Measuring the Cost of Living
Chapter 11: Measuring the Cost of Living
Chapter Objectives
Understand the Consumer Price Index (CPI)
Definition: A measure of the overall cost of the goods and services bought by a typical consumer.
Calculation methods and uses:
Used to calculate inflation rates.
Determines cost of living adjustments.
Calculate Annual Inflation Rate:
Using CPI data for specific years.
Evaluate Problems with the CPI:
Understanding the seriousness of these issues.
Compare CPI with GDP Deflator:
Use CPI for Dollar Comparison Across Years:
Importance of adjusting values for inflation.
Correct Interest Rates for Inflation:
11-1 The Consumer Price Index
Definition of CPI
Consumer Price Index (CPI):
A measure that reflects the overall cost of goods and services purchased by a typical consumer.
Monitors changes in the cost of living over time.
Computed and reported monthly by the Bureau of Labor Statistics (BLS).
Serves as an indicator of the value of money held by consumers.
Calculation of the CPI
Fix the Basket:
The BLS surveys consumers to determine the basket of goods and services typical of consumer habits.
Find Prices:
The BLS gathers pricing data on all items in the basket.
Compute the Basket's Cost:
Price data is used to compute the total cost of the basket.
Isolate Effects of Price Changes:
Calculation aims to identify the changes in prices over time.
Typical Basket of Goods and Services
Different categories show how consumers allocate spending.
Each category's spending percentage is termed “relative importance.”
Example of CPI Calculation
Calculate Inflation Rate: [ \text{Inflation Rate} = \frac{\text{CPI this year} - \text{CPI last year}}{\text{CPI last year}} \times 100 ]
Example Data Table:
Year | Price of Hot Dogs | Price of Hamburgers |
|---|---|---|
2022 | $1 | $2 |
2023 | $2 | $3 |
2024 | $3 | $4 |
Steps for CPI Calculation:
Survey Consumers:
Fixed basket consists of 4 hot dogs and 2 hamburgers.
Calculate Cost For Each Year:
2022: [ (1\times4) + (2\times2) = 8 ]
2023: [ (2\times4) + (3\times2) = 14 ]
2024: [ (3\times4) + (4\times2) = 20 ]
Set Base Year and Compute CPI:
Base year 2022 CPI = 100.
2023: [ \frac{14}{8} \times 100 = 175 ]
2024: [ \frac{20}{8} \times 100 = 250 ]
Inflation Rate Calculation:
From 2022 to 2023: [ \frac{175 - 100}{100} \times 100 = 75\% ]
From 2023 to 2024: [ \frac{250 - 175}{175} \times 100 = 43\% ]
Problems in Measuring the Cost of Living
Substitution Bias:
As prices change, consumers may substitute cheaper goods, but CPI does not account for this shift.
Introduction of New Goods:
New products increase variety and value, leading to an understated CPI.
Unmeasured Quality Change:
Improvements in product quality tend to be inadequately captured, resulting in a likely CPI overstatement.
GDP Deflator vs. CPI
GDP Deflator:
Reflects prices for all domestically produced goods and services.
Compares current prices to same goods in base year.
CPI:
Reflects costs of goods/services typically bought by consumers.
Inclusive of imported goods, while GDP deflator is not.
Indexation
Definition: The automatic adjustment of nominal amounts for inflation.
Examples include COLAs in employment contracts and adjustments in Social Security payments.
Nominal vs. Real Interest Rates
Nominal Interest Rate: Reported rate without inflation adjustment.
Real Interest Rate: [ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} ]
Example Calculation:
Nominal = 9%, Inflation = 3.5%, Real Rate = 5.5%.
Conclusion
Inflation leads to a decrease in purchasing power.
Understanding CPI and price indexes is crucial for economic analysis and comparisons across time.
Self-Assessment Questions
Why do imported goods impact CPI differently than the GDP deflator?
Reflect on the consequences of inflation on purchasing power for consumers.