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    Cagla Saribayrakdaroglu
    The document discusses measuring inflation and the cost of living using the Consumer Price Index (CPI). It explains that the CPI measures the typical consumer's cost of living by tracking the prices of goods in a fixed market basket. It is calculated by dividing the current cost of the basket by its cost in a base year. Problems with the CPI include substitution bias, failure to account for new goods, and difficulties measuring quality changes, all of which likely cause it to overstate inflation. The CPI differs from the GDP deflator in its inclusion of imported goods and use of a fixed basket. Converting dollar amounts using the CPI allows comparison of monetary values across time by controlling for inflation.

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    Slides 9

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    Cagla Saribayrakdaroglu
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    The document discusses measuring inflation and the cost of living using the Consumer Price Index (CPI). It explains that the CPI measures the typical consumer's cost of living by tracking the prices of goods in a fixed market basket. It is calculated by dividing the current cost of the basket by its cost in a base year. Problems with the CPI include substitution bias, failure to account for new goods, and difficulties measuring quality changes, all of which likely cause it to overstate inflation. The CPI differs from the GDP deflator in its inclusion of imported goods and use of a fixed basket. Converting dollar amounts using the CPI allows comparison of monetary values across time by controlling for inflation.

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    The document discusses measuring inflation and the cost of living using the Consumer Price Index (CPI). It explains that the CPI measures the typical consumer's cost of living by tracking the prices of goods in a fixed market basket. It is calculated by dividing the current cost of the basket by its cost in a base year. Problems with the CPI include substitution bias, failure to account for new goods, and difficulties measuring quality changes, all of which likely cause it to overstate inflation. The CPI differs from the GDP deflator in its inclusion of imported goods and use of a fixed basket. Converting dollar amounts using the CPI allows comparison of monetary values across time by controlling for inflation.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
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    14 views32 pages

    Slides 9

    Uploaded by

    Cagla Saribayrakdaroglu
    The document discusses measuring inflation and the cost of living using the Consumer Price Index (CPI). It explains that the CPI measures the typical consumer's cost of living by tracking the prices of goods in a fixed market basket. It is calculated by dividing the current cost of the basket by its cost in a base year. Problems with the CPI include substitution bias, failure to account for new goods, and difficulties measuring quality changes, all of which likely cause it to overstate inflation. The CPI differs from the GDP deflator in its inclusion of imported goods and use of a fixed basket. Converting dollar amounts using the CPI allows comparison of monetary values across time by controlling for inflation.

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    Measuring the Cost of Living

    In this chapter,
    look for the answers to these questions:
    • What is the Consumer Price Index (CPI)?
    How is it calculated? What’s it used for?
    • What are the problems with the CPI? How
    serious are they?
    • How does the CPI differ from the GDP deflator?
    • How can we use the CPI to compare dollar
    amounts from different years? Why would we
    want to do this, anyway?
    • How can we correct interest rates for inflation?
    The Consumer Price Index (CPI)
     measures the typical consumer’s cost of living
     the basis of cost of living adjustments (COLAs)
    in many contracts and in Social Security
    How the CPI Is Calculated
    1. Fix the “basket.”
    The Bureau of Labor Statistics (BLS) surveys
    consumers to determine what’s in the typical
    consumer’s “shopping basket.”
    2. Find the prices.
    The BLS collects data on the prices of all the
    goods in the basket.
    3. Compute the basket’s cost.
    Use the prices to compute the total cost of the
    basket.
    How the CPI Is Calculated
    4. Choose a base year and compute the index.
    The CPI in any year equals
    cost of basket in current year
    100 x
    cost of basket in base year

    5. Compute the inflation rate.


    The percentage change in the CPI from the
    preceding period.
    Inflation CPI this year – CPI last year
    = x 100%
    rate CPI last year
    EXAMPLE basket: {4 pizzas, 10 lattes}

    price of price of
    year cost of basket
    pizza latte
    2010 $10 $2.00 $10 x 4 + $2 x 10 = $60
    2011 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
    2012 $12 $3.00 $12 x 4 + $3 x 10 = $78

    Compute CPI in each year usingInflation


    2010 base
    rate:year:
    2010: 100 x ($60/$60) = 100 115 – 100
    15% = x 100%
    100
    2011: 100 x ($69/$60) = 115
    130 – 115
    13% = x 100%
    2012: 100 x ($78/$60) = 130 115
    ACTIVE LEARNING 1
    Calculate the CPI price price of
    CPI basket: of beef chicken
    {10 lbs beef, 2010 $4 $4
    20 lbs chicken}
    2011 $5 $5
    The CPI basket cost $120
    in 2010, the base year. 2012 $9 $6

    A. Compute the CPI in 2011.

    B. What was the CPI inflation rate from 2011–2012?


    ACTIVE LEARNING 1
    Answers price price of
    CPI basket: of beef chicken
    {10 lbs beef, 2010 $4 $4
    20 lbs chicken}
    2011 $5 $5
    The CPI basket cost $120
    in 2010, the base year. 2012 $9 $6

    A. Compute the CPI in 2011:


    Cost of CPI basket in 2011
    = ($5 x 10) + ($5 x 20) = $150

    CPI in 2011 = 100 x ($150/$120) = 125


    ACTIVE LEARNING 1
    Answers price price of
    CPI basket: of beef chicken
    {10 lbs beef, 2010 $4 $4
    20 lbs chicken}
    2011 $5 $5
    The CPI basket cost $120
    in 2010, the base year. 2012 $9 $6

    B. What was the inflation rate from 2011–2012?


    Cost of CPI basket in 2012
    = ($9 x 10) + ($6 x 20) = $210
    CPI in 2012 = 100 x ($210/$120) = 175
    CPI inflation rate = (175 – 125)/125 = 40%
    What’s in the CPI’s Basket?
    4% 3% Housing
    6%
    Transportation
    6%
    Food & Beverages
    6% 43%
    Medical care

    Recreation

    Education and
    15%
    communication
    Apparel

    17% Other
    ACTIVE LEARNING 2
    Substitution bias
    CPI basket:
    cost of CPI
    {10# beef, beef chicken
    basket
    20# chicken}
    2010 $4 $4 $120
    2010–11:
    2011 $5 $5 $150
    Households
    bought CPI basket. 2012 $9 $6 $210

    2012: Households bought {5 lbs beef, 25 lbs chicken}.

    A. Compute cost of the 2012 household basket.


    B. Compute % increase in cost of household basket
    over 2011–12, compare to CPI inflation rate.
    ACTIVE LEARNING 2
    Answers
    CPI basket: cost of CPI
    {10# beef, beef chicken
    basket
    20# chicken}
    2010 $4 $4 $120
    Household
    basket in 2012: 2011 $5 $5 $150
    {5# beef, 2012 $9 $6 $210
    25# chicken}

    A. Compute cost of the 2012 household basket.


    ($9 x 5) + ($6 x 25) = $195
    ACTIVE LEARNING 2
    Answers
    CPI basket: cost of CPI
    {10# beef, beef chicken
    basket
    20# chicken}
    2010 $4 $4 $120
    Household
    basket in 2012: 2011 $5 $5 $150
    {5# beef, 2012 $9 $6 $210
    25# chicken}
    B. Compute % increase in cost of household basket
    over 2011–12, compare to CPI inflation rate.
    Rate of increase: ($195 – $150)/$150 = 30%
    CPI inflation rate from previous problem = 40%
    Problems with the CPI:
    Substitution Bias
     Over time, some prices rise faster than others.
     Consumers substitute toward goods that become
    relatively cheaper, mitigating the effects of price
    increases.
     The CPI misses this substitution because it uses
    a fixed basket of goods.
     Thus, the CPI overstates increases in the cost of
    living.
    Problems with the CPI:
    Introduction of New Goods
     The 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 this effect because it uses a
    fixed basket of goods.
     Thus, the CPI overstates increases in the cost of
    living.
    Problems with the CPI:
    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.
    Problems with the CPI
     Each of these problems causes the CPI to
    overstate cost of living increases.
     The BLS has made technical adjustments,
    but the CPI probably still overstates inflation
    by about 0.5 percent per year.
     This is important because Social Security
    payments and many contracts have COLAs tied
    to the CPI.
    Two Measures of Inflation, 1950–2010
    15

    10
    Percent per year

    -5
    1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
    CPI GDP deflator
    Contrasting the CPI and GDP Deflator
    Imported consumer goods:
     included in CPI
     excluded from GDP deflator
    Capital goods:
     excluded from CPI
     included in GDP deflator
    The basket:
    (if produced domestically)
     CPI uses fixed basket
     GDP deflator uses basket of
    currently produced goods & services
    This matters if different prices are
    changing by different amounts.
    ACTIVE LEARNING 3
    CPI vs. GDP deflator
    In each scenario, determine the effects on the
    CPI and the GDP deflator.
    A. Starbucks raises the price of Frappuccinos.
    B. Caterpillar raises the price of the industrial
    tractors it manufactures at its Illinois factory.
    C. Armani raises the price of the Italian jeans it
    sells in the U.S.
    ACTIVE LEARNING 3
    Answers
    A. Starbucks raises the price of Frappuccinos.
    The CPI and GDP deflator both rise.
    B. Caterpillar raises the price of the industrial
    tractors it manufactures at its Illinois factory.
    The GDP deflator rises, the CPI does not.
    C. Armani raises the price of the Italian jeans it
    sells in the U.S.
    The CPI rises, the GDP deflator does not.
    Correcting Variables for Inflation:
    Comparing Dollar Figures from Different Times
     Inflation makes it harder to compare dollar
    amounts from different times.
     Example: the minimum wage
     $1.15 in Dec 1964
     $7.25 in Dec 2010
     Did min wage have more purchasing power in
    Dec 1964 or Dec 2010?
     To compare, use CPI to convert 1964 figure into
    “today’s dollars”…
    Correcting Variables for Inflation:
    Comparing Dollar Figures from Different Times

    Amount Amount Price level today


    in today’s = in year T x
    dollars dollars Price level in year T

     In our example,
     “year T” is 12/1964, “today” is 12/2010
     Min wage was $1.15 in year T
     CPI = 31.3 in year T, CPI = 220.3 today
    The minimum wage 220.3
    in 1964 was $8.09 $8.09 = $1.15 x
    31.3
    in today’s (2010) dollars.
    Correcting Variables for Inflation:
    Comparing Dollar Figures from Different Times
     Researchers, business analysts, and policymakers
    often use this technique to convert a time series of
    current-dollar (nominal) figures into constant-dollar
    (real) figures.
     They can then see how a variable has changed
    over time after correcting for inflation.
     Example: the minimum wage, from Jan 1960 to
    Dec 2010…
    The U.S. Minimum Wage in Current Dollars
    and Today’s Dollars, 1960–2010
    $12.00

    2010 dollars
    $10.00
    Dollars per hour

    $8.00

    $6.00

    $4.00

    $2.00
    current dollars

    $0.00
    1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
    ACTIVE LEARNING 4
    Comparing tuition increases
    Tuition and Fees at U.S. Colleges and Universities
    1990 2010
    Private non-profit 4-year $9,340 $27,293

    Public 4-year $1,908 $7,605

    Public 2-year $906 $2,713


    CPI 130.7 218.1

    Instructions: Express the 1990 tuition figures in 2010


    dollars, then compute the percentage increase for all
    three types of schools. Which type experienced the
    largest increase in real tuition costs?
    ACTIVE LEARNING 4
    Answers
    1990 2010 % change
    CPI 130.7 218.1 66.9%
    Private non-profit 4-year
    $9,340 $27,293
    (current $)
    Private non-profit 4-year
    $15,586 $27,293 75.1%
    (2010 $)
    Public 4-year (current $) $1,908 $7,605

    Public 4-year (2010 $) $3,184 $7,605 138.9%

    Public 2-year (current $) $906 $2,713

    Public 2-year (2010 $) $1,512 $2,713 79.4%


    Correcting Variables for Inflation:
    Indexation

    A dollar amount is indexed for inflation


    if it is automatically corrected for inflation
    by law or in a contract.

    For example, the increase in the CPI automatically


    determines
     the COLA in many multi-year labor contracts
     adjustments in Social Security payments and
    federal income tax brackets
    Correcting Variables for Inflation:
    Real vs. Nominal Interest Rates
    The nominal interest rate:
     the interest rate not corrected for inflation
     the rate of growth in the dollar value of a
    deposit or debt
    The real interest rate:
     corrected for inflation
     the rate of growth in the purchasing power of a
    deposit or debt
    Real interest rate
    = (nominal interest rate) – (inflation rate)
    Correcting Variables for Inflation:
    Real vs. Nominal Interest Rates

    Example:
     Deposit $1,000 for one year.
     Nominal interest rate is 9%.
     During that year, inflation is 3.5%.
     Real interest rate
    = Nominal interest rate – Inflation
    = 9.0% – 3.5% = 5.5%
     The purchasing power of the $1000 deposit
    has grown 5.5%.
    Real and Nominal Interest Rates in the U.S.,
    1950–2010
    SUMMARY

    • The Consumer Price Index is a measure of the


    cost of living. The CPI tracks the cost of the
    typical consumer’s “basket” of goods & services.
    • The CPI is used to make Cost of Living
    Adjustments and to correct economic variables
    for the effects of inflation.
    • The real interest rate is corrected for inflation
    and is computed by subtracting the inflation rate
    from the nominal interest rate.

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