# Measuring the cost of living

Aman 22 February 2013

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.

2

Measuring the cost of living
The consumers price index
• The consumers price index (CPI) is a measure of the overall cost of the goods and services bought by a typical household. • Pakistan Bureau of Statistics reports the CPI each month. • It is used to monitor changes in the cost of living over time.
3

4 .Measuring the cost of living The consumers price index • When the CPI rises. the typical family has to spend more Rupees/dollars to maintain the same standard of living.

.The consumers price index How the CPI is calculated • In calculating the consumers price index. Pakistan Bureau of Statistics uses data on over 487 items (goods and services). • Five steps are followed to estimate the CPI and inflation. • Consider a simple economy in which consumers only buy two goods: Burger and Soft drink.

– Statistics Bureau identifies a market basket of goods and services the typical consumer buys.The consumers price index How the CPI is calculated 1 Fix the basket Determine what prices are most important to the typical consumer. 6 . – They then conduct monthly consumer surveys to set the weights for the prices of those goods and services.

7 .The consumers price index How the CPI is calculated 2 Find the prices Find the prices of each of the goods and services in the basket for each point in time.

8 .The consumers price index How the CPI is calculated 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.

CPI = Price of basket of goods and services in current year Price of basket of goods and services in base year X 1000 . the CPI may be calculated as follows.The consumers price index How the CPI is calculated 4 Choose a base period and compute the index Once the base year is chosen.

The consumers price index How the CPI is calculated 5 Calculate the inflation rate Inflation rate = (CPI in Year 2) – (CPI in Year 1) X 100 CPI in Year 1 10 .

2 burgers Step 2: Find the price of each good in each year Year 2009 Price of Pepsi (Rs.Example of calculating the consumers price index and the inflation rate Step 1: Survey consumers to determine a fixed basket of goods Basket = 4 cans of Pepsi.) 10 Price of Burgers (Rs.) 100 2010 2011 15 20 200 300 Step 3: Compute the cost of the basket of goods in each year Step 4: Choose one year as a base year (2008) and compute the consumer price index in each year Step 5: Use the consumer price index to compute the inflation rate from previous year .

Water. Gas and Other Fuels 29% Clothing & Footwear 8% Alcoholic Beverage.The consumers price index FYI: What is in the CPI’s basket? When constructing the basket. Statistics Bureau tries to include goods and services most frequently used by the average consumer. Tobacco 2% . weighted by how much consumers use each item. Restaurants & Hotels 1% Recreation & Education Culture 4% 2% Communication 3% The typical basket of goods and services Miscellaneous Goods & Services 3% Health 2% Furnishing & Household Equipment Maintenance 4% Transport 7% Food & NonAlcoholic Beverages 35% Housing. Electricity.

1200 – the same basket in 2004 costs Rs.pdf 13 .The consumers price index How the CPI is calculated • An example of calculating the consumers price index: – base year is 2002 – basket of goods in 2002 costs Rs. – CPI_PBS.1236/Rs.1200)  1000 = 1003 – prices increased 3 percent between 2002 and 2004.1236 – CPI = (Rs.

The consumers price index Problems in measuring the cost of living • The CPI is an accurate measure of the selected goods that make up the typical bundle. 14 . but it is not a perfect measure of the cost of living.

The consumers price index Problems in measuring the cost of living 1 Substitution bias 2 Introduction of new goods 3 Unmeasured quality changes 15 .

– Consumers substitute toward goods that have become relatively less expensive.The consumers price index Problems in measuring the cost of living 1 Substitution bias – The basket does not change to reflect consumer reaction to changes in relative prices. 16 . – The index overstates the increase in cost of living by not considering consumer substitution.

which in turn makes each Rupee/dollar more valuable. – Consumers need fewer Rupees/dollars to maintain any given standard of living.The consumers price index Problems in measuring the cost of living 2 Introduction of new goods – The basket does not reflect the change in purchasing power brought on by the introduction of new products. 17 . – New products result in greater variety.

18 . – Pakistan Bureau of Statistics tries to adjust the price for constant quality. the value of a dollar falls. – If the quality of a good falls from one year to the next.The consumers price index Problems in measuring the cost of living 3 Unmeasured quality changes – If the quality of a good rises from one year to the next. even if the price of the good stays the same. even if the price of the good stays the same. but such differences are hard to measure. the value of a dollar rises.

introduction of new goods. • The CPI overstates true inflation. and unmeasured quality changes cause the CPI to overstate the true cost of living.The consumers price index Problems in measuring the cost of living • The substitution bias. • The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. 19 .

gov.pk/content/price-statistics • Base: June 2007-08= 100 . • You can download the CPI data from the website of the Pakistan Bureau of Statistics : – http://pbs. the typical family has to spend more Rupees/dollars to maintain the same standard of living.THE CONSUMER PRICE INDEX • When the CPI rises.

10 15 20 25 30 0 5 -5 Pak. Time Series for the CPI (Pakistan Bureau of Statistics) Consumer Price Index 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 .

Measuring inflation The GDP deflator • The GDP deflator is calculated as follows: Nominal GDP Real GDP GDP deflator = x 1000 22 .

• There are two important differences between the indexes that can cause them to diverge. 23 .Measuring inflation The GDP deflator versus the CPI • Economists and policymakers monitor both the GDP deflator and the consumers price index to gauge how quickly prices are rising.

Two measures of inflation 30 GDP deflator 25 Consumer Price Index 20 15 10 5 0 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 -5 .

Measuring inflation The GDP deflator versus the CPI • The GDP deflator reflects the prices of all goods and services produced domestically. whereas… • …the consumers price index reflects the prices of all goods and services bought by consumers. 25 .

26 .Measuring inflation The GDP deflator versus the CPI • The consumers price index compares the price of a fixed basket of goods and services to the price of the basket in the base year.

27 .Measuring inflation The GDP deflator versus the CPI • 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.

• Take a mason in 1960. • A price index can help establish what earnings would be relative to today’s prices.Correcting economic variables for the effects of inflation • Price indexes are used to correct for the effects of inflation when comparing Rupee/dollar figures from different times.15 per week. 28 . They would have earned the equivalent of Rs.

Amount in today’s Rupees= Price level today ∙ Amount in year T dollars Price level in year T • Specifically: Price level in 2012 Wage in 2012 Rupees = Price level in 1960 ∙ Wage in 1960 Rupees .Correcting economic variables for the effects of inflation • Our mason’s wage today can be calculated using the following general price index formula.

185. in today’s Rupees they would be earning Rs. • Some questions to consider: – Has the average person’s purchasing power changed over the last 50 years? – Has the standard of living actually improved since 1960? . 15 per week in 1960.49 – about what we would expect a mason to earn today.Correcting economic variables for the effects of inflation • Although our mason made only Rs.

for instance. the amount is said to be indexed for inflation. may be indexed.Indexation • When some Rupees/Dollar amount is automatically corrected for inflation by law or contract. 31 . • Superannuation contributions. Each year the contribution increases to account for rising prices – inflation.

Real and nominal interest rates • The nominal interest rate is the interest rate usually reported and not corrected for inflation. • The real interest rate is the nominal interest rate that is corrected for the effects of inflation. Quoted bank rates are nominal. 32 .

100. Real interest rate = Nominal interest rate – Inflation = 15% . • During the year inflation was 10%.10% = 5% . • Nominal interest rate was 15%.000 for one year.Real and Nominal Interest Rates • You borrowed Rs.

Summary • The consumers price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. • The index is used to measure the overall level of prices in the economy. • The percentage change in the CPI measures the inflation rate. 34 .

Summary • The consumers price index is an imperfect measure of the cost of living for the following three reasons: Substitution bias. • Because of measurement problems. 35 . the CPI overstates true inflation. the introduction of new goods and unmeasured changes in quality.

Summary • The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. 36 . • In addition. while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes. the CPI uses a fixed basket of goods.

• Various laws and private contracts use price indexes to correct for the effects of inflation.Summary • Dollar figures from different points in time do not represent a valid comparison of purchasing power. • The real interest rate equals the nominal interest rate minus the rate of inflation. 37 .