Chapter 2 Measuring The Cost of Living
Chapter 2 Measuring The Cost of Living
Chapter 2 Measuring The Cost of Living
Principles of
Economics
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How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.
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How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
cost of basket in current year
100 x
cost of basket in base year
price of price of
year cost of basket
pizza latte
2010 $10 $2.00 $10 x 4 + $2 x 10 = $60
2011 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2012 $12 $3.00 $12 x 4 + $3 x 10 = $78
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ACTIVE LEARNING 1
Calculate the CPI price price of
CPI basket: of beef chicken
{10 lbs beef, 2010 $4 $4
20 lbs chicken}
2011 $5 $5
The CPI basket cost $120
in 2010, the base year. 2012 $9 $6
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ACTIVE LEARNING 1
Answers price price of
CPI basket: of beef chicken
{10 lbs beef, 2010 $4 $4
20 lbs chicken}
2011 $5 $5
The CPI basket cost $120
in 2010, the base year. 2012 $9 $6
Medical care
Recreation 15.0%
Education and
communication
Other goods
and services 41.0%
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ACTIVE LEARNING 2
Substitution bias
CPI basket:
cost of CPI
{10 lbs beef, beef chicken
basket
20 lbs chicken}
2010 $4 $4 $120
In 2010 and 2011,
2011 $5 $5 $150
households
bought CPI basket. 2012 $9 $6 $210
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ACTIVE LEARNING 2
Answers
CPI basket: cost of CPI
{10 lbs beef, beef chicken
basket
20 lbs chicken}
2010 $4 $4 $120
Household
basket in 2012: 2011 $5 $5 $150
{5 lbs beef, 2012 $9 $6 $210
25 lbs chicken}
B. Compute % increase in cost of household basket
over 2011–12, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
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Problems with the CPI:
Substitution Bias
Over time, some prices rise faster than others.
Consumers substitute toward goods that become
relatively cheaper, mitigating the effects of price
increases.
The CPI misses this substitution because it uses
a fixed basket of goods.
Thus, the CPI overstates increases in the cost of
living.
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Problems with the CPI:
Introduction of New Goods
The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
In effect, dollars become more valuable.
The CPI misses this effect because it uses a
fixed basket of goods.
Thus, the CPI overstates increases in the cost of
living.
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Problems with the CPI:
Unmeasured Quality Change
Improvements in the quality of goods in the
basket increase the value of each dollar.
The BLS tries to account for quality changes
but probably misses some, as quality is hard to
measure.
Thus, the CPI overstates increases in the cost of
living.
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Problems with the CPI
Each of these problems causes the CPI to
overstate cost of living increases.
The BLS has made technical adjustments,
but the CPI probably still overstates inflation
by about 0.5 percent per year.
This is important because Social Security
payments and many contracts have COLAs tied
to the CPI.
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Two Measures of Inflation, 1960–2013
15
Percent change per year
10
-5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
GDP deflator CPI
Contrasting the CPI and GDP Deflator
Imported consumer goods:
included in CPI
excluded from GDP deflator
Capital goods:
excluded from CPI
included in GDP deflator
The basket:
(if produced domestically)
CPI uses fixed basket
GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.
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ACTIVE LEARNING 3
CPI vs. GDP deflator
In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
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ACTIVE LEARNING 3
Answers
A. Starbucks raises the price of Frappuccinos.
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.
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Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
Inflation makes it harder to compare dollar
amounts from different times.
Example: the minimum wage
$1.25 in Dec 1963
$7.25 in Dec 2013
Did min wage have more purchasing power in
Dec 1963 or Dec 2013?
To compare, use CPI to convert 1963 figure into
“2013 dollars”…
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Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
In our example,
“year T” is 12/1963, “today” is 12/2013
Min wage was $1.25 in year T
CPI = 30.9 in year T, CPI = 234.6 today
The minimum wage 234.6
in 1963 was $9.49 $9.49 = $1.25 x
30.9
in 2013 dollars.
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Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
Researchers, business analysts, and policymakers
often use this technique to convert a time series of
current-dollar (nominal) figures into constant-dollar
(real) figures.
They can then see how a variable has changed
over time after correcting for inflation.
Example: the minimum wage…
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The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1960–2013
$12
2013 dollars
$10
Dollars per hour
$8
$6
$4
$2
current dollars
$0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
ACTIVE LEARNING 4
Comparing tuition increases
Tuition and Fees at U.S. Colleges and Universities
1990 2013
Private non-profit 4-year $9,340 $30,094
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Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
The nominal interest rate:
the interest rate not corrected for inflation
the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
corrected for inflation
the rate of growth in the purchasing power of a
deposit or debt
Real interest rate
= (nominal interest rate) – (inflation rate)
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Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
Example:
Deposit $1,000 for one year.
Nominal interest rate is 9%.
During that year, inflation is 3.5%.
Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
The purchasing power of the $1000 deposit
has grown 5.5%.
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Real and Nominal Interest Rates in the U.S.,
1950–2013
15
10
(percent per year)
Interest rate
-5
-10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Nominal Real
Summary
• The Consumer Price Index is a measure of the
cost of living. The CPI tracks the cost of the
typical consumer’s “basket” of goods & services.
• The CPI is used to make Cost of Living
Adjustments and to correct economic variables
for the effects of inflation.
• The real interest rate is corrected for inflation
and is computed by subtracting the inflation rate
from the nominal interest rate.
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