Chapter 6

Measuring the Cost of Living

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 Learning Objectives
In this chapter, you will …
 Learn how the Consumer Price Index (CPI) is
constructed
 Consider why the CPI is an imperfect measure of the
cost of living
 Compare the CPI and the GDP deflator
• Learn how to use a price index to compare dollar
figures from different points in time
• Learn the distinction between real and nominal
interest rates

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CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION
WE CAN USE THE CPI TO COMPARE
DOLLAR FIGURES FROM DIFFERENT
TIMES
 The value of a dollar changes over time due
to inflation: a dollar today is worth more than
a dollar tomorrow
 This is why we cannot compare dollar values
across time
 We can use the CPI to inflate past $ values
or to deflate current $ values
CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION
 Assume that the price of gasoline was 9.5 cents per liter in 1957,
and $1.30 a liter in 2018. Was the 1957 price of 9.5 cents per litre
high or low compared with the 2018 price of gas ($1.30 per litre)?
 To compare the 1957 price of gas with the 2018 price, we need to
inflate the price of 9.5 cents per litre to turn 1957 dollars into 2018
dollars.
 The Bank of Canada’s Inflation
FYI Calculator
https://www.bankofcanada.ca/rates/r
elated/inflation-calculator/

A basket of goods and services that cost $100

in 1914 would cost how much in 1973?
In 1983? In 1993? In 2003? In 2018?

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 A C T I V E L E A R N I N G 4: Comparing Dollar
Figures from Different Points in Time

Suppose that in 1995 the CPI was 34.5 and in

2020 it was 104.2. The cost of a case of Okanagan
freestone peaches in 1995 was $10, in 2015, it is
$24.
a. What is the equivalent cost of a 1995 case of
peaches measured in 2020 prices?
b. What is the equivalent cost of a 2020 case of
peaches measured in 1995 prices?
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 A C T I V E L E A R N I N G 4: Comparing Dollar
Figures from Different Points in Time

Suppose that in 1995 the CPI was 34.5 and in

2020 it was 104.2. The cost of a case of Okanagan
freestone peaches in 1995 was $10, in 2020, it is
$24.
c. After correcting for inflation, did a case of
peaches become more expensive?
d. Do both calculations, a. and b. give the same
conclusion?
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 A C T I V E L E A R N I N G 4: Comparing Dollar
Figures from Different Points in Time
Answers

a. Cost of a 1995 case in 2020: $10(104.2/34.5) =

$30.20
b. Cost of a 2020 case in 1995: $24(34.5/104.2) =
$7.95
c. A case of peaches became cheaper
d. Yes, each calculation suggests that a case of
peaches was actually more expensive in 1995.

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Quick
Quiz

Henry Ford paid his workers $5 a day in 1914.

The consumer price index was 5.95 in 1914 and
133 in 2018.
How much is the Ford daily paycheque worth in
2018 dollars?
CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION
INDEXATION
 Indexation: the automatic correction of a dollar
amount for the effects of inflation by law or
contract.
 COLA (cost-of-living allowance) automatically
raises the wage when the CPI raises.
 Correcting Interest Rates for Inflation

Interest = a future payment, a reward for

postponing consumption
Example: $100 invested today at 5% will yield
$100(1*1.05) = $105 one year from now
or 5%*$100 = $5 in interest income

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CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION

REAL AND NOMINAL INTEREST RATES

Nominal interest rate: the interest rate that is
usually reported without a correction for the
effects of inflation.
Real interest rate: the interest rate that is
corrected for the effects of inflation.
 Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
Example:
 Deposit $1,000 for one year.
 Nominal interest rate is 9%.
 During that year, inflation is 3.5%.
 Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
 The purchasing power of the $1000 deposit
has grown 5.5%.
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 case Interest Rates in the Canadian Economy
study

What is the most popular movie of all time?

Copyright © 2020 by Nelson Education Ltd.

 Question
In the country of Hyrkania, the CPI in 2015 was
140 and the CPI in 2016 was 154. Jake, a resident
of Hyrkania, borrowed money in 2015 and repaid
the loan in 2016. If the nominal interest rate on the
loan was 14 percent, what was the real interest
rate?
a. 18 percent
b. 14 percent
c. 10 percent
d. 4 percent
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 Question
In Japan in 2015 nominal interest rates were 1.5
percent and the inflation rate was –0.5 percent.
What was the real interest rate?
a. -2 percent
b. -1 percent
c. 1 percent
d. 2 percent

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 Question
Suppose a borrower and a lender agree on the
nominal interest rate on a loan. Then inflation turn
out to be higher than expected.
a. Is the real interest rate higher or lower than
expected?
b. Who loses and who gains.
c. During the 1970s, inflation was much higher
than expected. How did this affect homeowners
who obtained fixed rate mortgages during the
60s?
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 Problem with Unexpected Inflation

 If the rate of inflation is higher than expected, we

have an arbitrary redistribution of wealth that
benefits borrowers and hurts lenders.
 If the rate of inflation is lower than expected, we
have an arbitrary redistribution of wealth that
benefits lenders and hurts borrowers.

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