measuring cost of living (ch 11)

Consumer price index (CPI)

• measure of the overall cost of goods and services bought by a typical consumer

• monitor changes in teh cost of living over time

CPI = [Basket’s cost in current year / Basket’s cost in the base year] x 100

How is the CPI calculated?

1. Fix the basket
   - the bureau of labor statisitcs (BLS) surveys consumers to find the basket of goods and services bought by the typical consumer

2. Find the prices
   - the BLS collects data on the prices of al lthe goods in the basket

3. Compute the basket’s cost
   - use the prices to compute the total cost of the basket.

4. Choose a base year and compute the CPI
   - deignate a year as the base year (benchmark)

5. Compute the inflation rate
   - percentage change in teh CPI from teh preceding period

Infaltion rate (CPI)

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

Substitution bias

• some prices rise faster than others over time

• 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

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 effect because it uses a fixed basket of goods.

Unmeasured quality change

• improvements in the quality of goods in the basket increase the value of each dollar

• the BLS tries to account for quality changes, but probably misses some, as quality is hard to measure.

• Thus, the CPI overstates increases in the cost of living.

Imported consumer goods

• included in CPI but excluded from GDP deflator

Capital goods

• excluded from CPI but included in GDP deflator

the basket

• CPI: fixed basket; prices of all goods and services bought by consumers

• GDP deflator: prices of all goods and services currently produced domestically.