Topic 3

Measuring the Cost of Living

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

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The Consumer Price Index

Consumer price index (CPI)
Measure of the overall level of prices
Measure of the overall cost of goods and
services
Bought by a typical consumer

Bureau of Labor Statistics

Computed monthly

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THE CONSUMER PRICE INDEX

When the CPI rises, the typical family has to

spend more dollars to maintain the same
standard of living.

Uses of the CPI

Another way of computing the inflation
rate the percentage change in the price
level from the previous period
Allows us to compare dollar figures from
different points in time
New York Yankees paid Babe Ruth a
salary of $80,000 in 1931
They paid Alex Rodriguez $33 million in
2010
Who was paid more?

Calculating CPI
1. Fix the basket
Which prices are most important to the typical
consumer
Thousands of goods and services
Different weights, depends on amounts
bought
2. Find the prices
At each point in time
3. Compute the baskets cost
Same basket of goods to isolate the effects of
price changes
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Calculating CPI
4. Chose a base year and compute the CPI
Base year = benchmark
Price of basket of goods & services in current

year
Divided by price of basket in base year
Times 100

5. Compute the inflation rate

CPI in year2 - CPI in year1
Inflationratein year2
100
CPI in year1
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Table 1

Calculating the Consumer Price Index and the Inflation

Rate: An Example

This table shows how to calculate the consumer price index and the inflation rate for a
hypothetical economy in which consumers buy only hot dogs and hamburgers.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 1

Calculating the Consumer Price Index and the Inflation

Rate: An Example

This table shows how to calculate the consumer price index and the inflation rate for a
hypothetical economy in which consumers buy only hot dogs and hamburgers.

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Consumer Price Index

Inflation rate
Percentage change in the price index
From the preceding period

Producer price index, PPI

Measure of the cost of a basket of goods
and services bought by firms
Changes in PPI are often thought to be
useful in predicting changes in CPI

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1
The Typical Basket of Goods and Services

This figure shows how

the typical consumer
divides spending
among various
categories of goods
and services. The
Bureau of Labor
Statistics calls each
percentage the relative
importance of the
category.

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The Consumer Price Index

Problems in measuring the cost of living
Substitution bias
Prices do not change proportionately
Consumers substitute toward goods that

have become relatively less expensive

Introduction of new goods

More variety of goods

Unmeasured quality change

Changes in quality

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Problems in Measuring the Cost of Living

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.

Problems in Measuring 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.

Problems in Measuring the Cost of Living

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.

Problems in Measuring the Cost of Living

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 1
percentage point per year.

GDP deflator versus CPI

GDP deflator
Ratio of nominal GDP to real GDP
Reflects prices of all goods & services
produced domestically
Excludes imported goods

CPI
Reflects prices of all goods & services
bought by a typical consumer
Includes imported goods
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GDP deflator versus CPI

GDP deflator
Compares the price of currently produced goods and
services
To the price of the same goods and services in the
base year

CPI
Compares price of a fixed basket goods and services
To the price of the basket in the base year

The weights of the GDP deflator changes

automatically while it does not in the CPI
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Figure 2
Two Measures of Inflation

This figure shows the inflation ratethe percentage change in the level of prices as
measured by the GDP deflator and the consumer price index using annual data since 1965.
Notice that the two measures of inflation generally move together.
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Correcting Economic Variables

Dollar figures 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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Dollar Figures from Different Times

Do the following to convert (inflate) Babe
Ruths wages in 1931 to dollars in 2009:
Salary2009 Salary1931

Price level in 2009

Price level in 1931

214.5
$80,000
15.2
$ 1,128,947
2007 Thomson South-Western

Indexation
Automatic correction by law or contract
Of a dollar amount
For the effects of inflation
COLA
Cost of living allowance

Social security

Real vs. Nominal Interest rates

When you deposit money in a bank today,
you expect to get your money back with
interest in the future
When you borrow money from a bank
today, they give you money which you will
repay with interest at some future time
The value of money today may be
different in the future because of inflation
Need to correct for inflation

Real vs. Nominal Interest rates

Suppose Sally deposits $1000 in her bank which earns an interest of 10% at a
time when a DVD cost $10. Her deposit is equivalent to 100 DVDs. A year later
she gets $1100. How many DVDs can she now buy? It depends on what
happens to the price of DVDs.
Inflation Rate

Price per DVD

Amount she can

buy

% change in
purchasing
power

0.0

10

110

+0.10

0.06

10.60

104

+0.04

0.10

11

100

+0.00

0.12

11.20

98

-0.02

Nominal interest rate - how fast youre the money is growing over time
Real interest rate how fast the purchasing power of your account is rising

Real and Nominal Interest Rates

Nominal interest rate
Interest rate as usually reported
Without a correction for the effects of
inflation

Real interest rate

Interest rate corrected for the effects of
inflation

= Nominal interest rate Inflation rate

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Interest rates in the U.S. Economy

Nominal interest rate

Always exceeds the real interest rate
U.S. economy has experienced rising
consumer prices in every year

Inflation is variable
Real and nominal interest rates do not
always move together

Periods of deflation
Real interest rate exceeds the nominal
interest rate
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Figure 3
Real and Nominal Interest Rates

This figure shows nominal and real interest rates using annual data since 1965. The nominal
interest rate is the rate on a 3-month Treasury bill. The real interest rate is the nominal interest
rate minus the inflation rate as measured by the consumer price index. Notice that nominal and
real interest rates often do not move together.
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