JP

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.

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

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

Problems in Measuring the Cost of Living

  • Substitution bias: when some prices in a basket change disproportionately 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

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

24-2 Correcting Economic Variables for the Effect of Inflation

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

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 that automatically raises the wage when the CPI rises

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 the 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