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You are on page 1of 31

Chapter 5 covered the definition and measurement of

the standard of living. We now turn our attention to

the cost of living.

The cost of living is given by the average level of

prices in the economy. To measure the average level

of prices we use a price index, one of the most

frequently used being the Consumer Price Index

(CPI).

urban consumers for a fixed market basket of

consumer goods and services. The Bureau of Labor

Statistics (BLS) publishes the CPI every month. The

BLS checks the prices of 80,000 goods and services in

the CPI market basket in 30 metropolitan areas.

The average expenditure on each item in the market

basket is the weight that is attached to that item.

E.g., if households on average spend 40% of their

income of housing and 15% on food, then an

increase in the price of housing should carry a weight

of 40% and an increase in the price of food should be

weighted 15% in determining the average overall

increase in the cost of living.

reference base period. Currently the reference

base period is 1982-1984. If the CPI were then

calculated to be, say, 105, in a later period, then this

means that prices on average were 5% higher in that

period than in the reference base period.

1. Find the cost of the CPI market basket at base

period prices.

2. Find the cost of the CPI market basket at current

period prices.

3. Calculate the CPI for the base period and the

current period.

consumers purchase only three goods: beer, pretzels

and aspirins.

Also, we will construct an annual CPI rather than a

monthly one.

For our calculation, the reference base period is

assumed to be 2000 and the current period is 2006.

period:

2000

Quantity

consumed

Price per

unit

Expenditure

beer

pretzels

aspirins

8

5

4

$2.00

$1.50

$0.50

$16.00

$7.50

$2.00

$25.50

period prices:

2006

Quantity

Price per

consumed unit

Expenditure

beer

pretzels

aspirins

8

5

4

$20.00

$11.00

$4.00

$2.50

$2.20

$1.00

$35.00

reference base period and in the current period:

CPI =

Cost of CPI basket at base period prices

X 100

CPI = ($25.50/$25.50) X 100 = 100.

In 2006 (the current period),

CPI = ($35.00/$25.50) X 100 = 137.25.

The interpretation of this number is that prices were

37.25% higher in the current year (2006) than they

were in the reference base year (2000).

in the cost of living over time, i.e., the inflation rate.

The annual inflation rate is the percentage change in

the price level from one year to the next.

The formula for calculating the annual inflation rate

is as follows:

Inflation rate =

CPI in previous year

X 100%

100) and in 2000 it was 172.2. Therefore the inflation

rate for the year 1999-2000 was:

Inflation rate =

172.2 166.6

166.6

= 3.36%.

X 100%

cost of living:

The cost of living is the amount of money that people

would need to spend to achieve a given standard of

living. The CPI is not an accurate measure of the

cost of living for two reasons:

1. In calculating the CPI, quantities consumed are

fixed. The CPI captures only changes in prices. But

quantities do change from year to year and changes

in quantity do affect the cost of living.

are measured by the CPI are not always measured

accurately, i.e., the CPI is a biased measure of the

cost of living. The sources of this bias are:

(a) New goods bias

(b) Quality change bias

(c) Commodity substitution bias

(d) Outlet substitution bias

by Michael Boskin of Stanford University (the

Boskin Commission) calculated that the CPI

overestimated inflation by 1.1 percentage points per

year. So if the CPI gives an inflation rate of 2.9%,

true inflation is probably only 1.8%.

Many private contracts are indexed to the CPI. E.g.,

many union contracts specify that wages must

increase at a rate equal to the inflation rate as

measured by the CPI. If the CPI overestimates

inflation, then indexed wages will rise more than

enough to compensate workers for increases in the

cost of living.

Many government expenditures, such as Social

Security benefits, welfare payments and civil servant

pensions, are indexed to the CPI and therefore

increase by more than what is necessary to

compensate recipients for the rising cost of living.

to real values

Nominal versus real

It is misleading to compare dollar values paid at

different dates because the purchasing power of the

dollar decreases as a result of inflation, e.g., fifty

years ago a dollar provided its holder with more

command over goods and services than a dollar

provides today.

different times, we need to measure real values, not

nominal values.

A nominal value is one that is expressed in terms of

current prices. A real value is one that is expressed

in terms of the prices prevailing in a given year.

in 1997 was $5.5 billion and in 2000 it was $6.8

billion. This means that in nominal terms

consumption has increased by

$6.8 billion $5.5 billion X 100% = 23.6%.

$5.5 billion

Does this mean that consumers are really buying

23.6% more goods and services? No! They are

spending 23.6% more dollars, but, due to inflation,

the purchasing power of those dollars in 2000 is

not as high as that of the 1997 dollars.

2000 the CPI was 172.2. We can use these two

numbers to calculate the relative value of a dollar in

1997 and 2000. This ratio is 172.2/160.5 = 1.073,

i.e., prices were on average 1.073 times higher in

2000 than in 1997.

We can use this ratio to convert the 2000

consumption spending into its 1997 equivalent, i.e.,

to express 2000 consumption spending in terms of

1997 prices:

Consumption spending in 2000 dollars

(CPI in 2000)/(CPI in 1997)

= $6.8 billion

172.2/160.5

= $6.8 billion

1.073

= $6.34 billion.

billion to buy the same basket of goods and services

that $6.34 billion would have bought back in 1997, i.e.,

at 1997 prices, because prices were 1.073 times

higher in 2000 than in 1997.

The $6.34 billion is real consumption expenditure in

2000 in terms of 1997 prices, whereas the $6.8 billion

is nominal consumption spending in 2000 expressed

in terms of current (2000) prices.

constant 1997 dollars increased by:

$6.34 billion $5.5 billion X 100% = 15.3%.

$5.5 billion

Recall that nominal consumption expenditure

increased by 23.6% from 1997 to 2000, which

simply means that consumers spent 23.6% more

dollars in 2000 than they did in 1997. But those

expenditures in 2000 only purchased 15.3% more

real goods and services, once we remove the effect

of the higher prices.

In macroeconomics we focus on the average

hourly wage rate. The nominal wage rate is

the average hourly wage rate measured in

current dollars. The real wage rate is the

average hourly wage rate measured in the

dollars of a given reference base year.

we use the following formula:

___________________________________________

(CPI in current year)/(CPI in reference base year)

was $15.68. What was the real hourly wage rate in

terms of 1982-84 prices? The CPI for 2004 was

188.9. The CPI for 1982-84 was of course 100.

Therefore,

Real wage rate in 2004 =

$15.68

_________________

(188.9)/(100)

= $8.30.

2004. This means that a worker needed to earn

$15.68 in 2004 in order to buy the same basket of

goods and services that he could have bought for

$8.30 in 1982-84, i.e., at 1982-84 prices, because

prices were 1.889 times higher in 2004 than they

were in 1982-84.

But the reference base year is not necessarily 198284. Consider the following example:

Marys grandmother earned $8,000 per year in

1966. In 2004 Mary earned $41,000. Who was

better off in real terms? The CPI in 1966 was 32.4

(1982-84 = 100). The CPI in 2004 was 188.9.

We can calculate Marys annual salary in 1966

dollars:

Marys real 2004 salary in 1966 dollars = Marys

nominal salary in 2004

___________________________

(CPI in 2004)/(CPI in 1966)

=_____________

$41,000

(188.9)/(32.4)

= $7,032.29.

$8,000 in 1966, was doing better than Mary whose

real salary in 2004, in terms of 1966 prices, was only

$7,032.29.

Alternatively, we can calculate Marys grandmothers

annual salary in terms of 2004 dollars:

Grandmothers 1966 salary in 2004 dollars = ___________________________

Grandmothers nominal salary

(CPI in 1966)/(CPI in 2004)

=____________

$8,000

(32.4)/(188.9)

= $46,641.98.

1966, earned $46,641.98 in terms of 2004 dollars,

was doing better than Mary who earned only

$41,000 in 2004.

An increase in a workers nominal hourly wage rate

tells us how many more dollars the worker is earning

in an hour. An increase in the workers real hourly

wage rate tells us how much more goods and

services the worker is able to buy with that hourly

wage.

will grow faster than the real wage rate because the

nominal wage rate includes inflation whereas the real

wage rate removes the effects of inflation.

In general, to convert any nominal dollar amount into

a real dollar amount, i.e., to deflate a nominal dollar

value, we divide the nominal amount by a ratio of

price indexes.

A nominal interest rate is the percentage

return on a loan in dollars. A real interest

rate is the percentage return on a loan in

terms of purchasing power.

For example, suppose you deposit $100 in a bank

account for one year at an annual interest rate of

10%. This interest rate, called the loan rate, is a

nominal interest rate. It means simply that you will

get back 10% more dollars at the end of the loan

period than you initially deposited.

period, prices on average increased by 4%. You

would need $104 at the end of the year in order to

be able to buy the same basket of goods and

services that you were able to buy for $100 at the

beginning of the year.

But since you are actually getting $110 at the end of

the one-year period, the real interest you have

earned is $6, i.e., you are able to buy 6% more

goods and services at the end of the year than you

were able to buy at the beginning of the year with the

$100. You are getting an extra 6% of purchasing

power, therefore the real interest rate in this case is

6%.

In general,

Real interest rate = Nominal interest rate Inflation rate

In this case,

Real interest rate = 10% 4% = 6%.

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