Chapter 24: Measuring the Cost of Living

• The Consumer Price Index (CPI) is used to monitor changes in the cost of living over time. The inflation rate can be measured using this.

Chapter 24.1: The Consumer Price Index

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

• Bureau of Labor Statistics (BLS): a department that computes and reports the CPI

• 24.1a: How the CPI Is Calculated

  • 5 steps used to calculate CPI that the BLS follows

    • Fix the basket: determine which goods are more common and have more weight than other products.

    • Find the prices: find the average prices of the basket goods in several periods of time

    • Compute the basket’s cost: Use data to calculate the cost of the basket in several periods of time

    • Choose a base year and compute the index: Use one year as a comparison similar to a benchmark.

    • Compute the inflation rate.  Inflation rate in year 2 = [(CPI in year 2 - CPI in year 1) / CPI in year 1] * 100

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

  • Core CPI: a measure of the overall cost of consumer goods and services excluding food and energy.

  • Producer price index (PPI): a measure of the cost of a basket of goods and services bought by firms

• 24.1b: Problems in Measuring the Cost of Living

  • Substitution bias: when some prices in a basket change unproportionately compared to others

    • Consumers respond to raised prices by buying less of that product

    • If an index measures a fixed basket of goods, it ignores consumer substitution and overstates an increase in the cost of living

  • Introduction of new goods: when a new product enters the market, giving consumers more options to choose from

    • If an index measures a fixed basket of goods, it does not show the increase in the value of a dollar that comes from the introduction of a new good

  • Unmeasured quality change: when the quality of a good lessens with time

    • If an index measures a fixed basket of goods, changes in quality are not accurately measured

• 24.1c: The GDP Deflator versus the Consumer Price Index

  • The GDP deflator is the ratio of nominal GDP to real GDP. It reflects the current level of prices relative to the level of prices in the base year

  • The GDP deflator reflects the prices of all goods and services produced domestically. THe CPI reflects this, but only the goods and services bought by customers.

  • The CPI uses a fixed basket to measure values, while the GDP deflator compares the price of currently produced goods and services

Chapter 24.2: Correcting Economic Variables for the Effect of Inflation

• 24.2a: Dollar Figures from Different Times

  • Amount in today’s dollars = Amount in year T dollars X (price level today/price level in year T)

  • A price index determines the size of the inflation correction

• 24.2b: Indexation

  • Indexation: the automatic correction by law or contract of a dollar amount for the effects of inflation

  • Cost-of-living allowance (COLA): a provision which automatically raises the wage when the CPI rises

• 24.2c: Real and Nominal Interest Rates

  • Correcting economic variables for the effects of inflation is important

  • The higher the rate of inflation, the smaller the purchasing power.

  • The higher the rate of deflation, the bigger they purchasing power

  • 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