Chapter 11 - Measuring the Cost of Living

11.1 The Consumer Price Index

How the Consumer Price Index Is Calculated:

• Consumer price index (CPI)- a measure of the overall cost of the goods and services bought by a typical consumer

• Inflation rate- the percentage change in the price index from the preceding period

• Producer price index- a measure of the cost of a basket of goods and services bought by firms

  

Problems in Measuring the Cost of Living:

• Substitution bias- when the price change from one year to the next, changes disproportionately
• Introduction of new goods- when a new good is introduced, consumers have more variety from which to choose, and it reduced the cost of maintaining the same level of the economic well-being
• Unmeasured quality change- when the quality of a good deteriorate from one year to the next while its price remains the same, the value of a dollar falls because you’re getting a lesser good for the same amount of money

The GDP Deflator versus the Consumer Price Index:

• The GDP deflator- the measure of the overall level of prices in the economy

  • Reflects the prices of all goods and services produced domestically

• Consumer Price Index

  • Reflects the prices of all goods and services bought by consumers

  

11.2 Correcting Economic Variables for the Effects of Inflation

Dollar Figures from Different Times:

• The purpose of measuring the overall level of prices in the economy is to allow us to compare dollar figures from different times

Indexation:

• Indexation- the automatic correction by law or contract of a dollar amount for the effects of inflation
  • An example would be long-term contracts between firms and unions include partial or complete indexation of the wage to the consumer price index
  • It is called a cost-of-living allowance

Real and Nominal Interest Rates:

• Nominal interest rate- the interest rate as usually reported without a correction for the effects of inflation

• Real interest rate- the interest rate corrected for the effects of inflation

• Real interest rate = Nominal interest rate – Inflation rate.