Chapter 24

MEASURING THE COST OF LIVING

 The consumer price index is
used to monitor changes in the
cost of living over time.

Consumer Price
index
When the consumer price index
rises, the typical family has to
spend more money to maintain
the same standard of living.
 In the previous chapter we learned how to
measure inflation using the GDP deflator.
As the CPI reflects the goods and services
Consumer Price bought by consumers, it is a more common
Index gauge of inflation. We are going to learn
how to measure the inflation rate using the
consumer price index.
What is Consumer Price Index?
The consumer price index (CPI) is a measure of the overall
cost of the goods and services bought by a typical consumer.
The Bureau of Labor Statistics reports the CPI each month.
It is used to monitor changes in the cost of living over time.
  Fix the Basket: Determine what prices
are most important to the typical
consumer.
◦ The Bureau of Labor Statistics (BLS)
How the identifies a market with the basket of
Consumer goods and services the typical
Price Index is consumer buys.
◦ The BLS conducts monthly consumer
calculated? surveys to set the weights for the prices
of those goods and services.
 Find the Prices: Find the prices of each
How the of the goods and services in the basket
Consumer for each point in time. Example of
hotdogs and hamburgers from the book.
Price Index is
calculated
 How the Compute the Basket’s Cost: Use the
Consumer data on prices to calculate the cost of the
basket of goods and services at different
Price Index is times.
calculated
 How the Choose a Base Year and Compute the Index:
◦ Designate one year as the base year, making it the
Consumer benchmark against which other years are compared.
◦ Compute the index by dividing the price of the basket
Price Index is in one year by the price in the base year and
multiplying by 100.
calculated
Formula of CPI
Cont…
The Inflation Rate
◦ The inflation rate is calculated as follows:

C P I in Y e a r 2 - C P I in Y e a r 1
In fla tio n R a te in Y e a r 2 = 100
C P I in Y e a r 1
Cont….
Although the example simplifies the real-world problem by including two goods,
it shows how the BLS computes the consumer price index and the inflation rate.
In addition to the CPI for overall economy, the BLS calculates several other price
indexes.
It calculates the producer price index(PPI) which measures the cost of a basket
of goods and services bought by firms rather than consumers.
Because firms eventually pass on their costs to consumers in the form of higher
consumer prices, changes in PPI are thought to be useful in predicting changes
in the CPI.
Problems in Measuring the Cost of
Living
CPI measures how much income must rise to maintain a
constant standard of living.
CPI is not a perfect measure of the cost of living.
There are 3 problems with the CPI measure:
1. Substitution Bias
2. Introduction of new goods
3. Unmeasured quality change
1. Substitution Bias
Consumers buy less of the goods whose prices change in relatively
large amount
Consumers buy more of the goods whose prices have increased in
lesser amount or might have fallen perhaps.
Consumers substitute towards goods that have become relatively less
expensive.
If price index is calculated using a fixed basket of goods it ignores the
possibility of consumer substitution and so overstates the increase in
the cost of living from one year to the next.
Example of Substitution bias
Suppose apple are cheaper than pears in the base year, so
consumers will buy more apple than pears. Hence when the BLS
constructs a basket of goods, it includes more apples than pears.
Now suppose pears are cheaper, consumers will naturally respond to
buying more pears than apple.
Since the BLS uses a fixed basket, which assumes buying the
expensive apples in the same quantities as before so the index will
measure a much larger increase in the cost of living than consumers
actually experience.
2. Introduction of new goods
People choose stores with greater variety. The increased set of
possible choices make each dollar more valuable.
As goods are introduced, consumers have more choices, and each
dollar is worth more.
As the CPI is based on a fixed basket of goods and services it does not
reflect the increase in the value of dollar that arises from the
introduction of new goods.
ADD- Example of VCR. The cost of living associated with the
introduction of VCR is not shown up in the index.
3.Unmeasured quality change
If the quality of the good deteriorates from one year to the
next while its price remains the same, the value of a dollar
falls because you are getting a lesser good for the same
amount of money.
Similarly, if the quality rises from one year to the next, the
value of a dollar rises.
Eg Suppose a car model gets better gas mileage from one
year to the next year, the Bureau adjust the price of the good
to account for quality change.
Cont…
When the quality of a good in the basket changes, the Bureau adjusts
the price of the good to account for the quality change.
Point here to be noted is that quality is hard to measure.
Several studies during the 1990s concluded that the consumer price
index (CPI) overstated inflation by 1 percent per year.
By certain techniques adapted by the BLS the bias is half as large as it
was.
This issue is important as many government programs uses CPI to adjust
for changes in the overall price level.
The GDP The GDP deflator is the ratio of nominal GDP to real GDP.
Because nominal GDP is current output valued at current
Deflator prices and real GDP is current output valued at base year
prices, the GDP Deflator reflects the current level of
versus the prices relative to the level of prices in the base year.

CPI

CPI reflects the prices of goods and services bought by a consumer

Why do GDP Deflator and CPI diverge
There are two reasons for the divergence:
1. GDP deflator reflects the price of goods and services
produced domestically whereas the consumer price index
reflects the prices of all goods and services bought by
consumers. E.g. Suppose price of airplane produced by Boeing
rises, even though the plane is part of GDP, it is not part of the
basket of goods and services bought by a typical consumer. The
price increase shows up in the GDP deflator but not the
consumer price index.
Example of Volvo as part of CPI
Suppose the car brand Volvo raises the price of its
cars. Because Volvos are made in Sweden, the car is
not part of U.S GDP. But U.S consumers buy Volvo’s,
so the car is a part of the typical consumer’s basket of
goods. Hence, a price increase in an imported
consumption good, such as Volvo shows up in CPI but
not GDP deflator.
Example of oil imported
Another very good example where the difference is spotted
is particularly when the price of oil changes. Although the
United States produces some oil, much of the oil we use is
imported. As a result, oil and other products such as
gasoline represents much of the consumer spending than
GDP.
When price of oil rises, the CPI rises much more than GDP
deflator
Why does convergence occur?
2.The second difference is how various prices are weighted to yield a single
number for the overall level of prices.
The CPI compares the price of fixed basket of goods and services to the
price of the basket in the base year. They do not change the basket
frequently. However, the GDP Deflator compares the price of currently
produced goods and services to the price of the same goods and services in
the base year. Thus, the group of goods and services used to compute the
GDP Deflator changes over time automatically.
If all prices are changing proportionately then the difference is not
important.
The GDP Deflator Vs the Consumer
Price Index
Figure 2 shows the inflation rate measured by both GDP Deflator and the
CPI for each year since 1965. We can see sometimes the two measures
diverge.
In 1979 and 1980 CPI inflation spiked up more than the GDP Deflator
largely because oil prices more than doubled during these two years. Yet
divergence between these two measures is an exception rather than the
rule.
In 1970s, both the GDP Deflator and the consumer price index show high
rates of inflation. In the late 1980s, 1990s and the first decade of the
2000s both measures show low rates of inflation.
CORRECTING ECONOMIC
VARIABLES FOR THE EFFECTS OF
INFLATION
Price indexes are used to correct for the effects of inflation when
comparing dollar figures from different times.
 Indexation- When some dollar amount is automatically corrected for
inflation by law or contract, the amount is said to be indexed for inflation.
Indexation is a feature of many laws. Social security benefits, for
example are adjusted every year to compensate the elderly for increase
in prices.
Federal income tax brackets- the income levels at which tax change are
also indexed for inflation.
Real and Nominal Interest Rate
The interest rate that is not
corrected for inflation and
measures the change in the
dollar amounts is called the
nominal interest rate.
Real Interest rate= Nominal
interest rate- Inflation rate
Below is an equation
The interest rate corrected
connecting nominal Interest
for the effects of inflation is
rate, real interest rate and
called the real interest rate.
inflation.
The nominal interest rate
The real interest rate tells
tells you how fast the
you how fast the purchasing
number of dollars in your
power of your bank account
bank account rises over
rises over time.
time.
Equation
connecting real
interest rate, Real Interest rate=
nominal interest Nominal interest rate-
rate and the
inflation rate Rate of Inflation
 Figure 3 Real and Nominal Interest Rates

Interest Rates Figure 3 shows real and nominal

(percent interest rates in the US economy
per year) since 1965. Here the inflation
15 rate is measured as the
percentage change in the
consumer price index.
10 Nominal interest rate
The figure also shows that real
and nominal interest rate do not
move together. For example, in
5 the late 1970s nominal interest
rates were high. But because
inflation was very high, real
interest rate were low. During
0 much of the 1970s real interest
rates were negative, because
Real interest rate inflation hindered people’s
savings more quickly than
–5 nominal interest payments
1965 1970 1975 1980 1985 1990 1995 2000
increased them.
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Real and nominal interest rate
continued..
The nominal interest rate almost exceeds the real interest
rate. This reflects the fact that the U.S economy has
experienced rising consumer prices in almost every year
during the period. By contrast, if you look at data for the
U.S economy during the late 19th century(in recent years),
we can see periods of deflation. During deflation, the real
interest rate exceeds the nominal interest rate.
Conclusion
Persistent increase in overall level of prices is the norm.
Inflation reduces the purchasing power of each unit of money over time.
Price indexed allow us to compare dollar figures from different points in time.
The nominal interest rate is the interest rate usually reported. It is the rate at
which the number of dollars in a savings account increases over time.
Real interest rate takes into account changes in the value of dollar over time.
The real interest rate is equal to the nominal interest rate minus the rate of
inflation