Chapter 24: Measuring the Cost of Living

• A dollar today doesn’t buy as much as it did 20 years ago. The cost
of almost everything has gone up.
• This increase in the overall level of prices is called inflation, and it
is one of the primary concerns of economists and policy makers.`
• The inflation rate is the percentage change in the price level from
the previous period.
• 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.
 Bureau of Labor Statistics undertakes Consumer Expenditure
Survey and the CPI market basket is developed from detailed
expenditure information provided by families and individuals on
what they actually bought.
 Calculating CPI
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

2
 Calculating CPI
4. Chose a base year and compute the CPI
– Base year = benchmark
• Price of basket of goods & services in
current year
• Divided by price of basket in base year
• Times 100
5. Compute the inflation rate

3
 Table 1: Calculating the Consumer Price Index and
the Inflation Rate: An Example

 This table shows how to calculate the CPI and the inflation rate
for a hypothetical economy in which consumers buy only hot
dogs and hamburgers.
Table 2: Calculating the Consumer Price Index and
the Inflation Rate: An Example

 This table shows how to calculate the CPI and the inflation rate
for a hypothetical economy in which consumers buy only hot
dogs and hamburgers.
 The Consumer Price Index
• The CPI is used to monitor changes in the cost of living
over time. When the CPI rises, the typical family has to
spend more money to maintain the same standard of
living.
• Inflation rate
– Percentage change in the price index from the
preceding period.
• 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
6
 Figure 1: The Typical Basket of Goods and Services

 This figure shows how the typical consumer divides spending among various
categories of goods and services. The Bureau of Labor Statistics calls each
percentage the “relative importance” of the category.

 The goods in the basket are often adjusted periodically to account for changes
in consumer habits.
 The Consumer Price Index

When the CPI rises, the typical family

has to spend more dollars to maintain
the same standard of living.
 The Consumer Price Index
• Problems in measuring the cost of living
– Substitution bias
• Consumers substitute toward goods that
have become relatively less expensive
– Introduction of new goods
• More variety of goods
– Unmeasured quality change
• Changes in quality
 Substitution Bias
• The basket does not change to reflect
consumer reaction to changes in relative
prices.
• Consumers substitute toward goods that
have become relatively less expensive.
• The index overstates the increase in cost of
living by not considering consumer
substitution.
 Introduction of New Goods
• Since CPI is based on a fixed basket of goods and
services, it does not reflect the change in purchasing
power brought on by the introduction of new
products.

• New products result in greater variety, which in turn

makes each dollar more valuable.
• Consumers need fewer dollars to maintain any given
standard of living.
 Unmeasured Quality Changes
• The third problem with the CPI is unmeasured quality change.
• If the quality of a good rises from one year to the next while its
price remains the same, the value of a dollar rises, because you
are getting better quality of goods for the same amount of
money.

• If the quality of a good falls from one year to the next while the
price of the good stays the same, the value of a dollar falls,
because you are getting a lesser good for the same amount of
money.

• Quality change bias Quality improvements generally are

neglected, so quality improvements that lead to price hikes are
considered purely inflationary.
 Problems in Measuring the Cost of Living
• The substitution bias, introduction of new goods, and
unmeasured quality changes cause the CPI to
overstate the true cost of living.

• The issue is important because many

government programs use the CPI to adjust
for changes in the overall level of prices.

• The CPI overstates inflation by about 1

percentage point per year.
 GDP Deflator Versus CPI
• GDP deflator
– Ratio of nominal GDP to real GDP
– Reflects prices of all goods & services produced
domestically
• CPI
– Reflects prices of goods & services bought by
consumers
 Thus, an increase in the prices of goods bought by
firms or the government will show up in the GDP
deflator but not in the CPI.

14
 GDP Deflator Versus CPI
• The second difference is that GDP deflator includes only
those goods produced domestically. Imported goods are
not part of GDP and do not show up in the GDP deflator.
• Hence, an increase in the price of a Toyota made in Japan
and sold in USA affects the CPI in USA, but it doesn’t
affect the GDP deflator.
• The third and most subtle difference results from the way
the two measure aggregate the many prices in the
economy.
• In other words, the CPI is computed using a fixed basket
of goods, whereas the GDP deflator allows the basket of
goods to change over time as the composition of GDP
changes.
 GDP deflator Versus CPI
• 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.
 GDP deflator versus CPI
Example 1:
 Suppose that a major frost destroys the nation’s
orange crop. The quantity of oranges produced falls
to zero, and the price of the few oranges that remain
on grocers’ shelves is driven sky-high.
• Because oranges are no longer part of GDP, the
increase in the price of oranges doesn’t show-up in
the GDP deflator. But because the CPI is computed
with a fixed basket of goods that includes oranges,
the increase in the price of oranges causes a
substantial rise in the CPI.
Example 2:
 Suppose that the price of an airplane produced by
Boeing and sold to the Air Force rises. Even though
the plane is part of GDP, it is not part of the basket of
goods and services bought by a typical consumer.
 Thus the price increase shows up in the GDP deflator
but not in the CPI.
Example 3:
 Suppose that Volvo raises the prices of its cars. A
price increase shows up in the consumer price index
but not in the GDP deflator.
Example 4:
A. Starbucks raises the price of Cappuccinos: 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.
• Economists call a price index with a fixed basket of
goods a Laspeyres index (e.g. CPI) and a price index
with a changing basket a Paasche index (e.g. GDP
deflator).
• Which prices indices is a better measure of the cost of
living? Neither is clearly superior.
• When prices of different goods are changing by
different amounts, a Laspeyres (fixed basket) index
tends to overstate the increase in the cost of living.
• Because it does not take into account that consumers
have the opportunity to substitute less expensive
goods for more expensive ones.
• By contrast, a Paasche (changing basket) index tends to
understate the increase in the cost of living.
• Although it accounts for the substitution of alternative goods, it
does not reflect the reduction in consumers’ welfare that may
result from such substitutions.
• For instance, CPI overstates the impact of the increase in orange
prices on consumers: by using a fixed basket of goods, it ignores
consumers’ ability to substitute apples for oranges.

• By contrast, GDP deflator understates the impact on consumers:

it shows no rise in prices, yet surely the higher price of oranges
makes consumers worse off.

• Luckily, the difference between the GDP deflator and the CPI is
usually not large in practice.
 Figure 2: Two Measures of Inflation

This figure shows the inflation rate—the percentage change in the level of prices
— as measured by the GDP deflator and the consumer price index. Notice that
the two measures of inflation generally move together.
 Correcting Economic Variables
• Dollar figures from different times

• Indexation
– Automatic correction by law or contract
– Of a dollar amount
– For the effects of inflation
– COLA
• Cost of living allowance
 Dollar Figures from Different Times
• Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2001:
 Regional differences in the cost of living
• 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.
 Figure 3: Regional Variation in the Cost of Living
• This figure shows how
the cost of living in the
fifty U.S. states and the
District of Columbia
compares to the U.S.
average.
 Regional differences in the cost of living
• Regional differences explained by
– Prices of goods – small part
– Prices of services – larger part
– Housing services – persistently large
 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

The real interest rate is the nominal interest rate minus the inflation rate as
measured by the consumer price index. Notice that nominal and real interest
rates often do not move together.
 Who Gains and Who Loses from Inflation?
• Inflation implies a general increase in prices and a
corresponding decrease in money's purchasing power.
• As a result of higher inflation, borrowers benefit from a
general increase in prices or a reduction in purchasing
power.
• In other words, if higher than expected inflation occurs,
then the real value of the borrower's debt is reduced.
• Assume that banks lend billions of dollars at a fixed
nominal interest rate of 5%. If inflation were to
unexpectedly increase from 2% to 4%, then borrowers'
real interest rate paid would be reduced from 3% to 1%.
 Example 2
• Suppose Sara deposits $1,000 in a bank account that pays
an annual interest rate of 10 percent. A year later, after
Sara has accumulated $100 in interest, she withdraws her
$1,100. Is Sara $100 richer than she was when she made
the deposit a year earlier?
• Sara does not care about the amount of money itself: She
cares about what she can buy with it.
• If prices have risen while her money was in the bank,
each dollar now buys less than it did a year ago.
• In this case, her purchasing power-the amount of goods
and services she can buy-has not risen by 10 percent.
 Summary
 The consumer price index shows the
cost of a basket of goods and services
relative to the cost of the same basket in
the base year.
 The index is used to measure the overall
level of prices in the economy.
 The percentage change in the CPI
measures the inflation rate.
 Summary
 The consumer price index is an imperfect measure
of the cost of living for the following three reasons:
 Substitution bias

 The introduction of new goods, and

 Unmeasured changes in quality.

 Because of measurement problems, the CPI

overstates annual inflation by about 1 percentage
point.
 Summary
• The GDP deflator differs from the CPI because
it includes goods and services produced rather
than goods and services consumed.
• In addition, the CPI uses a fixed basket of
goods, while the GDP deflator automatically
changes the group of goods and services over
time as the composition of GDP changes.
• The real interest rate equals the nominal
interest rate minus the rate of inflation.