CHAPTER

Measuring the Cost of Living

Economics
PRINCIPLES OF

N. Gregory Mankiw

© 2009 South-Western, a part of Cengage Learning, all rights reserved

In this chapter,
look for the answers to these questions:
 What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
 What are the problems with the CPI? How serious
are they?
 How does the CPI differ from the GDP deflator?
 How can we use the CPI to compare dollar
amounts from different years? Why would we want
to do this, anyway?
 How can we correct interest rates for inflation? 2
 The Consumer Price Index (CPI)
 GDP deflator is way to measure the economy’s
inflation rate, computed as the percentage
increase in the GDP from one year to the next.
 CPI also measures the percentage change in the
prices (inflation) in an economy over the years
 measures the typical consumer’s cost of living
 the basis of cost of living adjustments (COLAs) in
many contracts and in Social Security

MEASURING THE COST OF LIVING 3

 How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Statistics surveys the consumers
to determine what’s in the typical consumer’s
“shopping basket.”
2. Find the prices.
The BS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.

MEASURING THE COST OF LIVING 4

 How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
cost of basket in current year
100 x
cost of basket in base year

5. Compute the inflation rate.

The percentage change in the CPI from the
preceding period.
Inflation CPI this year – CPI last year
= x 100%
rate CPI last year
MEASURING THE COST OF LIVING 5
EXAMPLE basket: {4 pizzas, 10 cloth}

price of price of
year cost of basket
Pizza cloth
2007 $10 $2.00 $10 x 4 + $2 x 10 = $60
2008 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2009 $12 $3.00 $12 x 4 + $3 x 10 = $78
using 2007 base year:
Compute CPI in each year Inflation rate:
2007: 100 x ($60/$60) = 100 115 – 100
15% = x 100%
100
2008: 100 x ($69/$60) = 115
130 – 115
13% = x 100%
2009: 100 x ($78/$60) = 130 115

MEASURING THE COST OF LIVING 6

ACTIVE LEARNING 1
Calculate the CPI price price of
CPI basket: of beef chicken
{10 kgs beef,
2004 $4 $4
20 kgs chicken}
The Cost of basket cost 2005 $5 $5
$120 in 2004, the base year. 2006 $9 $6

A. Compute the CPI in 2005.

B. What was the CPI inflation rate from 2005-2006?

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 What’s in the CPI’s Basket?
4% 3% Housing
6%
Transportation
6%
Food & Beverages
6% 43%
Medical care

Recreation

Education and
15%
communication
Apparel

17% Other

MEASURING THE COST OF LIVING 10

 Problems with the CPI:
Substitution Bias
 Over time, some prices rise faster than others.
 Consumers substitute toward goods that become
relatively cheaper.
 The CPI misses this substitution because it uses
a fixed basket of goods.
 Thus, the CPI overstates increases in the cost of
living.

MEASURING THE COST OF LIVING 11

 Problems with the CPI:
Introduction of New Goods
 The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
 In effect, dollars become more valuable.
 The CPI misses this effect because it uses a
fixed basket of goods.
 Thus, the CPI overstates increases in the cost of
living.

MEASURING THE COST OF LIVING 12

 Problems with the CPI:
Unmeasured Quality Change
 Improvements in the quality of goods in the
basket increase the value of each dollar.
 The B. of Statistics tries to account for quality
changes
but quality is hard to measure.
 Thus, the CPI overstates increases in the cost of
living.

MEASURING THE COST OF LIVING 13

 Two Measures of Inflation, 1950-2007
Percent
Percent
15
15
per
per Year
Year

10
10

55

00

-5
-5
1950
1950 1955
1955 1960
1960 1965
1965 1970
1970 1975
1975 1980
1980 1985
1985 1990
1990 1995
1995 2000
2000 2005
2005
CPI
CPI GDP
GDP deflator
deflator

MEASURING THE COST OF LIVING 14

 Contrasting the CPI and GDP Deflator
Imported
Imported consumer
consumer goods:
goods:
 included
included in
in CPI
CPI
 excluded
excluded from
from GDP
GDP deflator
deflator
Capital
Capital goods:
goods:
 excluded
excluded from
from CPI
CPI
 included
included in
in GDP
GDP deflator
deflator
The
The basket:
basket: (if
(if produced
produced domestically)
domestically)
 CPI
CPI uses
uses fixed
fixed basket
basket
 GDP
GDP deflator
deflator uses
uses basket
basket of
of
currently
currently produced
produced goods goods && services
services
This
This matters
matters ifif different
different prices
prices are
are
changing
changing byby different
different amounts.
amounts.
MEASURING THE COST OF LIVING 15
ACTIVE LEARNING 4
Converting to “today’s dollars”
Annual tuition and fees, average of all public four-
year colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)
After adjusting for inflation, did students pay more
for college in 1986 or in 2006? Convert the 1986
figure to 2006 dollars and compare.

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ACTIVE LEARNING 4
Answers
Annual tuition and fees, average of all public four-
year colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)
Solution
Convert 1986 figure into “today’s dollars”
$1,414 x (203.8/109.6) = $2,629
Even after correcting for inflation, tuition and fees
were much lower in 1986 than in 2006!
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 Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
The nominal interest rate:
 the interest rate not corrected for inflation
 the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
 corrected for inflation
 the rate of growth in the purchasing power of a
deposit or debt
Real interest rate
= (nominal interest rate) – (inflation rate)
MEASURING THE COST OF LIVING 18
 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%.

MEASURING THE COST OF LIVING 19

 Real and Nominal Interest Rates in the U.S.,
1950-2007

15
15
year)
per year)

10
10
Rates
Interest Rates
(percent per

55
Interest
(percent

00

-5
-5

-10
-10
1950
1950 1955
1955 1960
1960 1965
1965 1970
1970 1975
1975 1980
1980 1985
1985 1990
1990 1995
1995 2000
2000 2005
2005
Nominal
Nominal interest
interest rate
rate Real
Real interest
interest rate
rate

MEASURING THE COST OF LIVING 20

 Types of inflation
Galloping Inflation -: Very Rapid Inflation which is
almost impossible to reduce.
Creeping Inflation -: Circumstance where the
inflation of a nation increases gradually, but
continuously, over time. Although the increase is
relatively small in the short-term, as it continues
over time the effect will become greater and
greater.

MEASURING THE COST OF LIVING 21

 Hyper Inflation -: Hyperinflation is caused
mainly by excessive deficit spending (financed by
printing more money) by a government, some
economists believe that social breakdown leads
to hyperinflation (not vice versa), and that its
roots lie in political rather than economic causes.

MEASURING THE COST OF LIVING 22

 CAUSES OF INFLATION
 Demand Push Inflation:
 Increase in money supply
 Increase in disposable income
 Deficit financing
 Foreign exchange reserves

MEASURING THE COST OF LIVING 23

 CAUSES OF INFLATION
 Cost Push inflation
 Cost-push inflation is the decrease in the
aggregate supply of goods and services
stemming from an increase in the cost of
production.
 An increase in the costs of raw materials or labor
can contribute to cost-pull inflation.

MEASURING THE COST OF LIVING 24

CHAPTER SUMMARY

 The Consumer Price Index is a measure of the

cost of living. The CPI tracks the cost of the typical
consumer’s “basket” of goods & services.
 The CPI is used to make Cost of Living
Adjustments and to correct economic variables for
the effects of inflation.
 The real interest rate is corrected for inflation
and is computed by subtracting the inflation rate
from the nominal interest rate.
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