Measuring the Cost of Living

Economics

Consumer price index

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

How CPI is calculated

1) fix the basket 2) find the prices 3) compute the basket’s cost 4) chose a base year and compute the index 5) compute the inflation rate

Inflation

the percentage change in the price index from the preceding period

Core CPI

measure of the overall cost of consumer goods and services excluding food and energy

Producer price index PPI

measure of the cost of a basket of goods and services bought by firms

Problems in measuring the cost of living

substitution bias; introduction of new goods; unmeasured quality change

substitution bias

consumers substitute toward goods that become relatively cheaper, the CPI misses this because it uses a fixed basket; therefore, CPI overstates increases in cost of living

Introduction of new goods

increases variety, consumers find more suitable products, CPI misses this 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, BLS misses some quality changes

GDP deflator

Ratio of nominal GDP to real GDP; reflects prices of all G&S produced domestically; compares price of currently produced goods and services to price of the same goods and services in the base year

CPI

reflects prices of goods and services bought by consumers, compares price of a fixed basket of G&S to price of the basket in the base year

Nominal interest rate

Interest rate as usually reported without a correction for the effects of inflation

real interest rate

Interest rate corrected for the effects of inflation; nominal interest rate- inflation

Indexation

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

Difference between CPI and GDP deflator

increases in the prices of foreign produced goods that are sold to us consumers how up in the CPI but not in the GDP deflator