Chapter 24 Measuring The Cost of Living

Chapter 24
Measuring the Cost of Living
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or 1
posted to a publicly accessible website, in whole or in part.
The Consumer Price Index
• Consumer price index (CPI)
– Measure of the overall level of prices
– Measure of the overall cost of goods and
services
– Bought by a typical consumer
– Computed and reported every month by
the Bureau of Labor Statistics
Calculating CPI, Part 1
1. Fix the basket
– Which prices are most important to the typical
consumer
– Different weight
2. Find the prices
– At each point in time
3. Compute the basket’s cost
– Same basket of goods
– Isolate the effects of price changes
Calculating CPI, Part 2
4. Chose a base year and compute the CPI
– Base year = benchmark
• Price of basket of goods and services in current
year
• Divided by price of basket in base year
• Times 100
5. Compute the inflation rate
Table 1 Calculating the Consumer Price Index and
the Inflation Rate: An Example, Part 1
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 5
Table 1 Calculating the Consumer Price Index and
the Inflation Rate: An Example, Part 2
The Consumer Price Index, Part 1
• Inflation rate
– 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
– Changes in PPI are often thought to be
useful in predicting changes in CPI
Figure 1 The Typical Basket of Goods and Services
• Problems in measuring the cost of living

– Substitution bias
• Prices do not change proportionately
• Consumers substitute toward goods that have
become relatively less expensive
– Introduction of new goods
• More variety of goods
– Unmeasured quality change
• Changes in quality
GDP Deflator Versus CPI, Part 1
• GDP deflator
– Ratio of nominal GDP to real
GDP
– Reflects prices of all goods &
services produced
domestically
• CPI
“The price may seem a
– Reflects prices of goods & little high, but you have
to remember that’s in
services bought by consumers today’s dollars.”
GDP Deflator Versus CPI, Part 2
• GDP deflator
– Compares the price of currently produced goods
and services
• To the price of the same goods and services in the
base year
• CPI
– Compares price of a fixed basket of goods and
services
• To the price of the basket in the base year
Figure 2 Two Measures of Inflation
Correcting Economic Variables, Part 1
• Dollar figures from different times
A price index such as the CPI

– Measures the price level and thus
determines the size of the inflation
correction
Regional Differences in the Cost of Living, Part 1
• The cost of living varies

– Not only over time
– But also over geography
• Regional price parities
– Measure variation in the cost of living
from state to state.
Regional Differences in the Cost of Living, Part 2
• Regional differences explained by

– Prices of goods – small part
– Prices of services – larger part
– Housing services – persistently large
Correcting Economic Variables, Part 2
• Indexation
– Automatic correction by law or contract
– Of a dollar amount
– For the effects of inflation
– COLA: Cost-of-living allowance
Real and Nominal Interest Rates
• 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 rate
Interest Rates in the U.S. Economy
• Nominal interest rate

– Always exceeds the real interest rate
– U.S. economy has experienced rising
consumer prices in every year
• Inflation is variable
– Real and nominal interest rates do not always
move together
• Periods of deflation
– Real interest rate exceeds the nominal interest
rate
Figure 4 Real and Nominal Interest Rates

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Chapter 24

Measuring the Cost of Living

• Producer price index, PPI

• Problems in measuring the cost of living

• Dollar figures from different times

A price index such as the CPI

• The cost of living varies

• Regional differences explained by

• Nominal interest rate

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