls from one year to
the next while the price of the good stays the same.
• The Statistics Institutes try to adjust the price for
constant quality, but such differences are hard to
measure.

e.g. the switch from 3G to 4G – faster internet

 Correcting Variables for Inflation:
Indexation
• When some dollar amount is automatically corrected for inflation by law or
contract, the amount is said to be indexed for inflation.

• For example, wage indexation is commonly used in order to adjust wages and
salaries for the effects of inflation on a periodic basis.

• Real Wage = Nominal Wage

Price Level

e.g. (Nominal) Hourly W:150 TL/hour; Price of simit: 10 TL, what’s the realW?
real W: 15 simits/hour
If price of simit increases to 12.5 TL;
Then real W = 12 simits/hour
 Correcting Monetary Variables for Inflation:
Comparing USD Figures from Different Times

• Inflation makes it harder to compare dollar amounts from different times.

• Legendary baseball player Babe Ruth’s salary in 1931 was 80,000 USD
• What does this mean today?
• Example: Convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2007:
• CPI in 1931 was 15.2 while 207 in 2007.
• If salary in 1931 is $80,000; then what is this salary worth in 2007?

Babe Ruth’s 1931 salary in 2007 dollars:

Price level in 2007

Salary in 2007 dollars = Salary in 1931 dollars ×
Price level in 1931
Salary in 2007 dollars = $80,000 × (207/15.2).
Salary in 2007 dollars = $1,089,474.
Correcting Monetary Variables for Inflation:
Comparing Prices from Different Times

Valuet = Valuet’ x CPIt

CPIt’

t: value in current year (t) prices

t’: value in a past year (t’) prices
The Most Popular Movies of All Times,
Inflation Adjusted

Copyright©2004 South-Western
 Correcting Variables for Inflation:
Real vs. Nominal Interest Rates

The nominal interest rate:

• the interest rate not corrected for inflation
• the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
• corrected for inflation
• the rate of growth in the purchasing power of a deposit
or debt
Real interest rate
= (nominal interest rate) – (inflation rate)
 Correcting Variables for Inflation:
Real vs. Nominal Interest Rates

• You deposited $1,000 for one year.

• Nominal interest rate was 7%.
• During the year inflation was 6%.
Real interest rate = Nominal interest rate – Inflation
= 7% - 6% = 1%
• This means you earned 7% more dollars but your purchasing power
increased by only 1% in real terms.
Real and Nominal Interest Rates in the U.S., 1960-2020
 100
120

20
40
60
80

0
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000

Deposit Interest Rates

2001
1978-2020

2002
2003

CPI
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Inflation and Nominal Interest Rates in Turkey,

2017
2018
2019
The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1938-2019

Historical trend

History of the federal minimum wage in real 2019 dollars and nominal dollars

The federal minimum wage was introduced in 1938 at the rate of $0.25 per hour (equivalent to $4.45 in 2018). By 1950 the minimum wage had risen to $0.75 per hour. The minimum wage had its
highest purchasing power in 1968, when it was $1.60 per hour (equivalent to $11.53 in 2018). The real value of the Federal minimum wage in 2016 dollars has decreased by one-third since 1968.
The minimum wage would be $11 in 2016 if its real value had remained at the 1968 level. From January 1981 to April 1990, the minimum wage was frozen at $3.35 per hour, then a record-setting
minimum wage freeze. From September 1, 1997 through July 23, 2007, the federal minimum wage remained constant at $5.15 per hour, breaking the old record. In 2009 the minimum wage was
adjusted to $7.25 where it has remained fixed for the past nine years.

The purchasing power of the federal minimum wage has fluctuated. Since 1984, the purchasing power of the federal minimum wage has decreased. Measured in real terms (adjusted for inflation)
using 1984 dollars, the real minimum wage was $3.35 in 1984, $2.33 in 1994, $1.84 in 2004, and $1.46 in 2014. If the minimum wage had been raised to $10.10 in 2014 that would have equated
to $4.40 in 1984 dollars. This would have been equal to a 31% increase in purchasing power, despite the nominal value of the minimum wage increasing by 216% in the same time period.