The Cost of Living/Inflation

The cost of living

Changes in prices impact how much we can buy.
Prices change at different speeds across time and place.
Changing prices have effects on people’s incentives and
choices.
• Price levels determine the relative value of
salaries, savings and borrowing, and the relative
cost of living in a different city.
How do we measure
Inflation?
 The market basket
The prices of many different goods and services must be
considered when comparing the cost of living across time
and place.
The market basket is a list of specific goods and services in
fixed quantities.
• The goal is to use this to see how the cost of buying these
goods and services changes over time and location.
• Items typically purchased by individuals.
• Keeping the quantities of each item constant ensures that
changes only reflect price changes.
 The market basket
Consider changes in the prices of four items you typically buy at the grocery
store.
How much did the cost of groceries rise between years?

Item Quantity Price last year Price this year

purchased
Bread (per loaf) 1 3.00 3.15
Milk (per litre) 1 2.50 2.55
Meat (per kg) 3 3.50 3.64
Carrots (per kg) 1 1.00 1.25

Cost last year = (3.00 × 1) + (2.50 × 1) + (3.50 × 3) + (1.00 × 1) = 17.00

Cost this year = (3.15 × 1) + (2.55 × 1) + (3.64 × 3) + 1.25 × 1) = 17.87
Price increase = [(17.87 - 17)/17] × 100 = 5.1%
 Price Indices:

 Different price indices are:

1.Consumer price index

2.Wholesale price index

 Consumer price index

The Consumer Price Index (CPI) is a measure that

tracks changes in the cost of a basket of goods and
services purchased by a typical household.

• CPI is the most commonly used index tool for

tracking changes in the cost of living in India.
 Consumer Price Index
• The CPI is the price of a representative market basket of
goods relative to the price of that same basket during a
benchmark/base year (multiplied by 100).

Cost of Market Basket in year t

CPI t   100
Cost of Market Basket in Base year

• By definition, the index always equals 100 in the base year.

• The index will be greater than 100 if the cost of the basket is
greater than the base-year cost.
• The index will be less than 100 if the cost of the basket is less
than the base-year cost.
 CPI in India
• CPI is a weighted average of prices. The weight on each price reflects that
good’s relative importance in the CPI’s basket. Note that the weights remain
fixed over time. Household survey is conducted to find out consumption of a
typical household.

The three consumer price indices are:

• CPI- for urban area (basket contains 460 items)
• CPI- for rural area (basket contains 448 items) and the
• CPI – combined
• Base for the index is 2012 ( January to December)=100.

• CPI series is published by the Central Statistics Office separately for rural,
urban and combined every month with effect from January, 2011.
 CPI in India
Old Series of CPI (Weights Revised Series of CPI
computed on the basis CES (Weights computed on the
Group Description 2004-05) basis CES 2011-12)
Rural Urban Combd. Rural Urban Combd

Food and beverages 56.59 35.81 47.58 54.18 36.29 45.86

Pan, tobacco and 2.72 1.34 2.13 3.26 1.36 2.38

intoxicants

Clothing and Footwear 5.36 3.91 4.73 7.36 5.57 6.53

Housing - 22.54 9.77 - 21.67 10.07

Fuel and Light 10.42 8.40 9.49 7.94 5.58 6.84

Miscellaneous 24.91 28.00 26.31 27.26 29.53 28.32

(Education, Medical care
etc.)
Total 100.00 100.00 100.00 100.00 100.00 100.00
The challenges in measuring price changes
The challenge is that the basket of goods remains fixed
even if consumers substitute between similar goods
• If the relative price of goods changes, the quantities
change as well.
• As new goods and services become available (innovation),
people will adjust what they consume.
The CPI keeps types and quantities of goods constant,
which does not account for consumption changes.

Ignores Quality changes .

 The inflation rate
 
The inflation rate is the size of the change in the overall
price level.
It is calculated as the percentage change in the CPI from
year to year:
 Calculating inflation rates
Calculate the inflation rates for 2015, 2016 and 2017 using
the following information.

Year CPI Inflation Rate

2014 100 –

2015 110 Blank

2016 238 Blank

2017 220
 Solution
Calculate the inflation rates for 2015 and 2016 using the
following information.

Year CPI Inflation Rate

2014 100 –

2015 110 (110 - 100)/100 × 100 = 10%

2016 238 (238 - 138)/138 × 100 = 72.7%

2017 220 (220 - 238)/100 × 100 = -18%

 The inflation rate
There are several common ways to report inflation.
The CPI:
• Headline inflation measures price changes for the entire
market basket.
• Core inflation measures price changes with food and
energy costs removed.
• Energy and food prices fluctuate often, which could
over- or understate the real change in overall prices.
Producer price index (PPI) measures the prices of goods and
services purchased by firms.
GDP deflator measures the prices of goods and services
produced in the country.
 Wholesale Price Index (WPI):
• Like CPI, WPI is a measure of cost of a given basket of goods.

• WPI is an economy-wide index covering 697 commodities and

2011-12 as the base year. Weights of the commodities are
derived based on the value of quantities traded in the domestic
market.

• It is the comprehensive measure of economy-wide inflation.

• CPI measures prices at retail level, WPI is constructed at

wholesale level. WPI measures average level of prices of goods
sold by producers. In WPI, fuel group gets a much higher
weightage and services not included.
 Deflating nominal variables using CPI

Suppose a worker made Rs 100/day in 1993.

How much is this worth today if the CPI in 1993
was 142 and today it is 237?
 Deflating nominal variables Solution

Suppose a worker made Rs. 100/day in 1993. How

much is this worth today if the CPI in 1993 was 142
and today it is 237?

Rs. 100 in 2016 prices = Rs. 100 × (237/142) = Rs. 166. 9/-

 Any nominal value in year X can be put into year Y value

using:
 Adjusting for inflation: Indexing
Indexing is a practice of automatically increasing
payments in proportion to the cost of living.
• These payments are often referred to as “cost-of-
living adjustments.”

Examples:
- Social security (increases in accordance with the
cost of living)
- Minimum wage increases
 Adjusting for inflation: Indexing
A fundamental theory in macroeconomics states that wages
should naturally rise to offset the effects of inflation.
• However, there are times when some prices change faster
than wages.
Indexing is a practice of automatically increasing payments
in proportion to the cost of living.
• These payments are often referred to as “cost-of-living
adjustments.”
 Adjusting for inflation: Minimum wage
While minimum wage has increased over time, the real value
of minimum wage has fallen since the late 60s.

• The nominal
minimum wage has
steadily increased
since the 1940s.
• The real value has
fluctuated as
Congress has
adjusted the
nominal value to
try to keep up with
inflation.
Source: https://www.dol.gov/featured/minimum-wage/chart1.
 Purchasing power indexes
Purchasing power indexes (PPIs) help describe differences
in prices across locations.
Developing a purchasing power index is similar to creating a
price index:
1. Find a market basket of foods and services to compare
across countries.
2. Measure the price of the goods in each country.
3. Calculate the cost of purchasing the basket in each
country.
4. Build an index showing how much the basket costs in
each country relative to some base.
 Purchasing power indexes
One example of a PPI is the Big Mac Index
LESS PRICE AS HIGHER PURCHASING
POWER
• Uses McDonald’s
Big Mac as the
basket.
• Compares the
price of a Big Mac
in each country to
the U.S.

MORE PRICE AS LOWER PURCHASING

POWER

Source: Interactive data from The Big Mac Index © The Economist, http://www.economist.com/content/big-mac-index.
 Calculating PPI-adjusted GDP

Suppose Argentina has a GDP per capita of $10,942 USD

and that the cost of living is 30.2% lower than the United
States. What is the PPI-adjusted GDP for Argentina?
 Solution
Suppose Argentina has a GDP per capita of $10,942 USD
and that the cost of living is 30.2% lower than the United
States. What is the PPI-adjusted GDP for Argentina?

1
 
PPI − adjusted GDP per capita=$ 10,972 ×
[
1− .302 ]
=$ 𝟏𝟓 ,𝟕𝟏𝟗
 PPP-adjustment
 
The PPP-adjustment recalculates economic statistics to
account for differences in price levels across countries.
For example, to compare GDP across countries:

The price level adjustment is the percentage difference in

purchasing power between the two countries.