• 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