Mankiw, cha. 11 - Measuring the Cost of Living

Consumer Price Index (CPI)

1). a statistic used to monitor changes in the cost of living,

2). measures the overall cost of the goods and services bought by a typical consumer.

CPI formula

Consumer Price Index = (Price of basket of goods and services in current year/Price of basket in base year) x 100

inflation

the situation in which the overall price level of the economy is rising

deflation

the situation in which the overall price level of the economy is falling

inflation rate

the percentage change in the price index from the preceding period.

the five steps of computing CPI (followed by the BLS):

1). Fix the basket - determine which prices are most important to consumers.

2). Find the prices - find the prices of each of the goods and services in the basket at each point in time.

3). Compute the basket’s cost - use the data on prices to calculate the cost of the basket of goods and services at different times.

4). Choose a base year and compute the index.

5). Compute the inflation rate.

inflation rate formula (determined using CPI):

inflation rate in year 2 = {(CPI in year 2 - CPI in year 1)/CPI in year 1} x 100

core CPI

a CPI index for all goods and services, excluding food and energy

producer price index (PPI)

measures the prices of the output of domestic producers

three problems inherent with CPI:

1). substitution bias,

2). introduction of new goods,

3). unmeasured quality change.

substitution bias

Consumers substitute toward (in favor of) goods that become relatively less expensive. Because the basket of goods is fixed from year to year, CPI ignores consumer substitution bias when calculating change in the cost of living.

introduction of new goods

The introduction of new goods increases the variety available to consumers. This, in turn, makes each dollar more valuable because it can buy more for less. But CPI is based on a fixed basket of goods, so it does not account for the increase in the value of the dollar that comes from the introduction of new goods.

unmeasured quality change

Depending on the change in quality of a good, consumers may be paying more money for shoddy products, or less money for higher quality products. When the quality of a good rises, the value of the dollar rises as well.

formula for converting dollar figures from year T into current-day dollar

amount in today’s dollars = amount in year T dollars x (price level today/price level in year T)

regional price parities

measure differences in the cost of living from state to state

indexed (adjective)

the automatic correction by law or contract of a dollar amount for the effects of inflation.

Example: Some long-term contracts between firms and unions include partial or complete indexation of the wage to the CPI. This is called a “cost-of-living allowance” (COLA), because this automatically raises the wage when the CPI rises.

cost-of-living allowance (COLA)

automatically raises the wages of a firm or union to proportion, whenever the CPI rises

nominal interest rate

the interest rate as usually reported without a correction for the effects of inflation; tells you how fast the number of dollars in your bank account rises over time

real interest rate

the interest rate corrected for the effects of inflation; tells you how fast the purchasing power of your bank account rises over time.

formula for comparing real interest rate, nominal interest rate, and inflation rate:

real interest rate = nominal interest rate - inflation rate.