Chapter 11- Measuring the cost of living

Consumer price index

CPI- overall cost of goods/services bought by a consumer

Core CPI

overall cost of consumer goods/services excluding food/energy

Producer price index

PPI- cost of a basket of goods and services sold by domestic firms

How is CPI calculated?

1. BLS surveys consumers to find what goods/services they buy (basket)

2. BLS finds data on the prices of these goods

3. Use prices to compute total cost

4. Choose a base year

CPI formula

basket cost in current year/basket cost in base year x 100

CPI inflation rate formula

(CPI this year - CPI last year)/CPI last year x 100

3 problems with CPI

substitution bias, introduction of new goods, unmeasured quality change

Substitution bias

Over time, prices of some goods increase faster than others, so consumers substitute cheaper goods. Since the CPI has a fixed basket of goods, it doesn’t account for these changes and thus overstates inflation

Introduction of new goods

When there is increased variety of goods, the value of a dollar increases. CPI misses this (with its fixed basket of goods) and overstates the cost of living

Unmeasured quality changes

An increase in the quality of a good increases the value of a dollar. It is difficult for the BLS to account for these changes in quality

Are imported consumer goods part of GDP or CPI?

CPI (not GDP)

Are capital goods (investments) part of GDP or CPI?

GDP (not CPI)

Main difference between GDP and CPI

CPI- fixed basket, the prices of all things bought by consumers

GDP- not fixed basket, the prices of all things produced domestically

Converting dollar figures from different time periods formula

Amount in today’s dollars= amount in year T x (CPI today/CPI in year T)

Indexation

automatic correction to salary of a dollar amount for effects of inflation

What does indexation look like?

An increase in CPI can lead to changes in the COLA in many multi year labor contracts OR adjustments in social security payments and federal income tax brackets

COLA

cost of living allowance

Nominal interest rate

interest rate not corrected for inflation- it measures the rate of growth in dollar value of a deposit or debt

Real interest rate

corrected for inflation- rate of growth in the purchasing power of a deposit or debt

Real interest rate formula

Real interest rate= nominal interest rate - inflation rate